Manic Swings - Inflation or Deflation?

Part 1: Bipolar markets are essential to the "adjustment process"
when voters and politicians prefer denial to a painful reality

by Michael Hampton, AKA Dr.Bubb | September 14, 2009

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On my website, which is an active investor's chatboard called GlobalEdgeInvestors dotcom, we became obsessed.  Almost everyone joined in, trying to work out which of the two "-flations" was most likely.  Several argued the current downwards pressure on price would not last, and massive money printing by the Fed would eventually hit the economy, and must somehow morph into much higher inflation.  Some were listening to Marc Faber, who is "certain the US will experience hyperinflation" sometime in the future.  On the other side of the debate, we saw persuasive arguments from Bob Prechter and Mish Shedlock who believe we will soon be living with even worse deflationary pressures.  In this article, I explore the idea that there is another possibility.  We may live through a long period where we continue to see both forces in conflict, bringing continuing price swings.

Moving beyond the Inflation versus Deflation debate

The "choose a -flation" debate is lively, but one thing I have noticed is the lack of profits for anyone who made a choice and committed their capital to a single theme.  In fact, we have seen wild swings in both directions.  A perusal of the charts of Oil or stocks, will show from the beginning of 2008, it looks as if a maniac driver has been at the wheel, driving the markets up and down.  Oil: rose +56%, then fell -76%, then rose again, +110%.  While for the S&P 500 index we have seen: +15%, -54%, and +50%, all within a period of about 18 months.  Suppose you had made your choice a year ago. Even if you have been able to forecast the descent into today's lower inflation rate and chosen a single "deflationary" investment, you would have had a terrible time building wealth.  With such huge swings, being frozen in a single investment, you would have missed out on some great opportunities along the way.

Might there be a better way. Why not bet on the big swings continuing?  At least for the next year or two, why not accept that markets will behave like an unstable individual with a "bipolar disorder", swinging wildly back and forth from a focus on one "-flation" to its opposite.  Each market swing pulls our attention one way, so one side gets the chance to "be right" for a while, but then the markets swing back the other way. Neither investment theme is triumphant.  The real journey is in a third direction. Towards an outcome which looks inevitable to me, but many people still choose to deny.

Here is why I think that these wide swings might continue - They are an essential part of a long term adjustment process, with increased prices coming in some areas, and reductions in others.  There's a pattern to the madness.

The Needed Adjustment

We live in a world where on one side of the globe we have creditor countries, which hold most of the world's savings, and also have a big share of the world's manufacturing capacity.  On the other side, we have countries which have become accustomed to consuming a lot, and producing little.  The consuming countries rely upon their ability to borrow money, recycling the excess savings from opposite side of the globe, to pay for their excessive consumption habits.  This situation is not stable, and any continuation of the historical pattern of consumption in the West supported by the savings from Asia, will simply make the debt imbalance worse.  And the current imbalance has already reached an unhealthy extreme, which threatens future economic growth and stability. 

Periodically, "cracks in the system" appear and the strained conditions of the borrowers become so evident that the consensus supporting asset prices crumbles. Then, property, stocks, and commodities all slide together, as lenders panic, lose confidence, and tighten their lending.  That's what happened in  2008-9, when stock indices fell by over 50%. Recently we have had a big swing back up in stock prices with property bouncing too, but I do not expect it to last. More sharp drops of 20%, 30% or more, are likely in the future, with sharp rebounds along the way.  And we will most likely experience some huge swings in commodity prices as well.

What needs to happen, I think is obvious.  Currency exchange rates and real wages need to be adjusted to a point where Western consumers adjust their spending, increasing savings, while producing more of what they consume and reducng their imports.  On the other side of the globe, the Far East countries need to save less, buy more of their own production as they increase imports from the West.

