Tuesday, January 26, 2010

The Case for Deflation Described and Challenged

Curious George has offered another post for me to assemble. It is so interesting that I want to frame it as a debate between the primary author, Gary Schilling, and the debater, Curious George. Gary Schilling has posted a very good description of deflation that you can link to. The title of his post is 2010 Investment Strategies: Six Areas To Buy, 11 Areas To Sell. For anyone who wants to see what a deflationist outlook is, this is the spot. Curious George introduces Schilling and then challenges his beliefs. I'll use colors to distinguish the two, Schilling's beliefs in orange, Curious George's challenges in green.

Gary Shilling is a long-time Forbes prominent investment advisor and economist. He is mostly a stock market bear and deflationist. While there is much to agree with in his 2010 forecast, there is plenty to debate. Shilling is far more experienced and credentialed than I but he is not beyond questioning.

We see the 2010 investment climate dominated by weak economic growth here and abroad, led by U.S. consumer retrenchment. More government fiscal stimulus and continuing Fed policy ease are likely in this setting. So is low inflation or deflation.


1. Buy Treasury Bonds...Many believe Treasury yields are headed up, not down. They think that all the bank reserves created by the Fed that have not generated bank loans will do so, flooding the economy with money and then create excess demand and inflation. They also think the continual heavy issuance of Treasurys to fund the nonstop federal deficits will push up yields. In contrast, we don't foresee the rapid economic growth needed to induce chastened banks to lend and cautious creditworthy borrowers to borrow. And if we're wrong, it will take at least several years to eat up global excess capacity during which the ever-inflation-wary Fed will no doubt remove the excess bank reserves, as Fed officials have already indicated.
We do expect large federal deficits for many years, in part because of pressure on government to create jobs and restrain unemployment in a slow growth economy. But those deficits will increasingly be funded by U.S. consumers as their saving spree continues. Although stock market bulls salivate over the prospect that increased saving will mean more equity purchases, we believe most of the money will continue to reduce the immense debt consumers have accumulated in recent decades.

To believe Gary Shilling’s 2010 forecast you also have to believe…
1. US T-bonds are fairly valued and even undervalued. Historic and manipulated low interest rates are no cause for concern. The US dollar is a safe haven, credible store of value and will appreciate from its undervalued state. The multi-trillion dollar budget deficits and multi-trillion fed monetization have little negative economic consequences and even positive outcomes. T-bond liquidity, “best credits in the world” and noncallable features are sterling. The 30 yr T-bond will decline from 4.7% to 3.0% due to outstanding demand. Foreign buyers will return to the US treasury market because they recognize value when they see it. Foreign buyers will have the capital to purchase an expanding supply of US debt. Consumers will step up and buy their share of attractive high yielding government securities. The net after taxes and inflation return of treasuries is compelling. Current fiscal and monetary policy is positive for treasuries. Velocity is the only source of inflation. Dollar devaluation and scarcity do not matter and do not lead to inflation. The US consumer saving spree will be a source of US debt funding and will not move into sovereign debt or hard money. The declining trade deficit somehow mitigates extreme fiscal and monetary policy. Economic statistics accurately measure their underlying functions. Hundreds of trillions of CDS and interest rate swaps will have little negative affect on the banking industry and the US dollar.
2. Buy Income-Producing Securities. This includes high-quality corporate and municipal bonds as well as stocks of utilities, consumer product companies, health care firms and others that pay meaningful dividends that are likely to rise. Master Limited Partnerships are also possibilities, but only if their underlying businesses are secure enough to continue significant income flows to limited partners and stockholders. Banks used to pay significant dividends but slashed them when their earnings collapsed. Nevertheless, their deleveraging and reversion to safer but less growth-oriented businesses will probably pressure them to again pay attractive dividends.
To believe Gary Shilling’s 2010 forecast you also have to believe…
2. Cities, counties and states will not default on their obligations or try to renegotiate with bondholders. Dividend paying companies will not reduce dividends. Banks are getting healthier. Banks will begin paying dividends again. The next wave of option arms, alt A and prime mortgages over the next 18 months will catch the banks rested and prepared to deal with the new wave of foreclosures. There will be no commercial real estate issue to add to the banks problems. The shadow inventory of residential real estate which is five times the size shown in multiple listings is not a problem for the banks.
3. Buy Consumer Staples and Foods. Among retailers, the winners may continue to be discounters.
3. No Issue
4. Buy Small Luxuries. Companies are adapting to small luxury modes in various ways. Some are offering the same products with lower cost and selling prices. Coach is cutting ladies handbag prices and working with suppliers to reduce costs. Neiman Marcus is pressing suppliers for lower-cost versions of designer styles.
4. No Issue
5. Buy The Dollar. Despite all its drawbacks, however, the dollar remains the world's reserve currency and safe haven, regardless of suggestions by the Chinese and others that the dollar should eventually be replaced by a global currency. This status for the buck appears to be reemerging and will grow if we're right and hopes for a rapid economic recovery are dashed... We favor selling British sterling... The euro is vulnerable... Commodity-driven currencies like the Canadian, Australian and New Zealand dollars are also likely to weaken...
To believe Gary Shilling’s 2010 forecast you also have to believe…
5. The financial crisis of 2008 drove safe money into the US dollar and the dollar fell as the crisis faded. Another rally in the dollar then could imply another crisis in the making. A new crisis will see the same behavior as the last crisis. Current fiscal and monetary policies have no negative consequences to the dollar. In fact the dollar can benefit from these policies. The dollar will remain the world’s reserve currency and a safe haven. The dollar’s status is “reemerging and growing.” The current dollar rally is just the beginning of a longer sustainable rally. Commodity prices will fall. Scarcity is not an issue. The fundamentals of commodities are poor. The technicals of the commodities are poor. Canadian, Australian and New Zealand currencies will fall against the dollar because they are commodity based and their economies, fiscal and monetary policies are not as sound as those of the U.S. The more fiat and more debased currencies always do better than those based on commodities.
6. Buy Eurodollar Futures. Eurodollar futures are a way for companies and banks to lock in an interest rate today, for money it intends to borrow or lend in the future, and for investors to bet on the future direction of short-term interest rates.
6. No Opinion.
7. Sell U.S. Stocks in General. Our $50 estimate of operating earnings, down 11% from estimates for 2009, puts the S&P 500 index P/E at a nosebleed 22.5 level, as noted earlier.
Selling stock indices short, either through futures contracts or ETFs, strikes us as a prudent idea.

