Monday, February 15, 2010

Inflation or Deflation? Cancer or heart attack?

I have been pounding on the inflation vs. deflation theme for some time, largely because I believe that this is likely to be the Investment Call of the Decade. Get it right and you’ll be a hero, but get it wrong and you’ll be a goat.

Why is making such a forecast so hard?

John Mauldin recently wrote in his essay Between dire and disastrous:

[W]e have made a series of bad choices, often the easy choices, all over the developed world. We are now entering an era in which our choices are being limited by the nature of the markets. Not only are we in a path-dependent world, but the number of paths from which we may choose are becoming fewer with each passing year.

Our economic future is more and more a product of the political choices we make, and those are increasingly difficult. We have no good choices. We are left with choosing the best of bad options. Some countries, like Greece, are now down to choices that are either dire or disastrous. There is no "easy" button.

Inflate, raise taxes or default
In other words, the developed world has done some really stupid things and it’s time to pay the piper. Paul Kedrosky's comments on the Mauldin essay was also apocalyptic:

We are in the fullness of time approaching the End Game. In country after country, the choices that have been made over the last decades will yield a Greek situation, where there are no good choices. And the longer the hard choices are put off, the more difficult they will become.

For some countries it could mean deflation. For others, it will look like inflation on steroids. Countries with sensible budgets and policies will thrive.

How the piper gets paid is dependent on future policy decisions, which are unknown. David Merkel of Aleph Blog says that governments have three choices, inflate, raise taxes or default. The first will lead to the cancer of rising inflation, the last two to the heart attack of a deflationary collapse.

This time is (sort of) different
I cringe whenever someone says “this time is different.” However, the policy choices that we face indicate that we are entering an era where things are different, but not unprecedented. The chart below from Macquarie Equities Research shows that macro-economic volatility has significantly risen.

Is this a New Era? Yes.

Is this time different? Yes.

Is it unprecedented? No.

Portfolio implications
The OECD experienced similar levels of macro-economic volatility back in the 1960’s and 1970’s. However, most of the investment professionals today have not experienced these kinds of macro conditions in their working lives and may not be able to adequately respond to this sea change.

Investment policies such as buy-and-hold which have worked well over the last 30 years are likely to be sub-optimal. Neither is the gold bugs' solution to buy gold, as the yellow metal is likely to perform poorly under a deflationary scenario. Dynamic asset allocation strategies, such as the Inflation-Deflation Timer model which are based on trend following principles, are likely to be better tools for navigating the treacherous seas ahead.


Michael Asus said...

The current economic environment is indeed tough and what is important to understand is the sheer magnitude of the debt problem facing the United States. With the total debt (both private and public) at 60 trillion dollars, or 400% of the GDP, the annual interest expenditures of 3 trillion merely to service this debt is an enormous drag on economic activity.

Inflating the debt away is however extremely difficult in the current climate, this is why I believe that the Washington Elite considers an attack on Iran a viable option out of this. By creating an oil shock the mechanism of cost-push inflation can be activated, with the help of which debts can quickly be inflated away as they were in the 1970s.

To find out more about this option please read

you will also learn about how this current situation came about into being and why deflation is such a sinister possibility for the US economy.

Gary said...

Sir -- while many investment managers were not around for the 1970s and may have trouble adjusting, you appear guilty of a similar offense.

There are four choices, not three. You forgot to mention the most obvious choice: CUT SPENDING

Societies cannot spend money they don't have. The baby boomer generation in the US (and its counterparts elsewhere) are the most selfish generation ever to have lived.

They have lived well beyond their means, and history shows they will either live below their means in their retirement / twilight years -- or else there will be revolution.

The existence of both the US and Canada are testimony to this -- both countries exist because the King of England (and France to a lesser extent) thought there were only three choices.

Both monarchies have ended, and the USA / Canada were created to implement choice #4 -- CUT SPENDING

It will happen, the only question is how

Cam Hui, CFA said...


While it is theoretically possible to cut spending, it is not politically possible.

IMHO, the one spending category that the US government could cut to balance the budget would be to drastically cut the military budget.

Gary said...

Mr Hui--

Military spending could be reduced somewhat, although if the US is to remain a global economic power, it must also remain a military power (some cuts are possible, but not much)

The obvious thing that will be cut that you are choosing to overlook is so called entitlement spending -- social security and Medicare

While baby boomers consider this the "third rail" of politics, cutting entitlements is the only thing that makes any sense at all.

Benefits have been cut before, means testing introduced (which is a cut by another name), and some benefits have already become taxable (another cut by a different name).

The most dishonest way of cutting benefits is to rig the CPI figures (which drive COLA in Social Security) to be less than actual cost of living increases -- again, this cut is already being made.

For those born after the baby boomers, entitlements are an empty promise. They will not be there for GenXers and beyond -- not even if one uses government accounting methods that would be considered fraud if committed by a private entity.

Simply put, GenXers (and younger) have "no skin in the game", and no reason to care **WHEN** (not if) entitlement programs get eliminated.

In all probability, entitlement programs will be transformed into elderly welfare programs, available to a limited group of retirees

The second obvious source of spending cuts is in government payrolls. Government bureaucrats in the US make almost double what private sector counterparts make, especially after factoring in the obscene public sector benefits

No one in the private sector gets a pension anymore -- so why should our so called "public servants"? Why do they get paid more, work less, and then get better benefits?

Slashing government payrolls is a second no brainer.

German polls show the German population doesn't want to work 90 hour weeks so Greeks can go lounge by the ocean -- and I would bet younger workers are not going to support entitlement spending and bureaucracy that doesn't benefit us in any way

Those are two obvious spending cuts. Older generations are going to have to learn to think "outside the box" (or remember some history). You cannot spend money you don't have, no matter how popular that spending might be to an elitist political class