Surfing Deflationary Waves

Includes: AGG, DIA, IWM, QQQ, SPY
by: Kevin Wilson


Historical records show that both inflationary and deflationary waves have swept over major economies over the last 800 years.

Great inflationary waves can be interrupted by smaller deflationary waves that can last for many years; we can use the Japanese Lost Decades as an analogy for the present wave.

Deflationary waves change investment behavior and prudent investors should allocate more to bonds and less to stocks in the early years of a particular wave.

Throughout the last eight centuries inflation has happened in a series of great waves, as has been thoroughly demonstrated by David Hackett Fischer in his book, The Great Wave: Price Revolutions and the Rhythm of History (1996; Oxford University Press, New York, 536p). These great waves all differed in duration, magnitude, velocity, and momentum, hence the term waves rather than cycles. Intercalated in the troughs between these great waves of inflation were waves of disinflation or even deflation. And within certain great waves there were sometimes complex counter-trends, or deflationary (smaller) waves. For example, in the period from 1924-1940 there was a long and damaging period of deep deflation associated with the Great Depression, which it is important to point out, was technically a balance sheet recession (BSR). Richard C. Koo has done extensive research (discussed in his book, The Holy Grail of Economics: Lessons from Japan's Great Recession, Rev. Ed., 2009, John Wiley & Sons (Asia) Pte. Ltd., Singapore, 339p) on the balance sheet recession and long-term mild deflationary wave suffered by Japan from 1990 to the present. According to Koo, the collapse of the huge Japanese asset bubble is what triggered the BSR of 1990, and was the source from which the long-term deflationary wave eventually gained enough energy to impact the Japanese economic shore. This period is now referred to by some as Japan's "Lost Decades."

It is very important to find an explanation for the persistence of the Japanese deflationary wave, because almost the entire world went through a BSR in 2008, and now a deflationary wave appears to be forming in its aftermath. In the case of the Japanese BSR, falling demand led to long term deflation, although it took about six years for the first wave of deflation to hit Japan after their BSR started in 1990. But this wave of deflation has never been vanquished in spite of 20 years of effort. The problem is permanently lower demand, but attempts to boost demand have all failed after short-term successes that fizzled out. Abenomics may be yet another example of short-term success and long-term failure. In any case, note that we also have seen seven years pass since the beginning of the Great Financial Crisis (GFC) in 2008. If the analogy is appropriate, then a deflationary wave at this point would not be very surprising, especially since many commodities have already fallen by over 50% since peaking in 2011.

One possible explanation for the persistence of the Japanese deflationary wave is the fact that neither conventional nor unconventional monetary policy has been shown to work in dealing with the aftermath of the BSR. Fiscal policy had more tangible results, according to Richard Koo. But since Japan is again facing recession and deflation for the sixth time since 1990, fiscal action can't really be the key to recovery either. I know that there are also demographic overprints that have also reduced demand. John Mauldin and Jonathan Tepper, in their book, Endgame: The End of the Debt Supercycle and How It Changes Everything (2011, John Wiley & Sons, Hoboken, NJ, 318p) have suggested that the solution to this may either be austerity or massive money printing and debt monetization. If we look elsewhere for evidence on this score, we can observe that a similarly extended period of a deflationary wave, only much more severe, occurred in the aftermath of the 1929-1932 BSR in the U.S. In this case, interest rates on the long term government bond did not return to their 1925 level until 30 years had passed. Here, in spite of political legends and economic theories that it was Keynesian government spending that saved us from the Depression, we note two key counterfactuals. First is the fact that a huge accidental savings rate increase, to a peak of 26% (caused by rationing and austerity during World War II), was what provided the capital and investment to end the debt-deflation cycle of the Depression. This idea was proposed by economist Lacy Hunt, and is further supported by the research of Nobel Laureate Robert Barro, who studied the effects of government spending in World War II and found that GDP was lowered by it, not enhanced by it. We did not have to face a depression in the U.S., but it may be that we are facing a Japanese-style debt-deflation wave that will be mild but persistent. Although the Japanese economy may never have suffered a true depression after their 1990 BSR, it has never really recovered after 20 years, either. Japanese deflation rates (using their CPI) averaged about 0 to -1% per year in most years since the mid-1990s (with a couple exceptions).

Source: Hoisington Research

We may now be entering what analyst Niels Jensen of Absolute Return Partners has termed Phase Three of the GFC, in which a meltdown in the financial sectors of emerging markets is anticipated. This time the EM credit system will hit a wall due to falling commodity prices and a massive debt overhang. Under this theory, Phase One involved the subprime credit crisis in the U.S., and Phase Two involved the Eurozone financial crisis. If we assume that Japan's recent history is a good analogy for what's coming, then something like their level of deflation (i.e., about -1 to -2% annually) may be what we experience in the next few years as well. This is according to economist A. Gary Shilling, whose recent book The Age of Deleveraging (2011, John Wiley & Sons, Hoboken, NJ, 512p), discusses the problem in detail. According to Shilling, it is pretty unlikely that the expected new deflationary episode will reach anything like the level of deflation measured during the Great Depression, i.e., -4.68% per year, or its shocking cumulative drop of -18.70% between 1929 and 1933. So the deflation that many fear is not what we are talking about here. We should still realize that if this milder deflationary wave happens, we will need to think about the way we invest. Indeed, we are probably facing substantial changes in the way investments will behave in the next few years.

