Comstock Partners, Inc.June 15, 2012
Special Deflation Report
Deflation is a much more likely outcome than major inflation
We have long maintained that a debt bubble followed by a credit crisis leads to a deflationary recession or depression, and a major secular bear market. Nevertheless, a lot of smart analysts who agree with us on the existence of a secular bear market argue that actions taken by the monetary and fiscal authorities lead to severe inflation rather than deflation. It is clear to us, and everyone else, that virtually every central bank on the planet is being as accomodative as possible and markets around the world are applauding. In the past this has caused a rise in asset prices (commodities as well as stocks), and almost everyone is convinced that this will lead to inflation or hyper-inflation. While their case is logical and well-reasoned, we disagree as we will explain in this report. We emphasize, however, that, in either case, the result will be a major lengthy bear market.
When a debt bubble bursts, the need to pare down the debt to more normal levels (deleveraging) can be accomplished through either inflating the way out or paying it down. A third alternative----declaring bankruptcy and writing the debt off---- is so drastic that it would happen only if, and when, the first two alternatives were to fail.
Inflating the way out of excessive debt is a logical argument made by many people who we respect. We already know that Fed Chairman Bernanke will go to great lengths to try to avoid the dread of deflation. As a leading academic economist, Bernanke made a specialty out of studying the Great Depression, and ended up agreeing with Milton Friedman and Anna Schwartz that the Fed didn't do enough, and allowed the money supply to shrink and turn a standard recession into a major depression. At Milton Friedman's ninetieth birthday party Bernanke said "I would like to say to Milton and Anna: Regarding the Great Depression, you're right, we did it. We're very sorry. But thanks to you, we won't do it again."
He first pointed out why he felt that deflation had to be avoided. He defined deflation as a general decline in prices caused by a collapse in aggregate demand so severe that producers must cut prices to find buyers. The effects of a deflationary episode are recession, rising unemployment and financial stress, resulting in nominal interest rates of close to zero. At that point, since the nominal rate cannot go below zero, the "real" rate becomes the expected rate of deflation. Therefore, the real costs of borrowing becomes high enough to discourage spending, worsening the downturn. All of this puts stress on the nation's financial system, increasing defaults, bankruptcies and bank failures.
Bernanke maintains, however, that when interest rates reach zero, and deflation still threatens, the Fed has still not run out of ammunition. Under a fiat system, "the U.S. government has a printing press that allows it to provide as many dollars as it wishes" Therefore, he states that under a paper money system the Fed can "always" generate higher spending and positive inflation.
The Chairman then proceeds to list the actions that the Fed could take. It could expand the scale of asset purchases and the menu of assets that it could buy; make low-interest loans to banks; buy government bonds with longer maturities; or set specific rate ceilings and buy unlimited amounts at prices consistent with the targeted yields. It could also operate in the markets for agency securities. Even if all of that doesn't work, Bernanke adds that the Fed can offer fixed-term loans to banks at low or zero rates with a wide range of assets put up for collateral.
Bernanke also added that fiscal policy could help through broad-based tax cuts and increased government spending. He said, "A money-financed tax-cut is essentially equivalent to Milton Friedman's famous 'helicopter drop' of money." The government could also issue debt to purchase private assets. If "the Fed then purchases an equal amount of Treasury debt with newly created money, the whole operation would be the economic equivalent of direct open-market operations in private assets."
As Chairman, Bernanke now has the power (subject to voting on the FOMC) to carry out the list of remedies that he proposed, and has already implemented many of them. This is precisely what is scaring those who believe in an inflationary outcome. They believe that central bankers, not only in the U.S., but around the world, will attempt to prevent the destruction of debt and will continue to bail out every debt- troubled entity until debt is inflated down.
Although we understand and respect the view of those believing in an inflationary outcome, we disagree for the following reasons. Both private and government debt are far too high and must be deleveraged. Federal debt soared from 32% of GDP in 1982 to 101% on March 31 of this year. (Please see Ned Davis Research-NDR Charts 1 & 2.) It was about 60% as late as 2000, and has since taken off. Although the level of federal debt has received most of the media and Wall Street attention, the level of household debt, which is equally or even more relevant, bore greater responsibility for the credit crisis. Household debt climbed from about 30% of GDP in 1955 to 98% in 2008 (and never rose above 50% until the mid 1980s), and has since fallen back to 84% as of March 31. (Please see NDR chart # 3) The 60-year average was 55%, and was at 66% as late as 2000.
