Sequestration And Money Pressure: Prepare For Deflation

by: David Cretcher

The news is abuzz about what Congress will do, if anything, to stop the sequestration scheduled to occur next month. What will be the effect on the economy if it does occur? Unfortunately for investors, whatever Congress does, they can rest easy it won't be enough. That is, it won't be enough to stop a significant decrease in money pressure and, with it, deflationary flows from the economy. No matter what happens, there will be a decrease in money pressure. It's is just a matter of magnitude.

In my working paper, "Money Pressure an Investor's Guide to Monetary Flows Through the Economy I outlined the hypothesis of how money sources outside the economy create monetary pressures within the economy. Money pressure builds in the economy like steam builds in a boiler. This money pressure flows through three main economic circuits, the domestic economy, foreign economies and the domestic financial circuit. The pressure s through these circuits turns the wheels of commerce like steam flows through a turbine. For investors, the direction of money flow effects which investments will succeed and which will fail.

Briefly, for those unfamiliar with the model, monetary pressure in the economy originates from five main sources - new federal government spending, new bank credit, business and personal "dissaving," decreased resources and industrial capacity, and increased exports. Conversely, the pressure can be vented from five counter sources - increased federal taxes, increased loan payments and defaults, increased resources and industrial capacity, increased imports and increased savings. Sometimes it is helpful to break out gasoline costs as a subset of imports and resource constraints, because the prices tend to move rapidly. A decrease in labor, e.g. lower unemployment, or resource constraints, like higher gasoline prices, will increase the pressure in the economy as competition for labor and resources decreases. Likewise, an increase in labor or resources, like high unemployment, will decrease competition for resources.

In simple terms we have a force dynamic like this:

When the monetary pressure within the economy gets so high that the pressure can't be vented by taxes, increased imports, loan payoffs or capacity expansion then and only then will it will be vented of from goods and service inflation. It takes more than money creation to cause inflation. If it were just caused by money creation we would have it all the time.

Money pressure vents through the opposite reactions.

Sequestraton and Money Pressure

How will sequestration affect these forces? It will affect these in two major ways, decreased spending and increased taxes, the effects of this is well known given the broad acceptance of the "fiscal cliff" metaphor.

Let's go through the potential dynamics?

Government spending will decrease - this will directly lower money pressure in the economy, as the government spends less money into the economy.

Taxes will increase - Increased taxes going forward will remove more money from the economy leaving less to be circulated and also directly reduce money pressure.

Exports will remain steady.- In the short run we can ignore US exports as they tend to change slowly.

Fuel prices may increase - Oil imports on the other hand tend to move quickly. So in our economy, we tend to have some asymmetry. The prices of what we export tends to move slowly and what we import, oil, tends to move quickly. If gasoline and diesel prices continue upward we will see an additional decrease in money pressure.

New bank loans will decrease - Less economic activity will mean fewer bank loans. It may also mean more defaults, both of these actions will lower the money pressure in the economy.

New bank loans are another asymmetry they tend to increase when the economy is expanding and they tend to decrease when it is contracting. Likewise, defaults tend to increase when the economy suffers. So if we see money going into the system from government spending and more money escaping from taxation we will see a slower issuance of new loans and an increase in loan defaults.

Unemployment will stay high or rise - As the government spends less, less labor will be required from government services. As taxes increase there will be less money in peoples pockets to spend on goods and services. Under these circumstances it will be difficult to significantly lower unemployment. This will increase labor availability and lower pressure.

Possible increased savings - As the economy slows businesses and people who keep their jobs and businesses with positive cash flow tend to get scared and start to save more. When they do this it temporarily removes pressure from the economy as money cannot be both saved and spent. This creates another asymmetry.

So the big picture will look like this.

Pressure points affecting the economy:

Government spending down.

Taxes up.

Exports flat.

Gasoline up.

Loans down.

Labor resources up.

Imports flat to increasing.

Increasing savings.

What about investments?

Inflation - All of these actions point to a lower pressure deflationary environment with very a low probability of goods and service inflation.

Stocks, Real Estate, and Gold - Most investments rely on asset price inflation. Asset price inflation is inflation of the price-earnings ratio on stocks or the cap rate on real estate, cost per square foot for residential real estate or the gold to dollar ratio etc. Assets inflation is like general inflation except the price of assets increases instead of the price of goods and services. It's still inflation just like general inflation and it requires money pressure just the same as goods and service inflation. Of course, when assets prices inflate investors do well, when they don't investors suffer. If there is less money pressure in the economy in general then there is less money to be cycled through these assets. For these assets to inflate there must be relatively more money diverted from the domestic and foreign consumption circuits to be instead circulated in the financial asset circuit. This is very unlikely. The odds are low that this will happen.

Government Bonds - If the Fed response to lower economic activity by additional QE it will create a shortage of government bonds. When the fed buys government bonds through QE it means there are fewer bonds in general circulation. If this happens and citizens and businesses save more because of decreased economic activity we will see an increase in government bond prices and a decrease in yields.

Overall investment outlook - the current events point to significantly lower money pressure causing lower asset inflation, lower general inflation, less government spending, higher taxes, lower economic activity, possible increased savings, and possible increased fuel prices. This forces will decrease money pressure and will be deflationary in the economy.

It is unlikely Congress, even in it's current dysfunctional state will let the full brunt of sequestration occur, moderating the full deflationary effects, the so called "fiscal cliff", but it will also do nothing to to move levers that will increase money pressure leaving us with a low pressure economy.

Specific investments - Given the current environment in Washington, investors should bias their portfolios towards investments that better better in deflationary times. Investments like long-term government bonds and investments that will generate cash flow from slow growth, like non-financial preferred stocks, utility stocks, high quality corporate bonds. Investors should underweight investments that perform well during inflation, like TIPS and that benefit from asset inflation like stocks, real-estate and gold. More sophisticated bond investors can look at premium bonds to partially protect against interest rate rises.

It's best to invest in a custom portfolio using actually bonds but investors looking for the convenience of an ETF portfolio should look for long-term government bond exposure at VGLT or TLT, TLO, aggressive bond investors can look at EDV. For preferreds look to PFXF, utility stocks RYU, or XLU, VPU, IDU.

The overall goal is to own stocks that do well in slower economies, bonds that benefit from deflationary environments, avoid inflationary investments and keep significant cash available.

Disclosure: I am long EDV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.