We decided that it was worth sharing our views of the inflation/deflation debate with all of our readers. In our weekly newsletter we are already positioned to take advantage of some of the current as well as potential trends that will benefit from our scenario.
The following are our views on different parts of the puzzle that show that we are currently in, and will likely be experiencing deflation for longer then most people seem to think.
Here are some interesting, and unfortunately not surprising, savings rate numbers. The current savings rate is 5.7%, the all time high in 5/1/75 was 14.6%, the all time low was in 8/1/05 with a savings rate of -2.7%, the historical average is 6.8%, and the 10-Year average is 1.7%. As you can see in the chart (click to enlarge) the past year has seen a huge uptick in the savings rate as consumers are trying to pay off debt and save some money.
Personal Saving Rate
Of course as savings go up, spending goes down. While this is good for the individual household it is a negative for the overall economy as it means less money is being spent on items from housing to cars to clothes. While this could just be an abnormal blip in the scheme of things there are several reasons to think that this time, the trend will hold for a while.
Baby boomers as a group don’t have anywhere near the funds they'd need to retire. After 2008 wiped out 42% of the world's wealth they should be scared and saving for their rapidly approaching retirements. Once the economy starts to pick up they may very well start spending like it was 1999 again but we don’t think that they will, because while most people are ok with the idea of working a bit past the age of 65, they do not plan on working into their 80’s and 90’s.
If the savings rate gets back up to the historical average of 6.8% or higher and then stays there for a while, it will be a huge drag on the economy. As consumers buy less and less, pricing will likely come down. We are already seeing this in the form of huge sales in stores across the nation. Many retailers have already had several markdown sales and it is safe to assume that this trend will continue for at least the next year or so. If our projections are right and the savings rate gets back to “normal” we will likely see a re-pricing as most businesses just accept that fact that their profit margins will be smaller going forward.
The monthly proclamations of a bottom by the NAR notwithstanding we have yet to see anything resembling a bottom in real estate. The Case Shiller 10-City index is down 33% from its peak and the 20-City index is down 32%. Both charts (click to enlarge) look the same, which is to say each month is lower then the last month. So far there has been no bottom.
Case Shiller 10-City Index
Not surprisingly housing sales numbers don’t look much better. In spite of the monthly bottom calling we continue to see more new lows every few months. As you can see in the chart below (click to enlarge) we are just off of new all time lows since the data series started in 1963.
SA Housing Sales
Zooming in a bit you can see that while we have had several blips over the last few years none of them have lasted for more then a few months and all have led to new lows. Our best guess is that we are headed lower in the next few months.
SA Housing Sales-A Closer Look
As if residential housing was not enough, the commercial real estate market is playing catch up. Residential peaked in June 2006 and commercial held up until October of 2007. Since October of last year however commercial has made a valiant effort to catch up and is now down -29.48% since then. In fact from March to April alone it dropped -8.62%. If real estate has found a bottom it is keeping its location secret because none of the data that we have seen points to it.
Moody’s REAL Commercial Property Price Index Composite (CPPI)
Of course you may be thinking that there has to be some commercial real estate that has found a bottom. This may be the case on a geographic basis but it is definitely not the case when it comes to segments of the commercial market. As you can see in the chart below (click to enlarge) industrial is the strongest part of the market and yet it is still down -14.26% from its highs. Apartments are next being down -19.01%, followed by retail which is down -23.11%, and finally office space which is down a whopping -30.22%. Judging by the massive drop this last quarter it is safe to assume that we have a ways to go before we really hit the bottom.
In case you haven’t noticed, employment has been horrible and getting worse. One of the newest “in indicators” is the exhaustion rate. While this indicator is not new it has luckily not garnered much attention over the years because it only gives a real signal once or twice a decade. The exhaustion rate is the rate at which people come off, or exhaust, their unemployment benefits without securing a job. Why is this the “it indicator” right now? Well if you look at the chart below (click to enlarge) you can see that we are not only at all time highs but are actually at 49.23%. Yes, that means that almost half of the unemployed are done receiving unemployment money. That of course leads to even less money to spend on anything.
After looking at the exhaustion rate chart it should come as no surprise that unemployment is high. In fact it is at its second highest level ever at 9.4%. As bad as unemployment is right now, it is going to get worse before it gets better. We will likely hit at least 11% ,and we would not be surprised to see 12-14% unemployment before jobs data bottoms out. (click on chart to enlarge)
At this point it should not be much of a surprise but as you can see in the chart below (click to enlarge), average weekly hours and non farm payrolls data are also both declining on a year over year basis.
Average Weekly Hours and Non Farm Payrolls
So how does all of this effect deflation? If people are not working then they are not able to spend as much on consumer goods and services. That includes clothing, food, entertainment, transportation, etc. If they stay unemployed long enough and fall off of their unemployment benefits then they are able to spend even less. Along with the lack of, or at least severely impaired, spending power there is a host of other side effects, which includes everything from defaulting on credit cards to defaulting on their mortgages. As consumers spend less, businesses have to lay off more employees as sales drop off and margins are squeezed which exacerbates the situation. One consistent relationship is that of the unemployment rate and capacity utilization (click on chart to enlarge). As unemployment rises, capacity utilization drops as demand falls out.
