Investment Summary
Two deflationary trends likely reverse over the next year, in my view. These reversals, coupled with the Fed increasingly more aggressive actions, likely result in accelerating inflation after a short period of deflation, in my view. While prices are potentially whipsawed, Real GDP likely continues to slow for 3+ months due to uncertain business costs and demand for products and services. Should the government allow the economy to re-allocate capital efficiently, the good news is the U.S. sets up for healthy growth within specific segments in the long-term, in my view.
Exporters, South American and Canadian raw material providers, and Asian consumer companies are all high on my radar for positive long-term trends. Bearish positions on Treasuries and bets on volatility are potential short-term positions in September and October as I prepare to wade back in.
Deflation Deconstructed
Deflation is caused by three basic market dynamics, which are money supply growth exceeding demand, improved productivity, and recessions. In my view, all three dynamics have had a role in creating the current environment of deflationary fears. The first two of these dynamics are reversing, in my view, with the ultimate impact on real economic growth likely complex. This resulting complexity offers properly positioned active investors exceptional returns, while passive index-focused investors are potentially loss leaders.
The most basic cause for deflation is the growth of money supply exceeds the growth in population. The tricky part in this equation is how to measure the population. It is more than simply the U.S. population since many foreigners (defined as people, companies and countries outside the U.S.) hold U.S. dollars. When China buys U.S. Treasuries it does so with U.S. dollars, thereby increasing the demand the U.S. dollars. It is no secret that the the U.S. has sold a lot of debt over the past couple decades, of which a large portion is owned by foreigners. So long as foreigners continue to buy our expanding debt, demand for the U.S. dollar remains healthy and the supply of our currency must grow faster than our GDP. This explains why the money supply of U.S. dollars has increased at a compounded annual growth rate (CAGR) of over 6% for 13+ years, despite economic growth below this level. While a healthy growth rate for money, deflationary pressure could be from the U.S. government not increasing the supply of dollars fast enough to satiate the growing demand for dollars around the world.
The second cause of deflation is structural, resulting from improved productivity. During the last quarter of the 19th century the U.S. experienced deflation possibly aided by technology improvements like the railroad and telegraph. Assuming a competitive market, companies that improve their productivity pass along some of their cost savings to customers in the form of lower costs. It is highly plausible that the technology advancements over the past 30+ years has increased productivity and therefore enabled businesses to pass along these cost savings to their customers. I believe this scenario is even more likely given the Fed's actions of lowering interest rates and therefore allowing less healthy companies to remain in business, therby apply pricing pressures in the economy.
The third cause of deflation is a general decline in economic activity during a recession or depression. This type of deflation can become a virtuous cycle due to deflation creating disincentives to invest money and consume products and services. During periods when this is the cause of deflation the government may need to stimulate demand through fiscal policies and directly increase the money supply, called quantitative easing, through more extraordinary action like asset purchases.
The first two deflationary trends may be reversing, in my view.
Fundamental demand for U.S. dollars may be starting to slow due to more viable alternative currencies, active policies by foreign companies, and general concern about the relative economic strength of the U.S. economy. China recently began selling a small portion of its holdings in U.S. Treasuries, likely reducing their holdings of U.S. dollars in the process. Furthermore, China announced last week that it is allowing foreign entities to invest their yuan holdings in China's sovereign debt to supplement their decision last year to allow all imports and exports to be settled in yuan, in lieu of dollars. Incremental demand for dollars declines from both of these actions by China. While these actions are relatively small compared to the overall level of dollars outstanding, if these actions accelerate the longer-term trend is worrying. While impossible to quantify, there are also some signs that the market for illegal products and services is adopting the euro at the expense of the dollar, which has traditionally been the currency of choice. The number of euro notes in existence has grown at an annual rate of 32% since 2002, with 500 euro notes accounting for 35% of the value in circulation. If nothing else, it appears as though fewer U.S. dollars are demanded in the world.
In the August 27 post I laid out the string of finite stimuli that have driven above sustainable growth in the U.S. for the past 30 years. One of the main drivers was improving productivity from increasingly connected and increasingly more powerful computers, as well as outsourcing manufacturing and services to lower cost geographic regions like China and India. Cloud computing likely provides further productivity improvements for companies, but we are past the bulge of productivity gains, in my view. I believe efficiency continues to improve, just not at the pace it was for the past 20 years. Therefore, I believe the deflationary pressures from productivity gains likely lessens going forward.
So do the first two trends, coupled with an inefficient base of invested capital as discussed in earlier posts, lead us to a recession, hyper-inflation, a combination, or something else (D-word)? Let's start with the assumptions that the economy continues to weaken in 2010 and the Fed likely throws everything it has to stave off deflation. This may mean a negative Fed funds rate, aggressive language, increasing asset purchases, and loosening restrictions on banks. Simply put, these two assumptions imply that supply of money grows faster than the demand for money. While this situation may last for a relatively short 2-6 months, the combination of weakening GDP and aggressive government actions likely weakens equity markets. Bond yields likely fall and the U.S. dollar may actually strengthen as investors seek its perceived safety. The excess money likely distributes unevenly in the economy, possibly inflating segment bubbles.
How does this play out longer-term? The good news is that the U.S. has efficient markets to handle the swings in currency, debt and equity markets; thereby re-allocating capital to the best purposes and hopefully avoiding a decade-plus re-calibration. The recent increase in M&A activity and the 100+ bank failures in 2010 are two indicators of markets already re-allocating capital. Should the U.S. dollar weaken we would likely see businesses invest domestically as foreign costs increase, like Whirlpool's recent decision. These efficient mechanisms for re-allocating capital helps quicken economic improvements. The bad news is that the U.S. has efficient markets that likely swing wildly until a new equilibrium is found. Segment bubbles may be formed and popped, possibly with long-term negative effects. It could be painful for investors, workers, and companies who will need to adjust quickly and likely build up new skills. The wild card is government action that may prolong the issues or even deepen the crisis.
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