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In
This Edition... |
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Though the arguments
for deflation have been dusted off and put back in play over the last three
days, it's not the foregone conclusion most investors seem to think
it is. Likewise, the pervasive inflation worries that had been in
place for the prior nine months or so have also been unnecessary
to date. One thing is for sure though....it's not like the economy can
sit on the fence much longer.... can it?
We'll take a
deeper look at the inflation/deflation debate below. However, keep in mind
this is just the first part of a two-part newsletter. The second
half will explain specifically what investors need to do in the event of
either outcome. Today's comments are the primer, yet an eye-opening read
all the same.
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Inflation
Versus Deflation: Reality Check |
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Not
since Rocky Balboa took on Clubber Lang have we seen such a fierce fight
take shape.... except maybe the Bush/Gore debacle.
 In
one corner we have the deflation pundits, freshly up from the amateur
ranks, and hungry to build on the evidence that Ben Bernanke served up
on Tuesday. The deflation idea also brings with it a new-but-large fan
base.
In the other
corner we have the inflation entourage - longer in tooth and a little more
'seasoned', but also supported by the raw data. Its followers seem to be
dwindling in number, but it's still got enough of the right backers in
its back pocket.
All silly metaphors
aside, things are about to get really interesting - one way or another
- real soon. The question is, what's the real story here?
The Big Picture
We've all felt
pretty lucky to have dodged the inflation bullet since mid-2009. After
all, a ton of cheap dollars and record-low interest rates would inevitably
lead to a price explosion, right? Funny thing though; it never really
panned out. Inflation hasn't been above 2.8% since the apparent recovery
began, and it only reached that level for a brief period in December. Before
and after, it's been closer to 1.0% than 2.0%.... and it's been decidedly
falling since December to boot.
 Now,
the
reason for the lack of inflation is become a little clearer - and investors
don't like the picture they're seeing.
It's not a matter
of luck or skill that staved of inflation. It's a lack of demand.
Yes, money is cheap, but only if you can get a loan. And, even for those
who can get a loan, why would they want to in this uncertain
environment?
That question
sets up a key point about the whole mess though. Deflation in itself
isn't
a problem. It's what deflation indicates (tepid demand) and what
it causes (crimped corporate margins, and usually weaker wages)
that are problems. Both are bad for business, which is why it's very, very
undesirable.
And this whole
deflation possibility isn't entirely (partially, but not entirely) a case
of "the sky is falling" hysterics drummed up by the media to sell
tickets, err.... advertising. A lot of people who should know what
they're talking about see an alarming amount of similarity between what's
going on in the U.S. now to what happened in Japan - deflation on steroids
- back in the 90's. Too much debt spurred by crazy real estate demand?
Check.
Unserviceable debt levels? Check. Falling incomes and weakening
employment? Check. It's all been seen before, with a nasty end result...
as
PIMCO's Scott Mather pointed out in a recent interview.
Though Mather
goes on to also cite differences, just drawing the comparison to Japan's
woes still sends shivers up the market's spine.
Enter the Fed.
Out of interest
rate ammunition now that rates are literally as low as can possibly be,
Bernanke & Co. opted on Tuesday to boost the economy by injecting a
little liquidity into it. The intended effect is said to be a slight drop
in long-term interest rates (and mortgage rates in particular) that
should prod consumers just enough keep the economy from stalling.
That was the
official party line anyway. There's a 'rest of the story' you didn't
hear though.
The Fed's
Gambit in Perspective
 Most
investors will readily recognize that the $10 billion being injected into
the economy for the next few months isn't much. What they may not
realize is just how ridiculously little it is. The M1 level (all
cash plus checking accounts) right now is around $1.7 trillion; that $10
billion is about half of a percent of the total liquid and on-demand money
holdings.
In some environments
such an injection would have a measurable ripple effect (the money multiplier
effect). In this environment though, it may have none.
Why?
The problem isn't a lack of cash in the system - there's already a stunning
amount of cash in the publics' hands. It's a lack of willingness to spend
it, borrow it, or lend it. The Fed is betting that the maneuver will shake
things up just enough to get the wheels spinning again .... which should
keep deflation at bay at least until the economy can find firmer footing.
And, perhaps it will. It's no guarantee though.
With all that
being said, and with the likely pointlessness of the Fed's quantitative
easing understood, there's another twist to this tale.
Do As I Do,
Not As I say
The deflation
chatter has been flipped on like a switch over the last three days, with
lots of table-pounding and emphatic gestures to drive the idea home. Most
of the arguments are pretty convincing too, which is why many folks believe
'em. Interestingly though, while many are listening to the deflation arguments
and nodding their head in agreement, they're also betting that inflation
is coming anyway.
 How's
that? Two pieces of evidence. The first one is that the spread between
treasuries and TIPS widened on Tuesday. The second is the spread between
10 year and 30 year bonds - it's also been widening going into and
coming out of Tuesday's Federal Reserve meeting. In fact, the 10 yr//30
yr. spread is at record levels. Both clues point the same direction though....
an
expectation of inflation despite all the deflation discussion.
If you think
the spreads are just coincidental, then think about this - Warren
Buffett saw the same information, and came to the same inflationary conclusion.
He also put
his money where his mouth is, making a conscious decision to shorten the
average duration of his bond portfolio - which makes him less vulnerable
to inflation. It doesn't exactly scream 'deflation' when the world's most
notorious investor is betting the other way.
And, considering
all that cash is still sitting on the sidelines but could flow back in
(as hoped) with no warning, it would be dangerous to discard the idea of
potential inflation.
Bottom Line
Quite a conundrum,
huh? Though the deflation argument is en vogue and has logic (and the
near-term trend) on its side, the inflation argument has the data and an
experienced veteran on its side.
Given all of
this, plus a keen understanding of how investors love to argue extreme
opinions, we can only come to this conclusion:
 Nobody
really knows if deflation, or inflation, is on the way.
How boring.
How timid. How..... true?
Go ahead and
jump in the debate if you want, from just an academic stance, or even as
an investor looking to make a decision. You'll never have finality though
- at least not until it's too late.
Oh, the
press will pose all the pundits' arguments as factual and meaningful, but
being helpful - or even right - isn't its goal. The market's simply
gotten bored now that earnings season is over, and the media needs a new
carrot to hold out in front of investors. The more exciting that carrot
is, the more heated the debate becomes. Don't be fooled though... all of
these forecasters are guessing, at best.
And just for
the record, the bulk of them also predicted rampant inflation that never
materialized. What makes them correct now if they were wrong then?
The unspoken
reality: The most likely outcome here is modest (normal) inflation;
the most extreme prognostications rarely pan out. And even if we
do
see the inflation scales tip decidedly on one side or the other, we've
seen nothing yet to truly suggest such an event is looming. We just
know that conditions are allegedly right for it.... like they were for
unbridled inflation a year ago.
Our advice?
As
always, let's respond to what the market is doing rather than what
we think it should be doing. And as of right now, as far as inflation
or deflation is concerned, it's actually doing nothing. It may do
something significant later, but that's conjecture.
The overarching
point is simple - don't get sucked into the guessing game. It's
easy to do when it's all you see, but this debate is more noise than substance
for now.
The risk all
investors are currently running is making a big decision on nothing more
than these educated guesses. Problem is, the economy's a moving target;
static guesses about it are a recipe for a mistake more often than not.
Be sure to look
for our next newsletter, where we'll be laying out contingency plans -
specific stock ideas - when and if we start to see inflation or deflation
materialize.
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Updated: 8:15 pm PDT (03:15 GMT), November 2, 2010
