Deflation Can’t Happen? What About All The Falling Prices?

In response to my recent post suggesting that the forces of deflation are fighting those of inflation  (mostly weak housing, growing unemployment, and compulsory reductions in state and local budgets vs. the easy Fed and large federal deficit spending), one reader chastised me for even considering the possibility of deflation.  He and many other commentators say “it can’t happen”. They assume we must be entering a period of inflation because that’s the only way the gigantic projected federal deficits that will create mountains of federal debt - both in the U.S. and even more so in Euro-land and Pound-land - can possibly be serviced.  Besides, that’s always how it’s comes out, they say.  Print a lot of money, you get inflation.

Inflation fears seem to have started to drive the dollar down which is keeping oil high despite ample supply.  And gold is looking a little frisky too.  If you think inflation is the future, sell anything denominated in dollars - or any fiat currency the value of which will be inflated away.  Buy gold, oil, Brazil, China.  Even copper.  The last thing you want to own is a bond.

The inflation bugs may be right but I still have a hard time squaring that picture with reality.   I see prices falling (which is called deflation by economists).  Homes for sale and homes for rent.  Every store seems to be running sales every day, 24/7.  Airline seats are on sale.  Cars are on sale.  Hell, pretty soon some former Chrysler and G.M. dealers will have to just about pay people to take their inventory away.  Basically, this is a buyer’s market for just about anything you can name - except gold and oil.

But what’s even more important than currently falling prices is that the immediate future seems to promise more of the same.  Increased unemployment is making more “good” mortgages into bad ones.   It’s causing a “third wave” of foreclosures according to Monday’s Times report.  As the Financial Times’ Lex column reported (5/20/09).

“That [the 3rd wave], in turn, puts further pressure on house prices, which means more losses for the banks, and greater difficulty when it comes to expanding consumer lending.  So consumer spending will continue to suffer at the cost of more jobs.  The housing market has moved beyond a cyclical swing from boom to bust into a fundamental cycle of negative feedback that weights on the whole economy.  This downturn has not yet run its course.”

Beyond the macro-economic cycle pushing prices down, I think there are two fundamental and gigantic forces combining to keep prices going down - and to keep unemployment in OECD economies going up.  They are globalization and technological progress.  They get very little notice in the press but I think they are key to understanding our new economic environment.

The Nexus of Globalization and Technology

You see it’s not just that globalization is moving jobs from OECD countries to Chindia.   And it’s not just that Moore’s Law and other technology gains are lowering prices of high-tech products constantly and letting more goods be made with fewer workers (adding to employment pressures).  If that were the whole picture then the OECD countries could make up the loss of their low-tech production jobs by creating new high-tech jobs making and selling high tech and complex, sophisticated products to Chindia.   And for a while things did seem to be working that way.  Each trading partner pursuing its “comparative advantage.”

But now we have the two trends combining to change the nature of international trade.  Now we see high technology itself moving to Chindia.  The OECD is rapidly losing its competitive advantage in high tech while it is still at a huge competitive disadvantage in labor costs.  So we read that China is developing next generation high-efficiency cars that they will export to Europe and the U.S.  Then we read that if G.M. succeeds in emerging from bankruptcy their plan is to produce the next generation of small efficient “G.M.” cars in China and import them to the U.S.  China is starting to make airplane components; it won’t be long before China will produce airplanes in competition with Boeing.  India is doing sophisticated medical procedures and luring Americans to save money on dental and other planned surgery by taking a vacation while they solve their medical problems.   Much U.S. accounting, legal, and consulting work is now done in India.

So if Chindia produces the high-labor-content cheap goods and the high-technology-complex goods and services- both at lower costs than the OECD can match - where does that leave the OECD worker with any prospect for employment opportunities in such a new world?   I wish I knew an answer to that question. Of course the pundits, the Tom Friedmans of the world, and the politicians always say, “We welcome competition because the American worker is the most productive in the world, blah, blah.”  Right.  Well, some people need to raise the flag and salute just to be politically correct.  I wish their talk of American competitiveness comported with any conceivable walk than I can envision for the future.

