The Battle of the Forces: Reflation vs. Deflation

In the conclusions to my latest newsletter I noted that, “Nearly every analyst is saying the market has come too far too fast and needs a pullback. Great, let’s have one.” Now I want to consider the pullback scenario further. While it’s true that when “nearly every analyst” says something, that thing is probably wrong, still I think it might be reasonable for investors to take steps to protect the portfolio gains of the past couple of months in preparation for a potentially serious pullback.

Let’s hope that it is truly “always darkest before the dawn” because the real economy to which the stock market is eventually linked is looking fairly dark right now. U.S. consumer spending, employment and business cap. ex. are all still falling, the auto industry contraction has further to go [it’s not clear to me that GM and Chrysler won’t ultimately be liquidated], and in Europe things actually look worse than they do here. In the northeast real estate agents tell me the standard bid for a house is 20% - 30% under the asking price, which bodes poorly for a leveling off in housing prices any time soon. The only positive indicator I know is the rising Baltic Dry Index - plus recent stock market gains.

Whether or not the U.S. economy can turn positive during the next 6 - 9 months is looking increasingly like a race between

1. reflationary forces, mainly spending by the Federal government, continued spending by wealthier Americans from their savings, and the growth of China and some other developing economies (Brazil, India, and Singapore maybe) against

2. deflationary forces including weak consumer spending by the growing number of unemployed and the worried-they-are-about-to-be-unemployed, cutbacks by state governments that must balance their budgets, the continuing downsizing of the auto industry and other businesses and downsizing by the even more desperate economies of Europe (especially Eastern Europe), Russia, and the third world.

It’s not clear to me that the forces for re-flation will work quickly enough and be strong enough to outweigh the deflationary forces of continuing job losses and continuing consumer de-leveraging. If not, then a return to economic growth may simply take a lot longer to achieve than anyone wants to think.

What de-leveraging means for economic recovery is that consumers will not use new borrowing to increase their expenditures and thus will not compensate for the continuing growth of unemployment that takes place during the last part of a recession and the early stages of a recovery.

John Mauldin said it well in his most recent weekly newsletter. Here’s an excerpt that concludes with his key point (in my opinion) that “we have not seen a deleveraging recession in the US for 80 years.”

From John Mauldin 5/16/09: The typical pundit keeps telling us unemployment is a lagging indicator, and that the recovery will be well under way before it shows up in the job numbers. Therefore, you should buy what they are selling, because the recovery is on its way. But that may not be the case this time. One of my favorite reads, when I get to see it, is the economic analysis from Bridgewater. They are among the best thinkers anywhere, and everyone who follows them gives them a great deal of credence. This is what they wrote about unemployment being a lagging indicator last month:

“Normally, labor markets lag the economy because incremental spending transactions are financed via debt, stimulated by interest rate cuts [my emphasis]. But as long as credit remains frozen, spending will require income, and income comes from jobs. And debt service payments are made out of income. Therefore, in a deleveraging environment job growth becomes an important leading, causal indicator of demand and other economic conditions [my emphasis].

… The deterioration in employment markets will continue because companies’ profit margins are so deeply damaged that a little bounce in growth won’t do much to alter their need to cut costs. This deterioration in labor markets will undermine demand and continue to pressure loan losses, which will keep the pressure on the banks and elevate the cost of capital for tentative borrowers, inhibiting credit expansion.

This again illustrates the problem of using past performance to project future results. You have to look at the underlying conditions in order to get a real comparison, and we have not seen a deleveraging recession in the US for 80 years. [my emphasis] Using the past data in today’s world is statistical masturbation: it may make you feel good, but it is not producing anything really useful, and may be harmful to your portfolio.

I would point to another factor holding back growth of OECD employment: the continuing impact of globalization. Competing with China, Mexico and other low-labor-cost countries for jobs (in the name of “free trade” which may be free but is certainly not fair) has been extremely debilitating to U.S. job creation for many years. It is still a headwind that the OECD worker must fight against.

