Inflation vs. Deflation: What Are Investors Facing?

 |  Includes: FXI, PGJ, SPY
by: James Kar

Lately, there is lots of news about whether we are facing inflation or deflation. In the currency market, investors believe we are having hyperinflation, not just inflation. Thus, the US dollar keeps going down, and the long-term T-bonds yields have been going up and commodities prices are heading up. However, at the same time, the US production is low, the housing market is still not turning around, and the most important real wages are not going up. In this environment, it should be deflation, especially when consumers are not spending money.

Most economists think we are facing inflation soon because the US government has been printing a lot of money, by the billions. Based on economic theory, increasing money supply will increase inflation rate. The theory holds when consumers can access to easy money to buy things. As demand goes up, so do prices. However, this time is quite different. Consumers are deleveraging so they will not borrow more to buy things. When house prices were going up, consumers used their house equity as an ATM machine, taking money out to spend. Now, house prices are dropping so these consumers have no equity to borrow money. In fact, consumers are saving more now because of economic fear.

Furthermore, banks are tightening lending standards. Banks are lending but to the selected few. Therefore, even with all the money in the system, the inflation rate will remain low since consumers cannot access the money even if they need it. On the other hand, consumers are trying to lower their debt and to save more. Consumers are scare now and will think twice before spending. When companies are still laying off employees, consumers will not spend when they are worrying whether they will still have their jobs next month.

One important point is that the inflation theory is assuming the Federal Reserve (Fed) will leave the money in the system. Last time, the Fed left the money supply intact too long, thus creating the housing bubble. I do not think the Fed will make the same mistake twice. In other words, the Fed will start draining the money out of the system when the economy shows signs of recovery. This leads to my economic recovery shape – W. As the US economy starts to recover, it will drop back down again when the Fed starts to decrease the money supply or actually to take money out of the system. The Fed can only jump start the economy with the money supply but the economic recovery can only sustain with real economic growth, not from artificial money growth model. If the Fed withdraws the money timely, then inflation will remain low. Otherwise, we will see hyperinflation if the Fed leaves the money in the system too long – just like the tech and housing bubble.

What I worry about is spending by China. The Chinese government has been buying commodities from copper to oil. China wants to secure natural resources for its economic growth, especially when oil hit $145 dollars last year. In order to secure constant and reliable sources, the China government has been establishing reserves and signing contracts with commodity countries, like Russia and Australia. This is particularly true when the Chinese government wants to diversify away from US dollars. The Chinees government has lost some confidence in the way the US handles its monetary policy. Since the Chinese government holds more than $1 trillion US dollar in reserves, any dollar deprecation greatly affects its holding value. Nevertheless, as economists have argued: what else can the Chinese government buy if not US dollars? Obviously, China will not buy Euros since Europe is in even worse shape. Therefore, there is no other currency the Chinese government can put its reserves. This argument is true. Thus, the Chinese government has been buying up natural resources instead. In fact, the last figures show that the Chinese government has been buying fewer T-bonds. Of course, China's government cannot just unload its US dollars since it will collapse the dollar, but it can buy less and less.

Another way to diversify US dollar holdings is for the International Monetary Fund (IMF) to issue “special drawing rights”. The Chinese government has been arguing to use “special drawing rights” for a while now. I will discuss this issue in my next article.

Bottom line: We will not see inflation in the near future. The dollar will remain weak and the US economy may be stagnant for a while.

Investment strategies: Allocate less in the US stock market and more in emerging countries, commodities, especially natural gas; and even foreign currencies.

On a side issue: I am worrying whether the economies of the emerging countries are decoupling from the US. Thus, the rest of the world may be recovering while the US is still in a recession. In other words, the issue is whether the US will be just like Japan in its lost decades. Of course, others will argue that there is no such thing as decoupling from US consumers. If the US consumers do not spend, these exporting oriented emerging countries will not recover, period. However, I do not think the decoupling issue is that simple. I will attempt to address this issue in the future.