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Economic Tsunami, the 2nd Wave - Prepare for Deflation

We are living in extraordinary times. The demographics of the aging baby boomer generation and the massive government interventions have changed the rules for investors. Over the next several years, we will be gyrating back and forth between the different economic cycles of deflation, inflation, re-flation and stagflation, and each will require an entirely different investment strategy.

Economic Update:

In short, the wheels are coming off. Regardless of the trillions spent on “stimulus”, the so called recovery is failing. Housing, the cornerstone of the economy because it is the collateral that banks lend off of, is resuming its downtrend, there are no job gains to speak of, consumer spending is the lowest in a generation and record tax increases will take effect soon. In actuality, it’s no one’s fault. It is merely a generational cycle of an aging population. Unfortunately this generation happens to be the biggest in history as 78 million Baby-Boomers retire. With the next generation not large enough to make up the spending difference, the economy simply doesn’t have a chance. So what’s next?


Deflation!

Deflation is brought about by a systemic slowdown of an economy that brings prices "lower" for goods and services. That is practically unheard of in a capitalist economy, except at the end of a generational cycle every 40 years or so, such as we are currently experiencing with aging Baby Boomers. The situation is exacerbated by excessive leverage, which is essentially too many people (and governments) with too much debt. The process of resolving this excess is called “deleveraging”, which is the massive elimination of credit and debt throughout the economy. Deleveraging by design is “deflationary”, and that is bad news for stocks!

The scary part of a deflationary investment environment is that it is completely foreign to today's investors. Very few are familiar with what is necessary to be successful during a deflationary period, and most will be caught dangerously short and unnecessarily putting their life savings at risk.Average Annual Family Spending by Age

The primary cause for deflation is the demographics of the aging Baby Boomers. Demographics tell us that:

  • People do very predictable things at different times in their lives, with peak spending occurring at approximately 48 years of age
  • The populations of the U.S. and the developed world are aging
  • As people age, they naturally spend less, generating less demand for goods and services
  • Less demand leads to decreased supply, a.k.a. production; less supply means fewer people are needed in the workforce
  • The deflationary spiral continues until a generation comes along that is big enough to fill the shoes of the Baby Boomers
  • That generation is the Echo-boomers, the children of the Baby Boomers, who will not reach their peak spending years until 2023
  • The massive deleveraging process in which the world is currently going through is undeniable.
  • US Banks are expected to cut an additional $1.5+ trillion worth of credit lines
  • States are set to lay off one million to two million more people this year
  • The new European austerity programs, ones which we will have to adopt as well (and soon!), will reduce consumption and perpetuate the deflationary spiral
  • Inflation continues to be subdued despite massive government stimulus spending
  • Overall, more than $10 trillion of consumer and $20 trillion of corporate credit will vanish
Inflation misconception:

Given the tremendous amount of borrowing and spending by world governments, many people feel that inflation is inevitable. It is true that the government is printing and spending like mad, trying its hardest to create inflation. However, what is essential for investors to understand is that the government’s attempts simply cannot create assets as fast as they are being destroyed. This is deflationary, not inflationary. Eventually they will succeed in creating inflation, but that is a concern for another day.

What could change this forecast?

·        More government stimulus

·        Unemployment declines

·        Consumer spending increases

These are not likely but we will keep an open mind.

Portfolio Strategy:

This is a very dangerous period, and investors must employ a "tactical" investment approach, as the old fashion buy-and-hold (buy-and-hope) approach will again prove disastrous. For instance: bonds and cash would be decimated by inflation, but may be very profitable during deflation. On the other hand, a portfolio of stocks and commodities would do well during inflation, but may be catastrophic during deflation. And of course, there will be a time in the near future where you will want to be in cash, so you must have an exit strategy.



Disclosure: "no positions"