Sagflation - Flattish real growth combined with more volatile prices.
In this post I take a closer look at inflation versus deflation and come to the conclusion that deflationary pressures are building, which is contrary to Bill Gross's view and likely contrary to the equity market's more bullish outlook. As a result, I have entered a large position (~40%) in 30-year Treasuries. I will also likely move investments into more conservative segments going forward.
The debate over inflation and deflation rages on within the highest offices in the U.S., as highlighted by a WSJ article. A key quote by the president of the Federal Reserve Bank of New York is, "We think that it's important not to overreact to a rise in headline inflation because the increase in commodity prices is probably going to be temporary rather than persistent." As I argued in previous posts, I believe the inflation has been building from the bottom-up, as evidenced by the recent higher-than-expected PPI numbers. This trend is putting pressure on margins, a worry for earnings going forward. The question I explore in this post is whether the inflationary pressures are likely to continue to move up into the more visible CPI numbers, or deflationary pressure in the economy begins to exert more force. Under my sagflation thesis, I argue the future economy likely exhibits slow growth and increasingly volatile prices. Thus a turn towards deflation is not unexpected.
The basic argument for tame inflation (or potential deflation) includes slack labor markets, excess world capacity, and deleveraging of high debt levels. The argument for inflation includes a highly expansionary monetary policy, rising commodity prices, and inflationary pressure in emerging markets spreading to the U.S..
In this entry I borrow the framework developed by A. Gary Schilling on inflation to breakdown the trends and hopefully glean a bit more insight into the future. His framework breaks down inflationary/ deflationary pressures into seven areas, which are commodity, wage-price, financial assets, tangible assets, currency, fiat, and goods and services. Mr. Schilling has argued a deflationary period is ahead for the world, most recently in his book published in late 2010 titled, "The Age of Deleveraging."
I argue that the fundamental trends should naturally lead to deflation but the Fed is using all its power to stave off deflation and thus causing inflationary bubbles to emerge in the economy, thus causing price volatility.
Commodity - Inflationary, but volatile
One of the larger investing stories over the past year has been the rise in commodity prices, most recently witnessed in oil prices and also cotton prices. These rises have pressured margins in many companies with more than a few finding ways to offset the pressures by improving efficiency, lowering quality or substituting a lower cost material. All that said, commodity prices are volatile and tend to swing as more supply comes on-line, investors make speculative direct invests, and demand changes. While difficult to forecast out one year, I suspect the commodity boom may begin to fizzle as high gas prices dampen demand, more supply is introduced, and investors begin to exit.
Wage-price - Flat
There remains significant slack in the work force since there are currently about 7 million fewer workers than four years ago. This slack has slowed the pace of growth in wages and salaries but the growth rate has started to pick-up again and remained positive throughout the recession. Wages continue to creep upwards, largely based on ingrained expectations of annual raises and at least a more stable jobs market. While wages have been increasing modestly, major consumer expenditures like gas and food have been increasing at a higher rate. Thus, the average U.S. worker has seen deteriorating purchasing power and thus is worse off in real terms. This is a deflationary pressure since spending becomes more tepid and even declines.
Financial asset - Inflationary
Financial assets have inflated in value over the past year as investors gain more conviction in their bullish outlook for the economy. In fact, the PE ratio based on the average of the trailing 10-years of earnings is nearing 25x, a level it had only reached once before the dot-com bubble but which appears to be a "new normal" expectation for the market.
The SP500 has rebounded strongly off its low and is back within 20% of its all-time high of close to 1,600. However, the earnings yield has continued to deteriorate to a negligible amount. In short, the market appears to anticipate an explosive economic expansion. In other words, the strong earnings growth must now carry the market higher, which may prove difficult as consumers spend more money on gas, food and debt service.
Tangible asset - Deflationary
The over-building in the housing market likely takes many years to work off, providing a significant deflationary pressure within the economy. Besides the over supply of houses and the tightening of mortgage lending standards, there is likely deflationary pressure from increased regulatory scrutiny, and potential tax changes that reduce the mortgage write-off benefit.
The story in the commercial real estate market is more fundamentally balanced between demand and supply, although prices has been relatively weak since their peak in 2007 and continue to decline. More difficult financing, a weaker consumer economy, and some excess supply are the likely drivers of the price declines. That said, many experts believe the commercial real estate market is near a bottom as businesses begin to hire again. New REITs are being formed in anticipation of a rebound, which provides some pause that the near-term stabilization is driven more by speculative buying by investors than fundamental demand growth. That said, if consumers revert to loading up on debt then the economy likely continues to rebound and commercial real estate likely performs well.
Currency - Inflationary
As the US dollar has declined, imports have become more expensive while exports and foreign revenue have benefited. The weaker dollar has encouraged inflation in commodities and within countries that somewhat link to the dollar, such as China. It is important to remember that imports account for less than 20% of GDP and thus inflationary pressure from imports is relatively modest. As a result, the weak dollar's impact on revenue has been fairly muted but the impact of higher costs has pressured margins.
It is difficult at this point to predict the impact of the end of QE2 on the dollar since there are fierce debates about QE2's impact on both treasuries and economic growth. I expect the dollar to continue a longer-term trend of decline, driven by weaker economic growth within the U.S., on-going accommodative monetary policy relative to foreign countries, and increasing viability of the Chinese yuan in international trade.
Inflation by fiat - Turning Deflationary
The aggressive deficit spending during the past ten years to fund the "war on terror" and then to offset the "great recession" was inflationary in nature. The state and local governments also fueled inflationary pressures as they expanded expenditures, funded by higher property tax revenue and the accumulation of debt. With the aggressive spending cuts expected by the federal government due to the leverage of the Tea Party, I expect the inflationary pressure to turn deflationary. With less federal money flowing to the states, increasing pressure to make-up losses in pensions, and declining property values, the spending at the state and local level also likely decreases. The threat of a downgrade of the rating of U.S. debt likely hastens the deflationary action of the government. Less spending means less demand, which means deflation.
The future actions of the Federal Reserve is always difficult to predict, and can actively offset fundamental pressures. However, the massive stimulation provided by the Fed
is coming to an end, and may even reverse if they decide to sell securities, although a reversal seems doubtful in the near future as the Fed Chairman remains concerned about deflation. Unless the Fed continuously "raises the ante" by increasing the level of stimulus, I believe the Fed's actions likely cannot offset the fundamental deflationary forces in the economy.
Additionally, foreign governments have actively raised rates and reserve requirements in efforts to slow down inflationary pressures in their countries. These efforts likely start putting a brake on world economic growth.
Goods and services - Stable Short-term, Deflationary Longer-term
Good and services likely resume their deflationary trend in the one to two years due to improvements in productivity, excess manufacturing capacity in many industries, and excess retail units that encourage competition. Offsetting these longer-term trends are higher commodity prices, which have increased PPI, and the disruption to the supply caused by the earthquake in Japan. Already businesses in the high tech and automotive industries are managing through shortages of parts. In fact, the earthquake may actually cause a near-term bump in the sales of some suppliers due to buyers increasing inventory in anticipation of parts shortages.
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