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Why I’m Not Betting On Hyperinflation
By Paddy Power Trader on March 28, 2009 | More Posts By Paddy Power Trader | Author's Website
One of the big thematic trades at the moment (which big hedgies like David Einhorn and John Paulson are apparently keen on) is the collapse of the dollar and the return of hyperinflation because of currency debasement. But I’m not convinced. Why?
I think there are several flaws in this argument. The debt being taken on by governments through the bank bailouts etc was there before - it was just on the private sector’s balance sheet, not the public sector’s. At one point in the economic cycle, what are now labelled as ‘toxic debts’ were actually regarded as ‘high performing assets’ by the banks. They generated cash, not haemorrhaged it.
Avoiding Deflation Is The Real Issue
So the real issue is how to avoid asset price deflation. If the value of the assets that debt is set against goes down, and individuals and companies can’t generate enough cash, then the debt becomes more expensive, if not impossible to service. It goes toxic. So the twin spectres of negative equity and defaulting debtors kicks the banks in the head. Especially when the banks also borrowed like crazy to fund acquistions and more lending. Perhaps the net amount of debt in the economy isn’t actually increasing, it’s just being transferred off the balance sheets of companies to the state (and taxpayer). Now regardless of what you think about the politics of that decision, there isn’t much that can be done about it.
If it’s a choice between massive corporations going bust and a total collapse in employment or governments taking on more debt, and some modest inflation as a result, then perhaps governments taking on more debt is the lesser evil. It’ll all have to be paid for one way or the other. If it’s on the public balance sheet we’ll pay through increased taxation and reduced public spending in the future. If it’s on the private balance sheet (ie individuals and companies) we need a stack of cash to pay down debt. Which most people don’t have. And if we want to avoid civil unrest and all out war between the haves and the have-nots then the government has to step in to prop up the banks, and try to prop up asset prices by maintaining investment. Otherwise we really are going to hit the skids.
So cash stays king, and in my book that still means dollars, as I’ve argued repeatedly before.
And inflation - especially if it’s not overdone, has the one advantage of reducing the ‘real terms’ value of historic debt. Modest inflation enables debt to become more manageable. It’s opposite - deflation - turns debt into a raging monster that threatens to consume the world and gobble up all the spare cash.
Deleveraging Isn’t Finished Yet
The second thing is that deleveraging - paying off debt - is far from over. The one thing everyone is focussed on is how to generate cash and pay off debt, particularly in an environment where they’re worrying about the value of their assets going down. In fact trillions of ‘net worth’ have been wiped out, as asset prices - equities, property etc - have collapsed. So there’s even less cash around to pay down debt. And if deleveraging isn’t over, then one thing governments can do to help is try to bring down the cost of capital - near-zero interest rates, printing money, quantitative easing, etc.
And my bet, for what it’s worth, is that demand will stay muted - people are hoarding cash - and that will keep a lid on inflation. Although I admit that currency debasement does pose some risks, especially in the UK and in Eastern Europe. The unexpectedly high CPI figure for February seemed largely to do with the reduction in value of the pound and thus the higher costs of imports. (Set against that it means that sterling-priced goods are more attractive - look at the situation in Northern Ireland!).
The one silver lining in this sky full of black clouds is that households which have managed to stay in work will see a real increase in their spending power over the next 12 months, as lower interest rates and tax cuts work through. And this, combined with some serious public spending on infrastructure, energy efficiency, education and healthcare - could - just - keep things afloat. It’s a long shot - but in my view the risk/reward ratio is stacked closer to the ‘recovery’ trade than all out armageddon. So that’s how I’m playing it.
How To Trade This?
If you want to bet on massive inflation you can buy gold, even perhaps oil, buy well-capitalised commodities stocks, and sell the dollar on the basis that the amount of cash being printed and the amount of debt being taken on by governments is going to send us all to armageddon. But somehow that view doesn’t quite seem to ring true right now, at least to this naïve rabbit.
My view is that we may well see some modest inflation, but I’m more persuaded by arguments that the inflationary risk is already priced into gold. Perhaps Gold might correct downwards some more, particularly if more money continues to go into equities and corporate bonds. On gold my view is neutral for now, if not slightly bearish. However I can see some scope for modest price increases in other commodities, as we’re trading at multi-year lows.
I’m looking to buy into companies which aren’t overleveraged, have strong cash flow, and that can take advantage of cheaper capital and lower input costs to pass savings on to consumers. I’m back on the track of thinking that discount retailers (the likes of Walmart (NYSE:WMT), Family Dollar (NYSE:FDO), and the UK supermarkets - but perhaps not Tesco (TSCO.L), ‘cos of their debts) fit the bill pretty well. Also drinks and cheap entertainment - cinema and other cheap nights out, or in - look good. Think Diageo (NYSE:DEO), Wetherspoons (JDW.L), Cineworld (CINE.L) and B Sky B (BSY.L). Perhaps even some utility and telecoms companies. In general I’m looking at companies which generate plenty of cash, have low levels of debt and which provide good value services and products to large audiences. And I’m also researching a few small cap companies that I think have massive potential to innovate in this environment. Suggestions welcome!
And if you have any ideas why the euro remains so strong in the face of this sort of economic carnage in Latvia and the Ukraine (to which the European banks are massively exposed) please let me know. Correction against the dollar - and even perhaps sterling - on the cards soon, surely? (As I write this EURUSD if plunging once more - down nearly 250 pips on the day).
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I tend to agree with your inflation ideas, at least for now, too many people have jumped on gold and anti-dollar. I don’t agree with going long yet though, I think there is still more downside and this is just a bear rally that will soon end. Shorting into coming earnings should be a beautiful thing.
There are only two ways for the US (and UK) to deal with the debt load: default or inflate it away. Bernanke wrote the script for option two in a series of speeches over the last decade (including, but not only, the helicopter speech). They are arrogant enough to think they can ‘goldilocks’ inflation to suit their purpose - not too much, just enough. Not a chance. Double digit inflation is in our future - although doubtless the figures will be massaged. But the inflation play is early. Time to short stocks after the month-end tape-painting is done, and wait for commodities to pull back.