It seems like the only competitive advantage the American worker retains now is in providing on-site services.  The burger flipper’s job is secure.  The Walmart job is secure.  Become a plumber or electrician - those jobs are secure.

So, deflation or inflation - or stagflation?  And how to invest?

This all adds up in my mind to two conclusions that seem inescapable.  First, this recession is not going to end in the next few months as a majority of registered economists now predict.  It is likely to drag on a good deal longer.   Second, when it does end, the new economy will be a good deal weaker than the one we experienced from 2002 - 2007.

That scenario might be okay for stocks if it came along with low interest rates, which usually do accompany low growth.  The problem is that we may experience the dreaded “crowding out” phenomenon that deficit hawks have always warned about but which heretofore has never occurred.  The gigantic federal deficits may well cause both a decline in confidence in the dollar and a need for higher interest rates in order to attract the capital the government will require.  That will make financing private deals harder and the general level of interest rates higher.  High interest rates are not a positive backdrop to equity investing, nor is a difficult market for private borrowers.

We are looking at multiple years of trillion dollar federal deficits projecting into the future - throughout the OECD.  And that’s only what has been officially projected.  There are all sorts of potential land mines out there that could increase federal deficits.   Foremost among them is a lower growth rate coming out of the recession than the administration has projected and thus lower federal revenues and high federal welfare spending.  There are also potential bankruptcies of the federal pension benefit guarantee entity and various municipal governments.   Such crises would require more huge federal outlays.

The potential for inflation exists if future deficits get monetized.  But future years’ deficits could be reduced by means of higher tax rates although nobody wants to talk about raising taxes right now.  I happen to agree with Paul Krugman that politicians’ fears of higher taxes is both unjustified and a potential impediment to finding a practicable solution to a potentially intractable problem, but we’ll leave that topic for another time.

Pundits are saying that recently higher gold and oil prices and the lower dollar are anticipating the inflation that may come in future years.   That seems to me like a dangerous assumption.  Anticipating events that may not be realized for a few years at the earliest could lead to great disappointment.  I hesitate to buy gold because I do not think we are necessarily going to see inflation.  I do think that fundamental supply problems will eventually push oil prices higher (as I discussed last March) so I choose to hedge potential inflation risks with oil futures options.  (Incidentally I also think there is a high likelihood that oil prices could drop in the short term so I am keeping a fair amount of cash on hand to buy oil equities if the opportunity does present itself.)

Foreign stocks in countries like China, Australia, Canada, and Brazil seem to merit inclusion in a portfolio these days.  Those currencies and economies should all do well in future years regardless of whether the OECD encounter deflation, inflation, or stagflation.  Owning stocks in such strong-currency countries rather than companies tied to the U.S. economy and the U.S. dollar seems like a smart approach for now.  I do so with ETFs such as EWA (Australia) and CAF (China) along with various Canadian energy plays.

If deflation seems to be taking hold I suspect we’ll see a test of the bear market lows.  Will foreign equities do well if the U.S. stock market has another melt-down?  I doubt it.  On big moves global markets seem to work in synch in the short term.  But I suspect strong-currency stocks will outperform U.S. equities short term and bounce back faster longer term.  To obtain additional portfolio protection it may not be a bad idea to own some out-of-the-money puts on the U.S. market.  I have some and am thinking of adding more.

The U.S. equities I do own relate to oil or alternative energy.  It’s clear that the electrification of the car is one of the next big trends.  There are a number of battery and battery-related companies with outstanding opportunities to become much bigger and more profitable.   I’ve written about some of these companies.

In short, the strongest conviction I have is that we are investing during extremely dangerous times.  Being “very careful out there” is the major imperative.   If cash offered safety, I’d say that’s where I’d most want to be.  But if inflation takes hold cash will not be a great place to be invested either.  That’s just one reason why today’s investment environment contains so many challenges.

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