2009 Mid Year Outlook: Expect Deflation and an Oil Price Drop

Inflation is not the act of printing more money. Printing more money leads to inflation but inflation is really more money chasing the same amount of goods which results in bidding up prices.

If the government expanded the money supply but as the new money trickled into the economy, everybody put that money into the bank we would NOT have inflation. We would have inflation when that new money came out and started bidding up asset prices.

Right now banks aren't lending. People can't get financing for the largest of purchases, home mortgages and cars. Lines of credit are being cut. Even people with good credit are having problems borrowing money, so imagine how people with average and poor credit are faring.

In the go go days anybody could borrow money to buy a home, a car, a European vacation or whatever they'd like on their credit card. The "what's my monthly payment" mindset took over. American's racked up obscene levels of debt. They consumed more NOW, but will in turn have to consume less later.

Debt is deflationary

Imagine you were living off of a fixed 50,000 dollars per year for 10 years.

Year 1 you spent 45k, nearly all of your money

Year 2 you spent 55k, all of your money + all of your savings

Year 3 you spent 60k, your 50 plus a borrowed 10K + (low) interest

Year 4 you spent 70k, your 50 plus a borrowed 20K in (low) interest

But now you bring in 50k per year but are 30k in debt. At some point you have to pay down that debt... It hampers your ability to borrow more money in the future. It means less consumption in the future.

If this situation happened to a couple of people, that's one thing, but when everybody is trying to save more money and reduce consumption at the same time, it means deflation. We have a consumer driven economy ~70% and the consumer is on life support. There was too much cheap money, bidding up of asset prices (mainly homes), we had over consumption and now we are facing less consumption (deflation).

The "inflation camp" sees what the government is doing and they rightly see that printing all of this money is inflationary, true. However there are even larger deflationary forces among us. I believe the inflationists underestimate the size and scope of the credit bubble. The inflationists are only looking at the response, but ignore the credit contraction they are responding to.

This response does not mean I agree with what the government is doing. The government is trying to do its best to combat deflation by creating inflation. The same people that mismanaged the economy with artificially low interest rates think that they can create a new bubble to get us out of the dumps and then "take away the punch bowl before the party gets good". Why are these people even allowed to play the economy? They didn't see a housing bubble, they didn't see the recession and they denied it until Depression 2.0 was on our door steps.

Having a huge internet stock bubble burst is one thing, but having a housing market bubble burst is much, much worse. Housing is tied to mortgages and banking and banking is tied to the entire economy infecting everything.

The most expensive things most Americans ever buy are homes and home mortgages. A few years ago almost anybody that could buy a home did. If you wanted to buy you could buy a home and some even bought multiple homes. Bank lending standards were "you have a pulse, you have a mortgage". People didn't put the traditional 20% down, I saw people buy homes and borrow 110% of the purchasing price to pay for closing costs and put cash in their pockets. We still have a huge over supply of homes, and we have severely tighter credit markets, people don't have 20% to put down, unemployment hurts the housing market and we have way more sellers than buyers. That means the home prices should go down further, or at worst stay level and not go up for years. We might not be that far off in price in many areas, but we have a ways to go as far as time. When the price bottom does come, don't expect that 15 to 20 percent price appreciation again any time soon. I told everyone I knew years ago that you should not buy now, because prices were obscene and that in 5 years they won't be higher than they are today. I've seen people incorrectly call for real estate bottoms since the very beginning. When this is all said and done, homes will no longer be looked at as an investment, they will more or less be looked at as a place to live.

I feel my views are a bit unique

Inflation/deflation = I side with the deflationists until banks start meaningful lending and Real Estate stops going down. Even then, when RE goes sideways, we might not have inflation unless the government starts printing/borrowing/spending even more money. Right now, they aren't even picking up the spending that was lost by the private sector... that means deflation for now.

Stock market = The deflationists see green shoots, the inflationists see pain. Although I believe in deflation I see pain in the economy yet we had a huge rally off the March 9 lows. Even during the great depression we saw a huge sucker's rally. I can't see the S&P moving up in a meaningful way with all of these headwinds.

