Thursday, January 28, 2010

The Case for Deflation - Discussion 1 With the Challenger

I really like the points Gary Schilling makes in his abbreviated 2010 Outlook posted previously here on FS. I am in general agreement. Curious George is not in agreement on some important issues. With all respect, I would like to respond to his challenges to Schilling for the purpose of clarifying my perspective. This is an issue that has been on the top of my list of difficult questions and I have put a lot of time into forming a position. Without having a position defined, I would be drifting in the direction of the last best argument I listened to. I can't accept that. I know Curious George has also made the effort. He recently sent a message which said in part "Nothing is more central to portfolio management than the inflation / deflation debate. We can't afford to get this wrong." He and I have, so far, arrived at different conclusions. There is no need to agree, but we do need to understand the difference in our positions to better understand the situation. In the end we'll be much better advisors. There is no clear right or wrong yet. History will reveal that. 

I hope this discussion will have a life of its own here, that will contribute to a greater understanding for everyone who participates in any way. If you have an opinion, please leave a comment, or even better, eMail me that you have a contribution to post on FS. Do that by using the envelope tool at the end of this post. That message does not need to be anonymous.

Let me describe why I believe this is such a difficult topic. Look at the terms and their definitions. The discussion is about deflation and inflation. I have worked at researching these economic conditions to better understand them and to learn which one is the strongest influence on our economy now and in the near future. These two influences are at opposite ends of the 'flation' spectrum! It's like asking is it hot or cold, is this the start or the finish, are you coming or going! How can we rationally not be able to recognize which one is occurring in our economy? They are so different. If you are an investor, where do you want your wealth invested if you do not have a position on this topic?? It is a legitimate question and I found it often in the financial press and blogosphere. It was for me, the most asked and perplexing question in 2009!! Do you have a position on this issue?

Curious George challenges Gary Schilling on some points that I would like to respond to. Here are some of Curious George's counter points in orange followed by my POV...

To believe Gary Shilling’s 2010 forecast you also have to believe...

1a. 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.

1a. There is room for questioning whether the US $ is a safe haven. My POV is that it is always decided in relation to other safe havens. In other words, if not the dollar, then where? I believe the dollar wins that question still for several years, but its days are numbered. I described this in more depth in a post titled "Dollar Relationship to Financial Assets".

To believe Gary Shilling’s 2010 forecast you also have to believe…
1b. 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.

1b. At 4.7% on the long bond there does not seem to be much more room to fall. The chart below shows that it has been lower, during the beginning of the credit crisis. I believe it is possible to see enough worry develop over other major currencies for the T-bond to seem like a safer choice for many. The yen is in danger of complete collapse, the euro is under pressure from members with individual crises (the PIIGS: Portugal, Ireland, Italy, Greece and Spain), and the British pound is in a financial system crises. I conclude, that it is possible, even likely, that the T-bond can still appreciate further.

Click to enlarge

To believe Gary Shilling’s 2010 forecast you also have to believe…
1c. 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.

1c. Curious George has made a number of valid points here. They are slow developing problems and it remains to be seen where they lead to. These are not trends with a short fuse. We have time, and they can be influenced with monetary and/or fiscal policy.

To believe Gary Shilling’s 2010 forecast you also have to believe…
2a. 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.

2a. On this issue, I agree with Curious George more than I don't. Our difference is that he sees it in the near term. I see this further out. We have a serious recession going on. It is not being resolved but instead we are getting massive doses of pain killers (stimulus, bailouts, and arm twisting of sovereign funds). They are doing the job for now and the pain is dulled. Here is a link to an early post that touches on this issue. It is titled Fight the Fed (Treasury). The article mentions the implicit guarantee that banks seem to have from Treasury and the FDIC. In addition, they are piling up their allowance for loan loss reserves as the graph below illustrates. I have to take the side of the Fed, Treasury and FDIC. They'll do whatever it takes, gulp.

 Click to enlarge

To believe Gary Shilling’s 2010 forecast you also have to believe…
5a. 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.

5a. The value of the dollar is not driven by supply and demand as much as by politics and perception. Inquiring minds may find the 1997 educational pamphlet from the Chicago Fed helpful, despite its age. The title is Strong Dollar... Weak Dollar.

To believe Gary Shilling’s 2010 forecast you also have to believe…
5b. 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.

5b. In a deflationary economy, commerce is slowing, industrial production is declining, the value of corporate inventories drops. Commodities are going to be in less demand, no matter what the perception of supply is. The following graphs help to illustrate that there is little evidence at the moment to support either inflation or deflation. The first one is Producer Price Index, All Commodities.
Next is Industrial Production Index

Next up is Industrial Production Index

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.

16. I have to concede to Curious George on the energy and food fronts. I know he spends a lot more time on this front than I do.

If this discussion has changed your beliefs, please leave a comment to describe what change you notice. That will help frame the discussion, if it continues further. I think it will. This should be very helpful. Is it? How?