Unemployment and Capacity Utilization (inverted)
If there is no demand then there is no spending. If no one is spending then there can be no inflation. If things are contracting then we are in deflation. One more indicator that shows this is that of the output gap. The output gap is the difference between the amount that we can produce and the amount that we are currently producing. In the chart below (click to enlarge) a positive number indicates under-utilization, and negative numbers reflect over-utilization. If the line is rising things are getting worse and if it is declining things are improving. As you can see the line has risen quite a bit and at least for now is showing no signs of turning around. The output gap is a good indication of available demand. As you can see. the output gap is bad and getting worse as demand continues to decline.
While we could go on and on about banking we will try and keep it short. Most people are pointing to the charts from the Fed on bank reserves and saying that they will cause hyper inflation. Yes, the monetary base is at historic highs but guess what? Until that money is actually in circulation it does not cause inflation. You can print ten quadrillion dollars but if you bury it in a hole then it does not cause inflation.
Look at the chart below (click to enlarge) of the Adjusted Reserves. As you can see it is at record high levels. While it is extremely high it is not in circulation yet and likely will not make it to consumers for some time.
This number is extremely high due to all of the money that has been printed over the past year in response to the financial crisis. But the inflationistas are missing one important point, namely that until banks have rebuilt their reserves they will not be lending. As long as residential and commercial mortgage defaults continue banks will continue to rebuild their balance sheets. Once they have a stable asset base they will start lending and we will likely see some really high inflation but until then we will be in a deflationary environment as the money is not being put into circulation.
Commodities are another reason that many use to justify their inflation arguments. After having a good bull market from the end of 2002 until fall of 2007, they took off and got a bit parabolic for the first half of 2008 before crashing and coming back to levels not seen since 2002. Of course as anyone who has filled up their gas tank knows, commodities have started to climb once again moving from 200 up to 250 from the March lows. (click on chart to enlarge)
Commodity Research Bureau Index
The rise has been widespread with energy, base metals, agriculturals, and even precious metals rising considerably. Aside from precious metals it appears as though the primary reason that we had such a strong rebound was due to buying out of China. In the first two quarters of the year the Chinese government decided to use some of their surplus to buy raw materials. They bought a lot of copper, secured oil contracts, and stocked up on everything else. Now it appears as though their buying is slowing to a trickle of what it was and with the run up in prices they are taking a break as they will likely get to buy more at lower levels.
While the buying out of China may help commodities put in a bottom, it does not appear as though it will drive them much higher. With the possible exceptions of precious metals and energy we see most commodities turning in flat to slightly negative results for the rest of the year. With the demand destruction that we have seen over the past year commodities have a tough road ahead of them before they will be able to climb higher.
So where does all this leave us? Demand has been absolutely crushed on several fronts: People are finally saving and paying down debt instead of spending. Real estate is still falling, and with inventories as high as they are, will likely not fully recover for years. Employment is as bad as at any time in the Post WW2 era. Banks are still impaired and unable/scared to lend. And with all this demand destruction commodities are unlikely to continue upwards for a while.
Finally there is the matter that while we can speculate on inflation we are currently in deflation as can be seen in the chart below (click to enlarge) of the CPI. We have officially been in deflation for the last three months and while it might slowdown a bit we will likely stay in a deflationary environment for longer then most people think.
CPI-YoY % Change 1922-Now
What are we doing?
So if we believe that we are in deflation what do we do about it? The best deflation trade that we have found is to be long bonds. As we stated in our last blog post as well as the last few newsletters, we are long TLT the 20+ Year Treasury Bond ETF. Not only are we in deflation but the trade was decent on its own merits.
Real yields on Treasury bonds at the end of May were at their highest levels since February 1995 and right now they are at 4.76% for the 10-Year and 5.58% for the 30-Year. In an environment where we expect most assets to fall or go nowhere, we think that Treasury Bonds offer good value (click on chart to enlarge).
10-Year Treasury Bond Real Yield
Treasury bonds got almost as oversold recently as they were overbought back at the end of 2008. By normalizing the trend using a 200-day moving average we build reversion to the mean charts that show how far above or below securities are from their mean. In the case of the long bond, our charts showed that it was extremely oversold and that it was a good time to start building a position.
TYX-30-Year Treasury Bond Yield Reversion to the Mean Chart
Looking at the chart of the TLT (click to enlarge) we could see it running up into the 100-105 range over the next month or two as investors take advantage of deflation, the oversold conditions, and the favorable real yield.
TLT 20+ Year Treasury ETF
While the long bond is definitely our favorite deflation trade, it also makes some sense to go long the US Dollar and/or the Japanese Yen as investors flock towards safety. Other trades would be to short stocks and short commodities in anticipation of them falling as demand continues to decline and margins shrink.
And what about inflation? We actually do believe that eventually all of this printed money will lead to some hefty inflation but right now we are in deflation. Additionally the inflation trade is the most overcrowded and one sided trade in the financial markets right now. If we are right we will do well, and with the aid of risk management if we are wrong we will be stopped out for a small loss.
Disclosure: We currently hold positions in TLT.