Oil = I believe oil at $70 is over valued and that oil is more correlated with the economy than most people would admit. So given a weak economic outlook, I think oil is currently overvalued in that sense but also in a supply and demand sense. The world's proven oil reserves is increasing, the world's oil consumption is decreasing (in this recession), we have a glut of oil right now and the price keeps rising. People are speculating the economy to jump start and I don't see it happening right now.

Gold = Over valued right now at ~ 910 an ounce. Inflation may be coming in the future, but it isn't a worry right now. The inflation/gold protection idea is too played out in my opinion. The idea that gold is a store of value was bought on by so many people that it's too crowded of a trade right now. At some point, anything can be overvalued or undervalued. In human history there have been many forms of money, Gold & Silver and other precious metals, but also livestock, farm land, tobacco, crops, cigarettes, weapons, seashells. The price of gold isn't very far from its highs while many other commodities have crashed by 50% or more. When everybody is talking about gold and you see gold commercials on TV all the time...

1920's comparison = The excesses of the 1920’s credit expansion led to what we call the Roaring 20’s. The stock market and real estate bubbles were symptoms of that credit expansion. Investors thought the stock market never went down (sound familiar)? People were investing 10% for 90% margin in the stock market (we had our over leverage in real estate, right now we’ve had 34 straight months of decline in Case Schiller index dating back to July 2006). The over leverage caused the bidding up of prices until everything popped. The hangover that followed was years of pain, economic contraction, unemployment, a New Deal government spending program, a New New deal to try it again, higher taxes, tariffs, deflation, and the AAA act. The genius of the Agricultural Adjustment Act was for the government to pay farmers money to kill livestock and burn crops. Destroying food and resources while people were starving to death was some bureaucrat's idiotic attempt to combat deflation and raise prices. The Great Depression really didn’t end until almost 15 years later when people traded the unemployment line for government uniforms to go fight in the horrible Second World War.

Comments

[whidbey:]

This is a real contribution in dealing with to the fear mongering.

It is likely deflation for some time to come. The pudding has not jelled at the Administration, but there is some evidence that they intend to attempt to fix the financial markets with some basic rule changes. G-S, and lightening the pressure on small business.

The GDP goes to "0" in 2009/10. Decelerating the economy will take another year +/- with few encouragements. I would guess a bond portfolio might be a nice experiment for this coming market.

Jul 06 09:27 AM

[DONE_SONZ:]

IOUs with no way to pay them back.That's what we are looking at if things don't improve.What would you suggest holding in that situation?The same thing I would hold if things do improve and the massive printed money starts chasing the low inventory of goods.

Jul 06 10:12 AM

[John Galt:]

Can somebody from Seeking Alpha please move this article to my profile $ John Galt? I didn't intend on creating a new profile when I created this article but it looks like you made one for me. I'd also like this outlook to be an editors pick as it's a macro/longer term outlook than a daily news event.

Thank You.

Jul 06 10:23 AM

[Per:]

A fantastic analysis of the economy and markets!

Jul 06 11:41 AM

[Vuke:]

Well argued but perhaps a bit one-sided. CB's everywhere know this deflation bogeyman and are prepared to fire any broadsides required to repel it. The nightmare of a truly deflationary period is too trying, from a political viewpoint, to be endured in today's unbalanced world.

We cannot be sure of the G8 or G20 next steps but you be sure they will happen in such a way that perceptions may once again change. Aside from trade and budget imbalances there are a world of improvements to be made out there. Writing off bad debt and getting on with those improvements is far preferable to re-living the 1930's and 1940's. War and depression solved little, from an historical perspective.

Jul 06 02:55 PM

[nmelendez:]

I do agree with you in principal. There are two scenarios i see can be played out:
1. Monetization of the dollar and increasing pay for everyone. This would not create inflation but everyone can pay off their debts. Problem is, after we did this who would trust our currency. Deflation would still occur since BRIC, UAE and SA would be buying from the cheper seller, which brings me to...

Jul 06 04:45 PM

[nmelendez:]

2. China has made deals with Brazil, Argentina, Iran and other countries to begin exchanges in each others currencies, bypassing the dollar. Why would i want more dollars if i can buy on the cheap?

