Deflationary Pressures And The Markets - Part 1

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by: Thomas Halikias

Summary

Reflation is a short-term illusion.

Neither monetary nor fiscal policy can stem the destiny of capitalism.

History proves that innovation is deflationary.

Many believe the era of extremely low-interest rates is nearing its end. Donald Trump's Presidential victory and his emphasis on "national interests" has sparked a massive bond market sell-off. Yields on the U.S. Treasury's 10-year bond have risen over seventy basis points (70 bps) in the months following his election. The common belief is that Mr. Trump's trade policies will reinvigorate U.S. manufacturing and, coupled with Mr. Trump's proposed fiscal spending, increase wages and employment.

In the short-run, protectionist measures may increase the price of imports, but these price increases will more likely serve as a reduction in earnings power, not as a cause of inflation. Inflation is a mindset, the expectation that prices will rise in the future. Without wage growth, the expectation of higher prices is unrealistic and limits the potential for significant inflation in the U.S. Additionally, the reflationary impact of President Trump's proposed policies may be muted by the strengthening U.S. dollar as our trade partners export deflation via aggressive rounds of currency devaluation.

The fallacy of the reflationist argument is the belief that the on-shoring of manufacturing will generate significant employment and create upward wage pressure. Prior to Trump's presidential victory, on-shoring had already gained momentum. The catalyst has been cheaper logistics coupled with advances in automation. New on-shoring measures will come in the form of highly automated facilities that require only a few well-trained staff. These positions will require skills that most unemployed or underemployed laborers lack. Additionally, the effectiveness of fiscal policy will be limited to the magnitude of the annual expenditures. Current proposals recommend expenditures that are only a small fraction of total U.S. GDP. Another limitation is that few projects will generate incremental gains outside of the initial investment. Most of the proposed outlays are for improvements in the cornerstones of the "old economy." The marginal benefit of improved airports or roads will not serve as a facilitator for additional GDP growth. If you factor in the general ineffectiveness of government spending, the overall impact of fiscal policy will most likely prove negligible.

While Mr. Trump's policies may have a marginal impact on the economy and inflation relative to current legislature, their ability to meaningfully change the course of the U.S. economy seem unlikely. Policy can moderate or exacerbate business cycles, but it cannot alter the destiny of the economy. The "destructive creation" initiated by innovation has been the hallmark of our economy, and that will not change.

In today's economy, technology is a primary source of innovation. News headlines are cluttered with the mention of automation, driverless cars and the expansive potential of artificial intelligence (AI). In the past, accelerated technological advancements often fostered Gross Domestic Production (GDP) growth but were also accompanied by productivity related deflation. The Great Deflation, the post-Civil War period from 1870 to 1890, coincided with the Second Industrial Revolution. During that period, technological advancements lead to a surge in productivity that resulted in a two percent (2%) annual rate of deflation. In reviewing the historical ebbs and flow of inflation and deflation (see the below chart), it is apparent that inflation is almost purely a byproduct of war financing and, at times, massive social programs.

Source: Edward M. Kerschner, NYU

It is commonly believed that today's technological achievements rival those of the Second Industrial Revolution. While discernible advances in GDP might not be as obvious as during the earlier era, recent innovation has created substantial social gain - e.g. greater product customization - that is difficult to incorporate into traditional GDP modeling. A more obvious parallel between the two periods is that of production and service efficiencies. Such efficiencies increase the supply of goods and services resulting in price and profit compression. With grand scale wars a thing of the past, continued technological advancements can only result in sustained periods of deflation. The last decade's unprecedented global monetary stimulus has done little to prevent deflationary pressures across the developed world.

As with the Great Deflation, recent technology advancements have disrupted numerous segments of the American workforce. Optimists believe the effects on the workforce will be transitory and new, unforeseen opportunities will emerge in tomorrow's economy. Others expect that the forces behind automation and AI will relentlessly devour low and medium skilled jobs, leaving millions without a proper source of income. Extremists believe that the need for comprehensive social programs - e.g. a Universal Basic Income - is all but a forgone conclusion. Regardless of which point of view prevails, the transitory employment dislocations will be significant and rival those of the Great Deflation. [A future note will address the merits of the extremists' warnings.]

A recent YouTube video of Swedish forestry company EcoLog's D590 harvester provides a daunting example of the efficiency and dexterity of the latest wave of mechanical technology. One D590, with a single operator, is capable of harvesting a section of forest quicker and cheaper than a team of laborers. The ramification of technology progress will not be limited to low-skilled labor. Computer programming is the application of a unique language. Advancements in AI have achieved great success in recognizing and translating conventional languages. It is only a matter of time before AI's language replication ability is applied to computer program languages. As AI capabilities continue to develop, many high-skilled sectors of the workforce will experience wage pressures similar to that of their low-skilled brethren.

Given the parallels of today's technological environment with that of the Great Deflation, a sustained period of deflation seems unavoidable. A compounding effect of the automation of many low-skilled jobs is that reduced employment opportunities and strict immigration legislation could potentially stem the tide of immigration into the U.S. Immigration has been a vital component of U.S. population growth both directly and indirectly through the higher birth rates traditionally found in immigrant families. The deflationary consequences of an aging and stagnant population have plagued Japan for decades.

So how would persistent deflation affect the markets? The Federal Reserve's accommodative monetary policy following the Financial Crisis has contributed to historically low-interest rates and sweeping gains across most U.S. investment markets - e.g. debt, equity and real estate. Many attribute these gains to the excess liquidity created by the Fed's "easy" monetary policy. However, national money supply statistics show little evidence of "easy" money. In fact, net money supply - the change in money supply multiplied by the change in money velocity - has shown little growth since the height of the Financial Crisis. A more likely explanation for the dramatic rise in asset price levels is the impact of exceptionally low rates on traditional valuation models. Or, in layman terms, investors "reaching for yield."

If you extend this assertion to its extreme, an interesting question arises: "How do you value an asset in a zero, or negative, interest rate environment?" For now, I will leave this for you, the reader, to ponder. In a follow-up post, I will outline the impact of negative rates on the major asset classes - e.g. debt, equity and real estate.

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.

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