This article is based on the research of James Montier, to be found here. However, I come to a decidedly different conclusion than Montier does.
Ironically, the closer we get to another deflationary debacle, the closer we get to hyperinflation. The sequence works like this:
- The central bank inflates paper assets (primarily bonds, but also stocks and derivatives) relative to commodities and other real assets. Capital flows from real assets into paper assets, initiating deflation in real assets. This may or may not be reflected in consumer prices at this stage, and therefore traditional measures of inflation/deflation.
- Commodity assets start trading below their production cost. At this stage it becomes quite likely that traditional measures of inflation are tending toward deflation. The central bank responds to the deflation by exacerbating the paper/real asset imbalance with further money printing. The US is currently at this stage, and certain Fed governors are advocating for a continuation of money printing. Even a majority of those advocating an interest rate hike want to put it off as long as possible and keep rates below normal for the foreseeable future.
- After an interlude where commodity producers struggle while the paper markets continue to soar, commodity producers cut back on production or go out of business because they can no longer profit from their production.
- Commodity shortages ensue. Commodity prices spike as a result.
- A commodity-led inflation ensues and is unstoppable because the central bank has already printed too much money. Capital flows from paper assets to real assets. The central bank loses control. Paper asset bubbles pop.
- People lose confidence in the currency and refuse to hold it. They buy real assets immediately after any payment. Currency velocity soars. Shortages are exacerbated.
- Hyperinflation ensues.
Montier talks about other typical events that may occur along the way as well (such as excessive government debt), but these appear to be the minimal set of preconditions. Montier concludes that the US is not currently in danger of hyperinflation. I show above how erroneous that conclusion is. If the Fed backtracks on tapering, the scenario unfolds.
I believe it is highly likely that global deflation will continue and become even more apparent as long as the dollar remains strong. If it does, it will spread to the US, and the Fed will feel obligated to change course and fight it. This should cause the dollar to fall, since interest rate hikes in 2015 are already priced in. For now, commodity producers, including energy, will continue to underperform, and foreign investments will suffer from adverse exchange rates, as will multinational corporations. Daring investors might consider shorting any of these. Bond prices should remain high as long as the threat of deflation remains. They will fall if the Fed continues on course. Deflations are normally adverse for corporate earnings in general, and with high valuations, any lapses will be severely punished by the market.
Disclosure: The author is long JDST.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The author holds gold in a Kitco pool account.