Part II: Deflation And Sluggish Growth Are A Greater Risk Than Inflation

Includes: IEF, IEI, TLH
by: Josh Cohen

In a recent article here on SA, I argued that deflation was currently a greater risk then inflation. After doing some additional research, I am now more convinced than ever that my analysis is correct and that the risk of serious inflation for at least the next several years is extremely unlikely.

I would like to start this piece by just establishing some basic definitions:

M2 Money Supply: M2 is essentially the measure most often used by economists to determine the amount of money in the broader economy and to outline different economic and monetary conditions.

Velocity of Money: This is a measurement of how quickly money turns over in an economy. A higher velocity of money indicates more economic activity, a stronger economy and a higher possibility of inflation.

GDP: One way to look at GDP is simply by multiplying M2 times the Velocity of Money.

Let us start by considering the M2 money supply using the latest figures from the St. Louis Fed. If you look at the last three years, which is approximately the time period since the recession officially ended, it looks like M2 has generally been growing and that therefore we should be well into a strong recovery.

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Looking at recent GDP numbers from the St. Louis Fed, however, we see that with the exception of a couple of quarters, the economic recovery has been quite sluggish overall:

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As economists have pointed out, this is the slowest economic recovery since the Great Depression. Why the atypical recovery this time? I believe this has to do with the consistent downward decline of the velocity of money over the last several years. If you look at the chart below, you will see that the velocity of money is now at its lowest level in almost 50 years (1.57):

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Now consider the chart below, which plots M2 against the velocity of money. If we keep in mind our definition of GDP above - M2 times the velocity of money - we can see that even though M2 has been slowly rising, this rise has been accompanied by an almost continued decline in the velocity of money, and hence GDP growth has overall been quite sluggish.

I agree with this excellent analysis from Carmen Reinhart and Ken Rogoff, who argue that the recovery from this recession is different then any other post Word War II recession. The chart below comparing job losses in the current US Great Recession to all other post-war recessions supports the Reinhart-Rogoff analysis:

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Taken in total, the information above leads me to believe that we will continue to remain in a slow growth environment for several years as the debt-deleveraging process continues. Given that analysis, it is not surprising that inflation continues to be low, and as Edward Harrison of Credit Write Downs just pointed out, the TIPs curve currently indicates the markets are pricing in near zero inflation over the next year.

How to invest in this environment?

I suspect many readers will disagree with me for this, but I think at a minimum one would want to have some amount of Treasury bonds in their portfolio. I believe a mix of shorter and longer duration Treasuries are a good approach. In this context, whatever total percentage you choose to allocate to Treasuries, a mix of the three ETFs below are a good bet:

iShares 3-7 Year Treasury Bond ETF (NYSEARCA:IEI)

iShares Barclays Capital U.S. 7-10 Year Treasury Bond Index ETF (NYSEARCA:IEF)

iShares Barclays 10-20 Year Treasury Bond ETF (NYSEARCA:TLH)

Treasuries are priced at record highs with correspondingly low yields, so I would not advocate a large amount of Treasuries in your portfolio. However, if you look at Treasuries purely as a straight forward hedge with a negative correlation to equities, you can see the rationale for holding at least some Treasuries. Yes, Treasuries may decline in value, but if they do decline then at least we can assume that the economy is recovering and that equities are generally rising nicely.

Again, I am NOT recommending anything more then a limited allocation to Treasuries, I am just suggesting that looking at the asset class strictly in the context of a hedge against an equity portfolio makes sense.

Disclosure: I am long Treasuries in a portion of my 401K.