In a market bounded by deflationary tendencies (rising savings rate, aging population, risk aversion), inflationary impulses (budget deficit in excess of 10% of GDP, huge expansion of Fed balance sheet), low private consumption (with 10% unemployment by a generous count), and rising government consumption, there is little maneuvering room on any side. Credit remains the year’s best performer. Munis, which predominate in my personal account along with some bank preferreds picked up cheaply along the way, have traded with negative duration all year — more like equities than like Treasury bonds.
For the time being, and the time being might be measured in years, I expect all returns to be miserable across asset classes, with equities chopping sideways forever — as I’ve argued all year. But the big drop in commodity prices and emerging market stocks was the dip I was waiting for to increase portfolio exposure to hedges against poor credit performance in the future. The main risk to credit is that corporate and municipal debt will trade with duration once again, and with a vengeance. If inflation returns (and that is the longer-term risk), fixed cash flows will melt away. So what should one own?
I really don’t know. We are in an entirely new and disturbingly different environment. What I own for my personal account is energy stocks (such as the Vanguard Energy Fund), a global metals ETF, some gold mining stocks, and an ETF composed of Chinese blue chips. In a reflated world, China should surge ahead, as should commodity prices.
My prior is that America is likely to repeat the Japanese experience, with very loose monetary policy, very high savings rates, and low demand keeping prices low for some time. Demographics are pushing the world towards deflation, a factor often left out of monetary-based analysis. If that is true, solid (that is, too-big-to-fail) credits generating reliable cash flows should be the best thing to own. But the risk is that the dollar will go haywire and inflation will spike nonetheless — so very volatile inflation hedges, including companies that in effect are levered commodity plays, make sense.
On savings rates, the FT had the following analysis yesterday of the US Flow of Funds data:
Want to to know why US house prices are still tumbling and shops are vanishing from the high street? Check out the first quarter flow of funds data from the Federal Reserve. Personal funds were still pouring into real estate as recently as the third quarter of 2007. After that, when house prices really began to tank, net expenditure on housing drained out at a quarterly rate of between 4 and 8 per cent. During the first quarter of 2008, it dropped 13 per cent.
The data also show that Americans are finally waking up to the reality of saving. In spite of the recession kicking off over 18 months ago, personal financial flows only turned positive in the fourth quarter. Partly as a result, aggregate financial savings jumped from $90bn to $320bn this quarter, the biggest number in decades.
Even so, that rate of savings is equivalent to only 2.3 per cent of gross domestic product, having been almost twice that level during the 1990s recession and more than 6 per cent in the early 1980s. That is bad news for consumption, especially as the move to a savings culture is happening so late. In the first quarter, the ratio of gross household debt to disposable incomes fell only 2 percentage points to a still-whopping 127 per cent. At the current rate of saving – and assuming no change to incomes – it would still take 14 years to shrink the debt ratio to its average of 88 per cent since 1974.
Americans, as I’ve been arguing throughout, have only just begun to correct their dis-saving of the past ten years. That’s why deflation is still more probable than inflation.