This adjustment is not easy, since the change requires asset writedowns, business restructuring, and a large reduction in Western living standards - which is not politically acceptable - at least not yet. Western countries, and especially their politicians will fight it.  Privately, some leaders may admit changes are needed and are inevitable. Yet it is not politically feasible to have open discussions which might lead to the appropriate actions, because it would mean embracing short term pain.  Most voters are simply unwilling to elect anyone whose policies involve voters reducing their living standards. Better for a politician to make the adjustments look like an accident.  In fact to gain votes, most candidates deny major changes are needed, and make bold public statements, about how they will lead without requiring any major sacrifices from voters. An extreme example was during the height of America's global ambitions some years ago, when George Bush, Sr. famously declared: "The American lifestyle is non-negotiable." Of course, the opposite was true. The wasteful American (also Canadian, British, and European) living arrangement has been the principle cause of the unhealthy debt and economic imbalances in the world.

The required adjustment also means overcoming cultural prejudices in the East, where people are prone towards savings.  This is because they do not trust their own governments to look after them in the future.  Savings is a form of self-insurance by those who want to control the quality of their own lives in retirement.  Far Eastern savings countries will have to accept some future pain too.  For example, jobs will be lost in some export-oriented industries. And, since their government-held savings are largely denominated in the currencies of the West, the real value of those savings will need to be written down.  Writedowns are politically unpopular, and resisted in the East, just as they are in the West. 

To hold onto power, leaders on both sides of the globe waste taxpayer funds, trying to restore the "old normal" through quantitative easing, vast governmental stimulus programs, and other short-term-oriented interference.  Leaders-in-denial have set in motion certain programs which resist the needed price changes, particularly falling stock prices, and the loss of jobs.  The stimulus and spending programs help to keep troubled businesses alive and spur temporary counter-swings in prices, after big impulsive moves in unfavorable directions.  But these corrections are temporary, the larger trends of falling wealth and diminished western fiat currencies will win in the long run, I believe.

Despite all the fruitless efforts to force the economy back to "normal" - as if the bubble world of 2005-7 was somehow sustainable- the clock cannot be turned back.  The "old normal" required an enormous shift of savings from East to West, and an unprecedented blindness to risk. Instead, the world will need to progress painfully towards a "new normal."  We will see massive changes in consumption patterns, living arrangements, and wealth.  Many high-paying "old" jobs in the west will be lost permanently, even as export oriented jobs are lost in the east.  The "new" jobs will take time to materialise, as they arise from meeting local needs with local products, while building an economy which is less wasteful of resources, and uses less long distance transport. 

New Ways of Defining Inflation and Deflation

To understand what is coming, I believe we need to redefine the forces of Inflation and Deflation that we are seeing in a new and more specific way, which fits our present global circumstances:

Inflation: an increase in the prices of key commodities, especially energy and food, when measured in dollars, sterling, or euros.  (Inflation rates will be lower when prices are measured in Yen, Rmb, and the currencies of other saver nations.) The coming inflation will be different from that of the old "demand pull inflation" of the seventies and eighties, when rising incomes in the West, pushed up property prices and consumer prices in equal measure.  Instead, we will see "cost push inflation" driven by falling currencies, and rising prices of essentials.  Especially pricey will be commodities where foreign countries, like China, Japan, and other savings-rich countries are using their stronger currencies to bid up the price.  Some asset classes, like property, which did well in the inflation of the 1970's will not do well in the manic-swinging world of 2008-2010 and beyond.  If western incomes are falling, property yields will stay under pressure, and real estate prices will only hold up as long as western governments can maintain artificially low interest rates, which will become more difficult as the crisis moves into its later more virulent stages. 

Deflation: a drop in the standards of living in Western consumer countries, and within certain sectors of Asian economies.   Old jobs will be lost, and especially those involved in producing, delivering, and selling products to be sold to over-stretched western consumers.  These old customers are going to be buying less of everything, so they will need a smaller quantity of imported goods, fewer malls to shop in, fewer cars to drive to the malls, and  fewer nonessential goods of all types.  Instead of spending as they did in 2005-7, they will lead more frugal lives, downsize their living spaces, and rebuild their savings, as they respond to the impact of falling stock markets and sliding house prices.

