The Age Of Stag-Deflation: Part 1: Understanding The Times

|
Includes: CPI
by: Tom Cammack, CFA

Summary

Stag-deflation occurs when traditional business cycles are replaced by the cheap credit boom/bust cycles.

It appears we are once again approaching Stage 2 -Debt Collapse/Crisis point in the Credit Boom/Bust Cycle.

"Sell the Rallies": Using the Japan experience to our advantage.

This is Part 1 of a two part series.

In the Old Testament days of Israel, the sons of Issachar were commended as "men who understood the times, with knowledge of what Israel should do" (1 Chronicles 12:32). In developing a wise, and hopefully successful, investment strategy we must first correctly understand the times in which we now find ourselves.

Stagflation has been defined by Investopedia as "an economic phenomenon marked by slow economic growth and rising prices." While I believe "stag" (sluggish economic growth) is a common thread of both the 1970's and the times we now live in, I believe the "flation" part of the equation has changed.

In the 1970's, the oil embargo/price shock caused a spike in Consumer Price Index (NYSEARCA:CPI) inflation during a time of sluggish economic growth. Thus, we had "stag-inflation", which was simply called "stagflation". Today, however, government and household debt imbalances are much higher and CPI-inflation is not considered to be a problem. In fact, there is talk among central bank officials around the world about "inflation targeting" - how to raise CPI above current levels, usually to the +2% area.

I am of the opinion that the traditional business cycle has been largely replaced with credit-driven asset price bubbles. Therefore, the risk now is on the "stag-deflation" side of the coin. I define stag-deflation as sluggish economic growth combined with declining leveraged asset prices (such as stocks and real estate). Periods of CPI inflation can still occur, but they are largely the result of food or energy supply disruptions. Overall wage inflation is very modest.

Below is a list of debt-driven asset bubbles that have occurred since 1976 (based on standard deviation from trend):

  • U.S. Midwest Farmland - peaked in 1979 and again in 2011
  • Gold/commodities - peaked Q1 1980 and again in 3Q 2011
  • NASDAQ - peaked Q1 2000 and 2Q 2015
  • U. S. Housing - peaked Q2 2006
  • Oil - peak in 3Q 2008
  • Biotech Index - peaked 3Q 2015

The debt/asset bubble cycle can be described generally as follows:

Chart 1: The Debt-Driven Asset Bubble & Burst Cycle

In this cheap debt, asset price-driven economy, we could easily experience the worst of all worlds - slow economy with too much debt, declining stock and housing markets, and CPI-inflation staying higher than real household incomes. The implications for most already underfunded pension plans are not good, especially considering the aging baby boomer population.

I am convinced that financial imbalances resulting from the debt super cycle have reached the point where a long-lasting global recession could easily occur, perhaps starting as early as 2016. Under this scenario, economic conditions would not respond to central bank and government stimulus measures, but only get worse over time. Loan demand from credit-worthy borrowers continues to be problematic and a hindrance to economic growth.

With low, and in some cases, negative investment returns occurring down the road, there will be increasing pressure on pension funds. With approximately 10,000 baby boomers reaching the age of 65 every day until the year 2030, the pension problem will likely get much worse. Given the U.S. government debt situation -- $19+ trillion outstanding and at least another $66 trillion of entitlement promises (present value), the outlook is grim. As bad as these numbers are, they are just as bad, if not worse, in Japan and Europe. In regard to Japan and Europe, David Stockman has written two excellent articles which I recommend reading: "Why This Sucker is Going Down" and "Draghi's Deadly Derangement."

Below are long-term charts of the Nikkei 225 and the Russell 3000:

Chart 2: Nikkei 225 Stock Index, March 1966 to March 2016

As you can see from the chart, buyers of the Nikkei 225 near the top (1988-90) are still under water to this day - over 25 years later.

Chart 3: Russell 3000 Stock Index, January 1979 to March 2016

Investment Implications:

  • Be conservative and stay overweight cash (more on this in the next article);
  • Regarding stocks, I am inclined to sell the rallies and buy only when most everyone is very bearish (I think this is especially appropriate for those of us over the age of 50);
  • Pay attention what is happening in other parts of the world - the inter-connectedness of financial markets makes this a necessity;
  • In the long-run, I believe it is important to remember the following equation:

Stag-deflation + Aging Population + Continual Central Bank Intervention in the Markets = A Very Bad Result

Your Path Determines Your Destination

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. I have no business relationship with any company whose stock is mentioned in this article.