Many simple souls (not PhDs in economics who know all about “comparative advantage”) have long asked how developed countries can compete against poor countries that have no social safety net or environmental controls without ultimately bankrupting the developed economies. Well, we may be finding out that such competition is not feasible on a sustained basis and that the developed countries will in fact be bankrupted in the long term if they keep exporting their jobs.

Implication for equities and oil

It’s always difficult to draw causal relationships between some forecasted economic scenario and the actions of the stock market. But it seems pretty clear that if the economy fails to show any sign of recovery over the next six months stocks are not likely to do well.

In sum, stocks rose after mid-March on relief that the banking system is not going to collapse. They kept going up on the hope for a V-shaped recovery. But the market will be disappointed if growth fails to appear in Q3 and Q4. If that turns out to be the case I suspect the market will get wind of it before it happens and will decline well in advance of the economic data being released. Such a decline could re-test of the March lows. If we get a re-test and it fails….ooops.

In terms of oil, a failure of the economy to start expanding has a less predictable impact. Yes, there is quite a bit of speculation to the $60 price of oil. A withdrawal or reversal of that speculation could bring oil down into the mid- to low-$40’s. On the other hand there are factors beyond the economic fate of OECD economies that could boost the oil price. They include political tensions - particularly in Iran and Nigeria - continuing rapid declines in existing oil fields, continuing lack of investment in new production, and the continuing growth of China, the Middle East and other developing economies that increases oil demand.

Bottom line: I’d still hold some equities related to oil, China, and “future energy needs” but I’d also add some hedges against potential broad market declines. I would sell cyclical non-oil stocks. I would not add to positions until there is some evidence that the economy is starting to stabilize. Simply having a lower rate of decline is no longer comforting to stockholders.

Whether or not markets do retreat over the next few months, it’s always good to remind ourselves that the amount of equities held in a portfolio should relate to one’s “tolerance for risk” - which means the amount of the portfolio that one is willing to see disappear in the short term in order to obtain the potential for it to appreciate significantly in the long term.

Here’s one way to quantify the issue: Assume that the downside risk to equity holdings is 33% from here (or you pick a number you like better). Visualize your current un-hedged holdings being worth 33% less. Would you still be sleeping well? If not, cut your un-hedged stock holdings back to the amount that would let you be comfortable or add hedges to the portfolio (stocks or options that will rise in a falling market).

Comments

[412703:]

Very well said

May 20 11:26 AM

[DONE_SONZ:]

GOLD

May 20 11:37 AM

[waf76:]

You can use temp employment as a leading indicator, that would be more precise.

May 20 11:45 AM

[Fighting Yoda:]

Deleveraging can only cause Deflation - too much excess capacity, too little demand and purchasing power (debt, job losses, lack of credit).

Here is an interesting read from the San Francisco Fed:
U.S. Household Deleveraging and Future Consumption Growth
www.frbsf.org/publicat...

May 20 01:42 PM

[Mayer Amsch...:]

I think that whenever the credit markets stop working properly we will see really crazy results and whip-sawing of stock prices. Even if the markets are functioning somewhat, it's because the feds are propping them up and we're going to see inefficient allocation as a result. So big drops and jumps are likely, the problem is timing, like in the 70s. My method isn't great, but it doesn't take too much of my time; I keep my regular accounts heavy in commodities, foreign currencies, commodity stocks and high yield foreign government bonds, and my IRA I try to buy dividend-yielding stocks on dips. I probably won't sell much unless the S&P breaks a thousand.

May 20 03:13 PM

[Jasper M:]

GOOD article. Much useful ideas.

May 20 03:33 PM

[Dirk McCoy:]

There are two extreme courses out of this- the first is reflation/inflation that will increase the price of oil and Chinese labor but will also provide incentives for investment and consumption. The second is protectionism, which will save some jobs at the cost of long term economic performance.

Every day we hear of protectionist actions- subsidizing American businesses, proposing higher taxes on foreign investment- and with the jobs and economic situation it's hard to blame them. But reflation via monetary growth is the better solution as it allows the market- not the Federal government- to determine which sectors need to grow and which need to shrink.