Almost no one still actively investing in the U.S. has lived through such an experience in this country. Only the Russians, Koreans, and Japanese amongst major economies have actually experienced long-term deflation pressures in recent times. Shilling has pointed out that historically, deflationary episodes are at least initially characterized by strong bond market rallies, especially for the longer term Treasury issues. Average government bond yields dropped from 3.70% in September of 1929 to 3.13% in June of 1931, giving investors a nice little capital gain. Others have noted the same trend for government bonds during deflationary episodes in Japan. It is also important to note that foreign (sovereign) debt issues sold off rather badly during the Depression, due to currency devaluations in many countries. Corporate bonds did well until late 1930, when they began a substantial sell-off due to well-placed fears about corporate balance sheets and cash flows. In the Japanese case, Japanese Government Bonds (JGBS) saw 10-year yields drop from around 6% in early 1990 to the current yield of below 1.00%, generating huge capital gains for long-term bond investors. This was in spite of literally two decades of massively increasing supply as the Japanese government exploded its net debt/GDP ratio from around 12% to 105%. However, this phenomenon was probably only possible because when the Lost Decades started, Japanese savings rates were amongst the highest in the world. Japanese households and corporations bought on average over 94% of the JGB debt issued, which then financed the perpetual government spending spree. There is a post-script to this story: demographic trends have steadily eroded the Japanese savings rate, and recently the government started to sell JGBs internationally on a large scale for the first time.

Deflationary conditions are exceedingly bad for stock markets, as Russell Napier has documented in his book, Anatomy of the Bear: Lessons from Wall Street's Four Great Bottoms (2007, Harriman House Ltd., Petersfield, Hampshire, UK, 304p) for the Great Depression. At the market bottom in July of 1932, the DJIA had lost 89% of its value from its peak in September, 1929. This is still a record, thank goodness. Every sector and industry eventually sold off, with even the more defensive areas like tobacco, food, energy and utilities dropping by 51%, 72%, 74% and 82% respectively. The reason for the drop was at first glance the panic induced by the Crash. It is no wonder then that 15 years later, average annual returns for the period were still slightly negative. In Japan, the market fell over 75% after 1989 and is still down 30.6% from its peak level in 1996.

One idea then is that investors who position their portfolio asset allocations for defensive purposes heading into a deflationary period would certainly have a good chance of offsetting their downside risk substantially. Decreasing allocations to stocks (where most losses originate) and increasing allocations to bonds (where gains may be made in initial stages) would probably greatly improve results over those of most passive index investors in such circumstances. It should also be pointed out that since real interest rates on short-term deposits are generally negative in a deflationary period, cash can sometimes be a great asset to hold. It increases in value (as long as there is no devaluation of the currency), since the cost of most things is declining over time. Still, devaluation is a common occurrence in deflationary periods associated with financial crises and sovereign defaults, so caution must be exercised. If fear of devaluations becomes important, it is possible that gold and other precious metals could offset that risk as they did in the earlier stages of the Great Depression. Many factors combine to complicate the outlook for gold. However, Mauldin and Tepper suggest that Gibson's Paradox may apply, meaning that negative real rates cause gold to rally. There may be something to say then about using gold as a hedge when there is great uncertainty about fiat currencies, as there is today.

It is also very important to recognize the opportunity that is hidden inside every deflationary wave. The opportunity would be the huge bounce-back of stocks once the bottom is reached in the markets. Of course it is impossible to call the market bottom except after the fact, but valuation metrics would allow investors to recognize deeply discounted, under-valued stocks once one is in the general vicinity of the bottom. Grasping the bull (market) by the horns, one might then buy solid stocks at bargain prices, earning substantial returns in the years to follow. Asset allocation changes then are paramount in protecting the portfolio during the early part of the deflationary period, and again when opportunity knocks towards the end of the period. Stock selection may be important in the recognition of bargains once the market is somewhere significantly below the most recent top. By first protecting the portfolio from the vicissitudes of the markets early on, and then exploiting the opportunity to buy cheap stocks later on, investors may do well in a relative sense, in spite of the huge volatility encountered. Indeed, one can more or less attempt to "surf the deflationary wave," given a disciplined approach to asset allocation.

To those who have moved to 100% cash in such a deflationary wave, or are thinking about doing so, I would suggest that you stop and think about what you are doing. If you ever plan to return to investing, you are de facto practicing as a full-fledged market timing enthusiast, without any pretense of staying engaged in the markets. This is almost certainly doomed to failure for most people, and is best characterized as wishful thinking. The extreme rapidity and momentum of rallies off bear market lows means that a market timer tends to miss much of the action before they are convinced to act. A value investor on the other hand can see the bargains and start buying them when they become enticing, which could very well occur in the down-leg, well before absolute market lows are reached.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.

Additional disclosure: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks or other securities mentioned or recommended.

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