When defined in this way,  we can see commodity inflation, and deflation of incomes are not polar opposites - and an investor does not have to choose between one camp or another.  Both influences co-exist.  In the months to come, we will see both of these trends, sometimes overlapping, and sometimes following each other in alternation.  The pressures, and price shocks will continue until the required economic adjustments are made, and the West has learned to cope with higher food and energy prices, and live on its own savings, while manufacturing locally more of the products it needs.

The move towards this new alignment is too controversial to be led by our politicians and business leaders, so it will tend to progress through a series of sharp and painful "surprise" adjustments, experienced as "inflationary" commodity price jumps and "deflationary" stock and commodity price crashes.  These will be painful to the wealth of the majority who are unprepared for the swings.  But for those who understand what is going on, they will look inevitable and predictable.  Those who are prepared can protect, and maybe even increase their wealth, as the shocks hit.

Swings - Commodity Buying and Stimulus, to Painful Restructuring, and back

The drivers of the price swings come from both sides of the globe. We have seen a clear pattern.  First, deflationary pressures in the West push asset prices lower.  Then, the other two drivers kick in, as a reaction to the falls, and they work to push prices higher.   I will examine these influences in detail, starting with the main driver which lifted global market off the Q1 lows - cheap credit from quantitative easing in the West, and aggressive lending in China, etc.

The price swings will move up and down, as if controlled by a pendulum, but one whose balance point is shifting, depending on the asset class.

+ Cheap credit and increased consumption of commodities, mainly from China and India ("Chindia") put upwards pressure on the prices of certain commodities. especially food and energy.  The upwards price pressure appeared in a wave, as a quick reaction to monetary loosening.  And in part, the price surge was fueled by opportunistic buying.  Savvy buyers in savings-rich countries saw that a deflationary swings in the economy had driven commodity prices back down to attractive levels. Then, armed with cheap credit, they bought aggressively, kicking off a new inflationary swing.  The latest inflationary move was led by Chinese stock indices, which bottomed in late Octobner 2008.  A huge Chinese financial stimulus package was announced, it has quickly translated into higher stock prices.  Jumps in commodities used by China, like oil, copper and iron ore are a coincidental signal that an inflationary upswing is underway. Rising commodity prices help to revive global stock markets, alongside the financial stimulus of loose credit and low interest rates in western countries.

As we saw in 2008, a deflationary swing depressed commodity prices while driving the value of the dollar upwards. The price drops provided a "window of opportunity", where cash rich Asian countries (and China, in particular) spent some of their dollar hoards liberally, stockpiling cheap resources, while simultaneously reducing their exposures to the vulnerable western currency. A buying spasms such as we are seeing can last for months, but will ultimately prove only temporary, because growth in western economies will prove anemic and the Asian growth will not be enough to sustain the upswing on its own.  Savings countries have remained alert to excesses within their own economies. When excesses appear, they begin restrict their own aggressive lending, as we are beginning to see in China now.  The upswing ends in excess stockpiles.  When commodity inventories are high and the cost of banks loans is rising, the stockpiling may cease suddenly, triggering the next deflationary counterswing.  As of late August, I am reading that credit is being tightened in China, with a slowdown in stockpiling. Consequently, I am anticipating another downwards swing in commodities and stock prices in the second half of 2009.  In the downswing, the Dollar may rise, as a flight from stocks, brings a temporary move back into the dollar as commodities and emerging market equities are sold.

