We Will Not See Inflation Until This Happens

Summary

• Charts show that COVID-19 is clearly a deflationary shock.
• Inflation will not occur unless we see an increase in the velocity of money through consumer bailouts.
• Bonds and gold are a better way to play the range of outcomes than equities.

Some investors seem to believe that the rate of change of the Fed balance sheet expansion will lead to an era of inflation or stagflation. Charts in the subsequent section will demonstrate that this is clearly not the case. The near to medium term future is one of debt deflation. Due to joblessness and overall changes in consumer behavior stemming from the lockdown, there is simply not enough cash flows to service current levels of debt. This will lead to widespread defaults and persistent deflationary pressure until the cycle turns positive again or until the Fed transfers nearly all private sector debt onto its balance sheet.

I believe that returning to economic normalcy after the magnitude of this slowdown will require a restructuring of the financial system akin to the post Great Depression era. If the Fed resorts to more QE and negative interest rates, the United States will enter a paradigm of permanently high debt, permanently low growth, and a wealth gap of historic proportions. Much like Europe and Japan, this paradigm is structurally deflationary. However, a mixture of debt forgiveness, currency devaluation, and universal basic income will recreate bottom-up demand at the risk of inflation.

I do not advocate modern monetary theory. Nevertheless, the Fed is stuck in a QE trap. More of the same will keep asset prices from collapsing but will be disastrous for the real economy and the average American. Escaping the QE trap will require radical policy prescriptions that investors should consider the effects of. The next section demonstrates why the current crisis is incredibly deflationary. The article then goes on to explain why velocity of money is key to understanding the deflationary impulse. Lastly, we will examine what assets should perform well at this critical juncture.

Price Collapse

A collapse in demand has led to a crash in global commodities prices. The Reuters Commodity Index, shown below, broke a nearly two-decade long head and shoulders top. The post-2001 ramp in prices is largely attributed to China entering the World Trade Organization and its subsequent breakneck pace of infrastructure spending. Prices for nearly all goods will continue to deflate as the world slowly exits shelter in place orders.

(Source: Global Macro Investor April 2020 Newsletter)

The largest evidence of deflationary shock in the commodities realm was temporarily negative WTI crude oil prices. Companies were paying buyers to take oil as these companies had no storage capacity after a crash in demand.

(Source: tradingeconomics)

The next evidence of a deflationary bust is the forty-year direction of bond yields. Unless the paradigm of Central Bank intervention changes due to inflation risk, yields will likely reach -2% to stimulate demand just as the BoJ and ECB. The risk to this strategy is that it creates a dangerous reach for yield in pension systems and destroys sovereign bonds as an asset class.

(Source: Global Macro Investor April 2020 Newsletter)

Additionally, if joblessness and psychological changes in consumer behavior lead to continually reduced demand, we could see a negative print on CPI and real interest rates would jump higher. Negative inflation means prices fall but it also leads to fall in wages, mortgages becoming less affordable, and consumers oftentimes delaying purchases in expectation that prices will fall further. Negative CPI also leads to higher real interest rates. A tightening of financial conditions at the most inopportune time may force the Fed to go deeply negative in terms of interest rates.

Defaults

Thus far, fifty-seven companies have defaulted amidst reduced cash flows - mostly in the retail and restaurant sector. Large names include J. C. Penney (JCP), Neiman Marcus (NMG-OLD), and Steak n’ Shake. While the chart below may not seem dire, the only companies to default thus far are those that could not sustain operating costs for more than one month. After three, six, or more months of sustained losses, this list will grow astronomically. Additionally, expect a wave of bankruptcies in Shale oil producers after global deflation continues to put downward pressure on oil prices.

(Source: S&P Global)

Lastly, only 52% of Americans are confident they can make rental payments in May compared to 69% from April. Landlords will be forced to sell in order to pay off mortgages or face foreclosure as less individuals and businesses can afford to pay rent on residential and commercial properties. Overall, expect this deflationary wave to hit real estate prices. Worse yet is the wave of homeless or displaced Americans that will occur once the eviction ban is lifted. To avoid this, I believe we will see more stimulus packages akin to Universal Basic Income for main street or landlord protection through debt forgiveness, especially given that this is an election year. QE will not prevent the current debt deflation. Stimulus checks may, but at a great cost.

The Inflationary Catalyst

The key to understanding the lack of inflation in the current context is velocity of money. Inflation occurs with higher demand driving prices up (demand pull) or higher input costs feeding through to the consumer (cost push). Printing money is thought to create inflation because it means more money chasing the same amount of goods. However, as the chart below demonstrates, something systemically broke in 2008, leading to fewer and fewer transactions.

(Source: Meridian Macro Research)

Economic activity on main street remained subdued post-GFC, while the liquidity injections went primarily towards freeing the balance sheets of primary dealers and eventually making its way towards risk assets such as equities.

What will increase the velocity of money and lead to inflation? Freeing up the balance sheets of average Americans through debt forgiveness and supplementing them with universal basic income. Unfortunately, escaping the trap created by radical monetary policy can only be solved through radical fiscal policy or by letting capitalism run its course and allowing bankruptcies in insolvent companies.

Assets to Own

We will see persistent deflation unless the Fed bails out the consumer and increases velocity of money. Some bets are less risky than others at this current juncture. Buying equities now is a bet that the Fed will continue to inflate the equities bubble through QE and negative rates despite the insolvencies to come. It is a bet on the dislocation between fundamentals and market prices and an acceptance that true price discovery does not exist. The recent rejection of the S&P 500 rally at the 61.8% Fibonacci retracement level last week was both a technical trader’s delight and confirmation that price discovery may be manipulated, but not dead.

