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Deflationary Threat To 1990’s Market Replay Story

  • Written by Syndicated Publisher No Comments Comments
    March 28, 2014

    Yesterday, I wrote a piece discussing why “It Is Impossible To Replay The 90’s”making the point that we are likely replaying the 1970’s instead.  My friend and colleague, Doug Short, emailed me with a valid point suggesting that the inflation of the 70’s, due to the Arab Oil Embargo, was not likely.  The real concern, in his opinion, is that we are in an era of stagnation, with the ongoing risk of deflation being the real “wolf at the door.”  To these points, I very much agree.

    As a point of clarification, my comments regarding the 70’s was more about the 18-year secular cycle that left investors deeply scarred after three successive bear markets.  However, Doug’s point is very interesting, and something that is a much more relevant threat to the current “recovery story” going forward.

    As I have discussed previously, the real threat to the Central Banks of the world is“deflation.”  Deflation has a deleterious effect on economic growth and once the deflationary cycle takes hold, it is extremely difficult to break.  This is why there has been such a focus by Central Banks to create “controllable inflation” through ongoing injections of liquidity via monetary policy.  Of course, the reality is that inflation is a function of a variety of factors and there is NO historical evidence that inflation can be contained, or controlled, by monetary policy once it appears.

    The chart below is the STA Composite Inflation Index which is simply the average of the Producer Price and Consumer Price Indexes.  With inflation still running well below the Fed’s target inflation rate of 2%, despite increasing their balance sheet to over $4 Trillion, the issue of ongoing deflationary pressures is evident.

    Inflation-Composite-Index-032514

    Note:  It is also important to note that sharp spikes in inflation have also subsequently led to recessionary bouts in the economy.  In other words, be careful what you wish for.

    First, let’s discuss what comprises inflation. In my view there are three components to inflation:  the velocity of money, wage growth and commodity prices.   The velocity of money is how fast money moves through the economy.  As money is loaned to businesses to create new products, build plants or expand employment – increased demand leads to higher prices.  As employment is increased, and the slack in the labor force is absorbed, the competition for employees causes wages to rise.  Higher wages lead to higher demand for goods and services.  The increased demand for goods and services leads to higher prices for the raw materials needed to produce those products.  In other words, these three components work together in creating inflation.  The index below is a composite index of these three factors to show the level of inflationary pressures in the economy.

    High-Inflation-Index-032514

    There are two important points to make about the chart above.  The first is the high correlation between the inflation index and overall economic activity.  This is EXACTLY what you would expect to see as rising economic activity leads to higher inflationary pressures and vice versa.  Secondly, notice the sharp drop in the index since the peak of economic activity in 2011-12.  Slowing rates of inflationary pressure has been a reflection of slowing rates of economic growth.

    The chart below breaks out the three components of the inflation index above so you can see what is happening more clearly.

    Inflation-Composite-Index-Breakout-032514

    With all three components of the index on the decline there is little evidence of stronger economic activity on the horizon.  The risk, as Doug stated, is a continuation of the stagflationary economy with ongoing threats of deflation along the way.

    I wrote last year that the Federal Reserve has gotten itself caught in a liquidity trap much the same as Japan has faced for the last 30 years.  To wit:

    “The signature characteristic of a liquidity trap are short-term interest rates that are near zero and fluctuations in the monetary base that fail to translate into fluctuations in general price levels.  The chart below shows that, in fact, the Fed has actually been trapped for a very long time.”

    Liquidity-Trap-032514

    “The problem for the Fed has been that for the last three decades every time they have tightened monetary policy it has led to an economic slowdown, or worse, as shown by the vertical dashed lines. The onset of economic weakness then forced the Federal Reserve to once again resort to lowering interest rates to stabilize the economy. 

    The issue is that with each economic cycle rates continued to decrease to ever lower levels.  In the short term it appeared that such accommodative policies did in fact aid in economic stabilization as lower interest rates increased the use of leverage.  However, the dark side of those monetary policies was the continued increase in leverage which led to the erosion of economic growth, and increased deflationary pressures, as dollars were diverted from productive investment into debt service.  Today, with interest rates at zero, the Fed has had to resort to more dramatic forms of stimulus hoping to encourage a return of economic growth and controllable inflation.”