+ Ongoing reductions in consumption in the West, will persist for years.  Western countries need to transform their economies away from being "consumption-led machines", and towards a better balance between savings versus spending; with more local manufacturing to meet the more essential local consumption needs. Also, they will have to invest in more locally generated energy.  They will have to change their energy "diets", so their are fewer imported items on their energy menu, and also because imported energy will get much more expensive when priced in weak western currencies.  Old and outmoded investments will have to be written down, with increasing pressure on profits, dividends, and bank balance sheets.  Economic changes may take years to engineer, especially when political leaders are in denial about the scale and the nature of change which is needed.  Whatever empty promises politicians may make to "restore the economy" to past glories, the deflationary swings serve a key purpose. They "bring reality home" to the general public that things are not fine; the economy is not healthy. Falling stock prices and the desire for sustainable new job growth, will keep the pressure on for a more dramatic economic restructuring, and political promises with crumble into sand.

+ Government stimulus related spending, is an attempt to soften the painful impact of the ongoing restructuring.  The timing of these programs will help determine the jumps in revenues of some restructuring industries, and will have a major, albeit temporary influence on stock prices too. But stimulus spending is inherently wasteful, and will be increasingly limited by budgetary constraints. The government programs will eventually have to move beyond mere spending and become smaller and better targeted to the areas where changes are really needed to bring about transformation in the future economy. Wasting money on programs that simply delay the downsizing of dying industries, will become impossible as the US government finds it harder to find the money.

The swings that I have identified are leading towards a very unhappy perfect storm: a severe crisis for American suburbanites.  When the dollar drops, the suburbanites' addiction to foreign oil will make a gas-guzzling living arrangement totally non-viable, just when government finances will be too weak to help.

Cash, Clunkers and the suburbanite's coming Catastrophe

As we move further into the crisis, Western governments may find they have less public support for temporary stimulus programs. Future governmental interference may take the form of tax incentives.  We saw tax oriented legislation in the recently-passed cap-and-trade program.  The law enacted was not ideal, but it does establish some useful incentives. Companies will strive to become more energy-efficient to avoid taxes, while those producing renewable energy will have the benefit of some enhanced revenues.  Unfortunately, most government stumulus programs tend to bring temporary and highly unpredictable benefits, as we have seen with the cash-for-clunkers program.  It is hard to build a long term business around a short term tax-incentive. Some popular stimulus measures, like the cash-for-clunkers program, will be merely borrowing current sales from future demand, rather creating a sustainable demand upon which one can build a sustainable business.  We can only hope that such short term programs are abandoned, for something better with have a clearer long term objective.  Major intelligent long-term oriented restructuring is what is needed, not just temporary spending.

History has shown that politicians nearly always chose short term bandages over painful long term cures. For decades, the US Congress proved incapable of passing sensible long term oriented legislation, like matching the higher gasoline taxes that were imposed in Europe years ago. The changes that really matter, like substantially higher prices for imported energy, are likely to be forced upon the US through through changes in exchange rates, if polticians in the US and otehr countries lack long term vision and courage. 

There is a big risk in the stimulus spending we have seen in the US (and the UK too) during 2009.  The spending is not well-targetted.  Too much money is being wasted, and the debts and dollar claims are piling up.  The real change and the major pain still lies ahead some months or years in our future.  Larger debts will mean an eventual bigger slide in the US dollar (and in other Western currencies too.)  The ultimate result may be a higher US dollar oil price than we would have seen without such massive spending.  High oil prices, such as $200 per barrel, or even my own forecast of oil at $400 per barrel, will mean enormous pain for energy users, and suburbanites in particular. 

My point is that "easy solutions," like today's cash-for-clunkers program, waste money and boost government debt, and do not work.  In the long run, the wasteful spending will deliver poverty and destitution for many Americans.  The irony is great. Those who live in the outer rings, may think the clunkers program was wonderful - they had a brief improvement in their living standard. A new car was partially paid-for by the government.  But the waste may simply increase the chances that the beneficiaries of the clunkers program will themselves wind up as down-and-outs, abandoned by a bankrupted government, which can no longer muster the financial resources to help rescue those in the "Stranded suburbs" of tomorrow.

Continues, next week, where I talk about : How the three Drivers-of-Swings influenced prices in 2008/9, and How to invest in a world of bipolar markets

Copyright © 2009 Michael Hampton
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