Economy Still Deflating, Launch of QE2 Notwithstanding

by: Charles A. Smith

Previously we've contrasted the fragile, uneven nature of the current U.S. economic recovery with the ongoing string of upside surprises in S&P 500 earnings. In general, big capital is winning and labor and small business are losing in what is widely characterized as the "new normal" recovery.

These contrasting outcomes for different segments of the U.S. population are simply not sustainable, as the political backlash from rising income and wealth disparity continues to build. Herb Stein, former Senior Fellow at the American Enterprise Institute, famously said that "If something cannot go on forever, it will stop." In this case the endpoint of extraordinary government spending and money creation will eventually be higher inflation. In the meantime, however, deleveraging efforts on the part of the average household are frustrating the efforts of policymakers.

After 18 months of ebb and flow following the 2008 financial crisis, deflationary forces regained the upper hand this past summer. This resulted in renewed efforts on the part of the Federal Reserve to stimulate growth in the form of $600 billion of additional money creation, also known as "quantitative easing". As with previous attempts to spur the economy via renewed consumer borrowing and spending, this latest effort has thus far had little effect other than to push up stock and commodity prices. Gold, copper, cotton and oil prices are rising, indicating that reflationary efforts are working. Real estate values continue to erode, however, indicating that reflationary efforts are failing.

With repeated stimulative efforts on the part of the Fed and Treasury (somewhat less likely after Republicans took control of the House) in the cards, the final chapter of the deflation/reflation story has yet to be written. Our best guess is that the next 12 months will continue with a deflationary bias, as both bank lending and home prices continue in the doldrums.

Our expectations for a steady diet of low-grade domestic deflation are buttressed by overseas events. China recently raised bank reserve requirements in an effort to cool property inflation, and the European Monetary Union (EMU) is in disarray over debt problems in Ireland, Portugal and Spain. Several of these peripheral nations may eventually be forced to leave the EMU in order to regain control of domestic monetary policy and repay their debts in devalued punts, escudos and pesetas. This would likely create steady appreciation in the dollar, and additional safe-haven flows into U.S. Treasury Bonds.

Right now (quantitative easing notwithstanding), debt repayment and cash accumulation remain uppermost in investors minds. There are some signs that corporate capital spending is reviving, though mostly in the areas of productivity-enhancing computer systems and software. Jobless claims have stabilized, but hiring does not appear set to take off. Minor employment gains at the corporate level are largely being offset by further cutbacks in state and local government. Our job as money managers is to navigate these crosscurrents in a fashion which best builds the after-tax, after-inflation value of your investment.

We remain focused on companies with stable cash flows and minimal financial leverage, as debt service is a difficult burden in a still-deflating economy.

Disclosure: No positions