- 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.
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.
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.
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.
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