Jul 06 04:47 PM

[John Bowman:]

Exactly which prices are going to deflate? Home prices have already deflated and will possibly fall even more. However, many people make this major purchase maybe once or twice in a lifetime. And most already have mortgages which they are presently paying off or are already paid off. So home prices are for the most part irrelevant in the deflation picture. Correct me if I'm wrong.

Automobiles, SUVs and trucks: Somehow, I doubt that the price of vehicles will drop once all of the inventory is cleared out.

Food and energy: With cap and trade and the increasing worldwide population, I don't foresee deflation there. As a matter of fact, I see higher prices in the future.

Local income tax, sales tax, property and federal tax: They are hurting right now with increasing unemployment: No where to go but up. Same with water and sewage. And the stimulus packages and bailouts wil eventually have to be paid for.

Auto and homeowner's insurance: I don't see them deflating.

Health insurance : It never goes down.

Appliances, electronics and toys: They could deflate. But some electronics like TVs and computers have been deflating for some time.

Restaurants wil probably go under before they try to cut prices.

Haircuts, beauty supplies and services: hard to tell.

Pet supplies and services: I don't see them coming down in price soon or ever.

What does that leave? Oh...toilet paper..well, that could go in the crapper.

Maybe I have missed something, but I don't think it would be anything significant.

Jul 06 06:52 PM

[mgcolin:]

You're right a lot of the things you mentioned will likely not deflate, but houses in most places could easily drop further -- just compare current non-foreclosure prices to what they were in 1998. In most places housing is still double what it was in 1998. So massive drops to come there.

And all the services prices you mention could also drop. American workers are about 40% overpaid vs. their competition in Asia (adjusted for productivity).

Jul 06 08:37 PM

[texpat:]

Inflation originally meant an increase in the money supply. You're going along with the majority who coopt the term.

WW2 in itself didn't end the depression, but it forced people to save because there wasn't much to buy. When the war ended, these savings helped to kickstart the economy.

I think you're right that all of this will cause houses to be thought of as places to live, not as investments.

The big thing you're missing is derivatives. The size of all the bad debt pales in comparison to the size of derivatives. The attention has been on CDS's, but the value of interest rate and FX derivatives is far higher than that of credit derivatives. When you have interest rates around 0% and routine FX changes of over 1% a day, which would have caused great consternation in the past, you have to think that a lot of those derivatives are under stress. If they start to default, they will be the wellsprings of bailouts (money printing) that will make what has happened thus far seem like a picnic.

Jul 07 11:30 AM

[Claque:]

I like this article. It takes the housing bubble into full account while appreciating the role banks are playing with tight money as well as keeping the stimulus in mind. It has an informative historical perspective. It has common sense. And, it seems to lack a partisan axe to grind. 'Very helpful and organizing!

How various sectors of the economy, various industries and professions will adjust prices will be a fascinating thing to watch, if deflation works itself out over a longer period. (Deflation could work itself out I suppose with stagnant prices, a return to the regression line of the ever-increasing cpi that got ahead of itself.) Some sectors are fluid and respond immediately such as the airlines. Others will resist downward pressure until they face bankruptcy, I imagine.

Jul 07 03:53 PM

[Tony Daltorio:]

The US will experience both deflation and inflation. The deflation will be concentrated in assets where there were bubble-type valuations - real estate, US stocks,etc. The inflation will be in everything else.

Like most deflationists, you continue to underestimate how far the Fed and the government will go. Let's say a year from now, the US is facing 15% unemployment and negative 6% GDP. You tell me that, as a last resort,the Fed will not print up multi-trillions of dollars to pay off everyone's debts, bailout a bunch of companies, etc.

Jul 07 04:29 PM

[Thomas J. G...:]

I read something interesting once about the Internet Bubble. It was bad but it was contained to the people who had unrealized capital gains on internet stocks. A real problem occurs when a large class of people default on their debt and that flows through to the banks that lent them the money. This subprime/mortgage meltdown we just had is this latter type of problem. I think I read this is how Roubini and those type of economists were able to tell that this downturn was going to be worse than others.

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Jul 23 06:28 AM