The problem is that GDP growth is dependent on a reasonable, although not excessive, amount of debt growth. For the last few decades it has taken more and more debt growth to achieve a given amount of GDP growth. Now debt must be reduced, and deleveraging is strongly deflationary. In order for governments and households to reduce debts they have to lower spending, and less spending means declining aggregate demand that causes producers to cut prices as Bernanke indicated above. Left alone, this leads to a negative feedback cycle resulting in less pricing power, competitive currency devaluations, protectionism and tariffs, plant closings and debt defaults. (Please see chart #4 titled "Cycle of Deflation-authored by Comstock Partners).
The question facing us is whether a combination of monetary and fiscal policy can stop the negative feedback from happening and actually lead to severe inflation, as many think. Although we cannot be dogmatic about it, our answer is: probably not. Despite TARP, the early 2009 fiscal stimulus, near-zero interest rates, QE1, QE2, "Operation Twist" (the Treasury bond purchasing program) and a myriad of other actions taken by the Fed, Congress and the administration, the recovery has been extremely sluggish and now seems to be turning down again. Once again, the Street is abuzz with talk of more Fed easing. However, the easiest and most reliable measures have already been taken and any remaining weapons are unorthodox, untried and subject to unknown negative side effects.
The problem is that the Fed can take their horse to water, but they can't make him drink. Since 2008 they have already tripled the monetary base, the item they control most directly, without a commensurate increase in money supply. The money supply divided by the base is called is called the money multiplier. Since 2008 the money (M2) multiplier has dropped from slightly under 9 to 3.7. The pattern is similar whether one uses M1 or MZM. Simply put, the huge increase in the base has induced a relatively small increase in the money supply. In turn, the increased money supply has not resulted in commensurate increase in GDP. The GDP divided by the money supply is called the velocity of money. Velocity has also dropped sharply in the last few years. (Please see NDR charts 5 & 6 for "Money Multipliers" and "Velocity".) Therefore, when taken together, all of the government efforts to stimulate the economy since late 2008 have resulted only in a tepid recovery that is showing signs of petering out.
In our view, it is the overwhelming force of the debt deleveraging that has overcome government efforts to inflate. We have pointed out that household (H/H) debt has dropped to 84% of GDP from its peak of 98% in 2008. H/H debt rose for 222 consecutive quarters, from when statistics were available in 1952 to mid-2008. These increases in H/H debt were not even interupted by the severe recessions of the early 1970s and early 1980s. And believe it or not, H/H debt has now declined for the last 16 quarters-- even Ripley would have a hard time believing this. This is an astounding number, indicating a great change in the economy. It still has a long way to go in order for H/H debt to reach the 66% level of 2000, let alone the 60-year average of 55%. Households, therefore, have to continue to increase savings and reduce spending for, perhaps, years to come to get their balance sheets in order. Since this reduces the demand for goods and services, businesses have little reason to hire new workers or increase capital expenditures. Since household spending accounts for 70% of the GDP, the negative effects are felt throughout the economy.
Under these circumstances, we believe that inflation cannot take hold in the real world. Businesses feel minimal pressure from rising wages and have no compelling need to raise prices. Even if they tried, consumers would not have enough income to pay the higher prices and would resist, forcing producers to rescind whatever price increases they try to put through.
Even now, there are straws in the wind indicating that the world may be headed for deflation. The economy is once again slowing down from a growth rate that was already mediocre. Recently we have seen lower-than-expected results or actual declines in GDP, job growth, retail sales, income growth, manufacturing production, core capital goods orders, vehicle sales and initial unemployment claims. There is uncertainty on tax rates, a dysfunctional congress, a contentious election and the so-called "fiscal cliff". Treasury bond rates are the lowest since at least the Eisenhower administration and in some cases on record. Commodities are declining worldwide (see charts 7 & 8). Globally, we are witnessing a recession and sovereign debt crisis in Europe, the increasing possibility of a hard landing in China, and weakness in Japan, India, Brazil and a number of other emerging nations.
In sum, we think that the global forces behind deleveraging have more firepower than the all of the world's central banks and governments together, and that deflation is a much more likely outcome than a major inflation. At the same time we recognize that a lot of smart people make a logical case for inflation. In either case, however, the outlook for the market is exceedingly bearish.