When an Asian laborer earns 10-15% what a US laborer earns, you really have to ask yourself how long we can maintain that imbalance in a world where information and expertise are fluid- and where the high growth markets are outside this country. Pulling back from involvement in the outside world would be a huge mistake long term.

May 20 04:24 PM

[whidbey:]

Which of the choices should we pull for / fear the most?

The deflation is likely the more worrisome.

Inflation is only slightly better, but the secret that Ph.D. economists don't like to discuss is, there is no received wisdom about what to do in a deflationary economy. Yet your arguments for Emerging market deflation is sound, and we should fear that happening because if it does it is almost intractable to manage. Deflations lead to wars as fixes.

May 20 05:15 PM

[The Geoffster:]

Hard assets win this debate in my book. The deflation/reflation question will be resolved soon in favor of inflation as the FED well recognizes; hence, QE coupled with stimulus spending. The American dollar is a fiat currency. It has no intrinsic value. It is simply a medium of exchange which, up to now, everyone has accepted. Although governments cannot cure wealth destruction by printing money to replace the lost wealth and the short term effect of wealth destruction is deflationary, sooner or later, people recognize that the ratio of money to wealth is enormous and refuse to accept the debauched currency in exchange for their goods or services. By the time the central bankers put on the brakes, inflation has already entered the pipeline and it takes time to wring out the excess liquidity. Compound this reality with political pressures to keep interest rates low and massive, uncontrolable debt and you have a recipe for disaster.


On May 20 11:37 AM DONE_SONZ wrote:

> GOLD

May 20 09:49 PM

[johngonole:]

I'm just going to throw out an idea here. I haven't looked vetted this idea yet. Perhaps the solution would be to divert what capital we have left into improving our productive efficiency versus allowing the government to increase spending.

Lets face facts. Personal spending and business spending is slowing due to what is disposable versus the debt burden. The current solution is for govt. spending to increase to attempt to offset the resizing/right-sizing of the economy. The competitive pressure on wages from low wage overseas will continue.

Debt is too high and wages aren't going to explode anytime soon. In order to support wages and lower debt we need employment to improve and wages to at a minimum hold up. Govt deficit spending is risky because the spending must be invested in a way that will improve productivity and efficiency. The question can govt really do that very well.

Ron Paul was correct when he stated we must pull back our defense spending due to all the overseas operations. I would go one step further. We need to pull back on not only in spending on defense but many many other programs that produce nothing of value to the common man. We have universities full of professors who spend money in order to publish papers on research that in most cases in completely useless. Case in point is a study of the use of drugs in the rave scene in BRAZIL. If government spending doesn't produce something it needs to be seriously considered for a cut.

I propose huge government spending cuts. Hopefully so much that we could also get huge tax cuts while still balancing the budget. Or at least lower the deficit to realistic terms. The left over tax money would then be in the hands of people who know what to do with it. They can pay down their personal debts more quickly or invest it into improving productivity of their businesses. Both will help make us more competive.

I realize that at first glance the idea of the govt reducing spending is scary from a deflationary spiral standpoint. But the government is just as capable as the banks at pissing our money away into a black hole. That is really the problem. Capital has been misallocated for far to long in this country.

I would support realistic government research on real energy production. Ethanol is obviously not it. I think Geothermal, Nuclear are probably our best bet.

Whatever decisions are made. The only one that will work is the idea that improves our productivity. Afterall productivity is where real wealth comes from. There could be zero currency in exisitance and if we were all productive we would be wealthy.

May 21 02:05 AM

[Gregman2:]

"Competing with China, Mexico and other low-labor-cost countries for jobs (in the name of “free trade” which may be free but is certainly not fair) has been extremely debilitating to U.S. job creation for many years." When our global corporations and ownership classes sell manufacturing-supply chains to foreign interests, they get cash but workers aren't left with much. Where would the job creation come from at this point? The green industries? The auto industry?

May 21 01:41 PM