    The problem for the financial markets is that, as discussed previously, asset prices have detached from the underlying fundamental factors.  The aging demographic trends will continue to strain the financial system forcing increasing levels of indebtedness to offset the rising cost of living.  That drain on the financial system, combined with poor fiscal policy to combat the myriad of issues restraining economic growth, does not bode well for a return to the 1990’s type stock market.  The continued monetary interventions are likely doing nothing more than continuing its long tradition of fostering boom/bust cycles in financial assets.

    As I stated recently in “What Inflation Says About Bonds & The Fed:”

    “The real concern for investors, and individuals, is the actual economy. We are likely experiencing more than just a ‘soft patch’ currently despite the mainstream analysts’ rhetoric to the contrary. There is clearly something amiss within the economic landscape, and the ongoing decline of inflationary pressures longer term, is likely telling us just that. The big question for the Fed is how to get themselves out of the ‘liquidity trap’ they have gotten themselves into without cratering the economy, and the financial markets, in the process. As we said recently this is the same question that Japan is trying to figure out as well.”

    The chart below shows the Japan problem.

    Japan-Liquidity-Trap-032514

    Should we have an expectation that the same monetary policies employed by Japan will have a different outcome in the U.S?  That seems to be the general theory by the majority of analysts and academia.  Of course, this is no longer just a domestic question since every major central bank is now engaged in coordinated infusions of liquidity.

    For individuals, this is the real “monster in the closet.”  Rising inflationary pressures can be offset by purchasing assets that rise with inflation such as commodities, hard assets, real estate, etc.  However, in a stagflationary, or a more damaging deflationary cycle, there are no real solutions.  This is why deflation is such a concern.

    The Federal Reserve is currently betting on a “one trick pony” to jump start an economic growth cycle.  The hope is that the inflation of asset prices and suppression of interest rates will kick start a organic, self-sustaining, economic recovery.  However, as I stated yesterday, these programs have in effect actually run in reverse by acting as a transfer of wealth from the middle class to the rich.  This “reverse robin hood” mechanism has likely done little more than fuel the next asset bubble without any repairs to the underlying fundamental economy.  Dr. Richard Fisher, President of the Dallas Fed, recently made five points in this regard:

    1) QE was wasted over the last 5 years with the Government failing to use “easy money” to restructure debt, reform entitlements and regulations.

    2) QE has driven investors to take risks that could destabilize financial markets.

    3) Soaring margin debt is a problem.

    4) Narrow spreads between corporate and Treasury debt are a concern.

    5) Price-To-Projected Earnings, Price-To-Sales and Market Cap-To-GDP are all at “eye popping levels not seen since the dot-com boom.”

    In response to Doug’s point – “this time is indeed different” from the 1970’s.  However, it is different only from the standpoint that what confronts the markets, and the economy, is not worries of spiking inflation but an ongoing, persistent and pervasive threat of deflation.  Increases in productivity, a large amount of slack in the real labor pool, low levels of demand and, as discussed yesterday, a highly leveraged consumer all contribute to the ongoing problem.  Regardless, the fundamental and economic environment will remain clear headwinds to the start of the next “secular bull market” for some time to come.  While it is entirely possible that we could see a further “melt-up” in stock prices in the months ahead, rising asset prices and a surging economic recovery are likely to remain two different things.

    Images: Flickr (licence attribution)

    About The Author

    Lance Roberts – Host of StreetTalk Live

    After having been in the investing world for more than 25 years from private banking and investment management to private and venture capital; Lance has pretty much “been there and done that” at one point or another. His common sense approach has appealed to audiences for over a decade and continues to grow each and every week.

    Lance is also the Chief Editor of the X-Report, a weekly subscriber based-newsletter that is distributed nationwide. The newsletter covers economic, political and market topics as they relate to the management portfolios. A daily financial blog, audio and video’s also keep members informed of the day’s events and how it impacts your money.

    Lance’s investment strategies and knowledge have been featured on Fox 26, CNBC, Fox Business News and Fox News. He has been quoted by a litany of publications from the Wall Street Journal, Reuters, The Washington Post all the way to TheStreet.com as well as on several of the nation’s biggest financial blogs such as the Pragmatic Capitalist, Zero Hedge and Seeking Alpha.

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