(Source: Business Insider)

There are better ways to play the range of outcomes. One, keep a long bonds position as rates will go to zero or negative. Do not expect this trade to last long. Two, gold will rise strongly under a debt deflation as sovereign bonds lose their place in investors' portfolios. Three, consider bitcoin as a sound money alternative to Central Bank manipulation. Even marginal ownership of bitcoin can protect a portfolio. Investors should be underweight commodities and neutral to underweight U.S. equities.

Analyst’s Disclosure: I am/we are long GLD, TLT, SPY. 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.

Comments

[own_account]

On the right track until you suggested bitcoin.

I think options are the best way to trade any market.

[David de los Ángeles Buendía]

Hello @Ariel Santos-Alborna ,

You are generally correct. The economy of the United States, the traditionally industrialized nations, and the world generally, is primarily deflationary.

This is not principally an issue with a simple increase or decrease in the supply of money. What drives an economy is the creation of goods and services and the exchange of those commodities for other goods and services, mediated through money. Money is simply the medium of exchange, it is like lubricant in an internal combustion engine. The engine turns because petrol and air and burnt, the motor oil just helps that process move smoothly. The lubricant does not turn the crank shaft. Economic growth is principally about capital creation and the production of goods and services with monetary policy being the handmaiden.

What is happening right now is that the economic engine has no fuel because of the corona virus. Too much or too little supply of money and credit are not the problem.

I would note however this has been the general situation for a few decades now. With the export of manufacturing capital, the main agent of growth, inflationary pressures have been very low. Deflationary pressures have generally been dominant since the 1980's although it has only rarely expressed itself by falling prices. This where monetary policy has played a key role is in combatting the outright fall in prices. By expanding the supply of narrow money (M0), in Japan since the 1990's, in the United States and Europe since 2008, and now everywhere in the world, inflationary pressures are created, which have generally balanced the deflationary pressures, keeping prices more or less stable. With Quantitative Easing, deflation would have dominated and prices would have fallen.

[stonkless]

The price of everything has gone up substantially since 1980.

[David de los Ángeles Buendía]

Hello @snorekr ,

If you read my response to @snorekr below it would be the same as my response to your comment.

[Jason Tillberg]

inflation will come from shortages and a dramatic decline in productivity due to the utter lack of investment in the real economy.

Americans will demand free money and make that faustian bargain, but it won't end well as Goethe noted in his book, Faust.

[David de los Ángeles Buendía]

Hello @Jason Tillberg ,

How likely is that to happen? If most goods and services can be supplied inexpensively and efficiently outside of the United States and inexpensively imported, when would shortages ever occur?

[Jason Tillberg]

Hi @David de los Ángeles Buendía ,

Specifically commodities like food, energy and metals.

There seems to be an effort to reinvent the economy with lower use of CO2. Energy is an input cost to produce something and productivity comes from the careful measurement of input costs. Any effort to replace CO2 as energy source will make the cost go up for sure.

I also fear all these efforts to social distance and what have you are going to hurt productivity as well.

So while the initial collapse in price is one thing, collapse in demand will add fuel to the fire and put companies that produce commodities out of business thus shut down the supply all together.

So a collapse in new investment while all our current assets depreciate.

Another idea that's not going to end well is paying people not to work via universal basic income, which we're already doing on a massive scale when you consider personal current transfer receipts. Nothing is being produced, only consumed, depreciated.

As for sending foreigners our dollars to import their goods and services, I'm highly against that as that is the reason why our net international investment position is some - $11 trillion. More of that would only result in more foreign ownership of US assets.

Go too far on the money printing, we can compromise the value of the US Dollar and there goes trade imbalance as we could no longer afford as many imported goods and we'll be the ones working to supply the world. We'd see a surge in the cost of living and a collapse in living standards.

[ptcsys]

There is one thing you did not consider . The cost of doing business is way higher now. The low cost of gas and rent cannot compensate for the high cost of everything else to do business

[David de los Ángeles Buendía]

Hello @ptcsys ,

I do not see any evidence of this. The Producer Price Index[1] and Consumer Price Index[2] in the United States give little indication of increased costs.

[1] fred.stlouisfed.org/...

[2] fred.stlouisfed.org/...

[docstox 12]

I prefer the Chapwood Index, not the bogus Government CPI, to truly gauge inflation.It ran 9.6% last year.Any wonder why so many people are living week to week and don't have any money in the bank for an emergency?
If you have capital and have invested to stay ahead of inflation, equities, real estate, gold, you are fine.Sadly, only a low percentage do thus the rise of the socialist party with Bernie and AOC in the forefront.

[Diminishing Returns Happen]

The Chapwood Index is preposterous, as you would know if you spent any time at all looking into it. Too many reasons to list here, but here's a good start: www.reddit.com/...
In short, it's skewed toward measuring inflation for the quite wealthy...and does a poor job even of that.

Sure CPI is flawed as well, but nowhere near as flawed as the Chapwood Index, which shouldn't merit anyone's attention. Fake News, as you might like to say :)

If you're going to try to summarize something that really can't and shouldn't be tritely summarized: 'big-ticket' expensive items have definitely seen inflation greater than the CPI, but the CPI is intentionally focused on consumer goods and services being purchased by middle-to-lower income people precisely because the CPI is used to adjust programs targeting said people.