7. I agree completely.
8. Sell Homebuilder and Selected Related Stocks. Low mortgage rates are a plus, but are only meaningful to those who qualify for loans as lending standards tighten. Most now need to meet the old conservative standards of 20% down, good credit, full documentation of income and assets, etc. And lower borrowing rates don't help underwater homeowners either refinance or buy other houses. Furthermore, rates on large "jumbo" mortgages remain high. Finally, lower house prices don't induce buyers who expect the downward trend to continue and hold out for even-lower prices.
8. I agree completely.
9. Sell Selected Big-Ticket Consumer Discretionary Equities--for two powerful reasons. First, as consumers persist in their saving spree they'll continue to curtail spending on expensive postponeable items. Second, as widespread price declines persist, they will be anticipated. Prospective buyers will wait for lower prices.
9. I agree completely.
10. Sell Banks and Other Financial Institutions. Stringent, probably excessive regulation is replacing the laissez faire model. Higher capital requirements and other limits on risk-taking will curb bank profitability. So will the limits on executive pay aimed at reducing the incentive to take big risks.
10. I agree completely.
11. Sell Consumer Lenders' Stocks. Layaway plans are replacing the buy now-pay later approach. With the switch from a quarter century consumer borrowing-and-spending binge to a long run saving spree, the credit card business has moved from a growth industry to a laggard.
11. I agree completely.
12. Sell Many Low and Old Tech Capital Equipment Producers. Besides the depressing effects of excess capacity, low and old tech companies suffer from ongoing problems. Foreign competition continues to grow as their technology is transferred to China and other cheap production locales. Some suffer rising cost pressures due to lack of productivity gains. High-cost unionized labor forces are sometimes a problem. And many sell into saturated, slow growth markets.
12. No Opinion.
13. If You Plan to Sell Your House, Second Home or Investment Houses Any Time Soon, Do So Yesterday. This strategy has worked for the last two years and will continue to do so if we're correct and house prices nationwide fall another 10%.
13. I Agree
14. Sell Junk Bonds. Slow revenue and cash flow growth will make it difficult if not impossible for a number of financially weak and weakening firms to service their bonds and other debts.
14. I Agree
15. Sell Commercial Real Estate. As discussed earlier, excess capacity and big refinancing requirements in coming years will continue to plague hotels, malls, warehouses and office buildings.
15. I Agree
16. Sell Most Commodities. And the strengthening dollar should depress the prices of the many commodities traded worldwide in dollar terms. We look for falling commodity prices this year.
To believe Gary Shilling’s 2010 forecast you also have to believe…
16. peak oil is a myth. You have to believe depletion is not a problem and new oil is easily extracted from deep water and the Canadian oil sands at today’s prices. Additional oil from these sources is not needed. Oil companies will provide as much oil as needed at any market price even below production cost. After declining 80% from its highest price, natural gas is fairly priced or even overpriced and producers provide all the market can use at this price point. Food commodities are not in short supply and there will be no weather event interrupting food supplied to the market. Rising population, expanding middle classes in China and India coupled with possible weather events have no impact on food commodity prices. Food stocks are not at abnormally low levels.
17. Sell Developing Country Stocks and Bonds. Still, most developing economies depend on exports for growth, and the U.S. consumer has been the biggest buyer of those exports and far and away the globe's biggest spenders. As the American consumer saving spree continues to shrink the U.S. trade and current account deficits, those developing economies will be subdued.
17. No Opinion