The markets are increasingly worried about rising oil prices slowing economic growth. The rise in oil prices appears related to supply worries associated with Iran, rather than strong demand. However, the increase in the PPI for crude materials has slowed to less than 5% annually, after rising at a rate greater than 15% for the past two years. Aggressive actions by the ECB and Federal Reserve may continue to drive inflationary pressures, but I believe deflation may ultimately take over as the market driver later in 2012.
Is Deflation to the Market what Lawrence Taylor was to the Quarterback?
Twenty-to-Thirty Years of Healthy Deflationary Forces I estimate Have Built-up...
(1) Technology advancements - Advancements continue but the pace of economic change relative to the pace during the periods of the personal computer, internet and enterprise software is likely slowing.
(2) Manufacturing outsourcing to China - As wages rise in China, commodity prices increase, and the yuan appreciates the deflationary pressure may actually switch to inflationary.
(3) IT outsourcing to India - Wages in India continue to rise and much of the low-hanging fruit has been harvested.
(4) Business reorganization - Really a derivative of the previous three trends, but as businesses find less opportunities to increase revenue or reduce costs through reorganizations, the economic impact slows.
But, Unhealthy Deflationary Forces are Also Building...
(1) Housing overhang - The Economist estimates that American households have lost a "whopping $9.2 trillion." This loss despite mortgage rates near historic lows that make financing the purchase of a house more affordable.
(2) Excess retail space - From 1999 to 2009 the shopping space per person in the US increased almost 30% from 18 square feet to 23 square feet, driven largely by inexpensive construction financing and unsustainable rising consumer debt, in my view. This increase occurred despite the percentage of online shopping increasing from 5% in 2006 to around 9% currently.
(3) Contracting number of bank customers - Meredith Whitney estimates that the number of "unbanked" Americans is rising, from 1 in 4 in 2005 to close to 1 in 3 currently. The problems facing banks include less access to securitization, increased regulation, and low interest rates. This trend of a shrinking customer base implies higher transaction costs for unbanked individuals and a lower savings rate, both drags on economic activity.
(4) Unemployment - At over 8%, the unemployment rate has been a drag on the economy.
And Bad, but Necessary, Timing of Dissipating Artificial Inflationary Forces...
(1) Diminishing power of central banks - With historically low interest rates I believe the ability of the central banks to boost economic growth through the expansion of credit is nearing an end. Furthermore, I believe the central banks are reaching a point in which printing excessive money is one of their remaining choices to offset deflation. With the GOP proposing "The Sound Dollar Act," which would eliminate the Fed's mandate to promote full employment, I believe the expansionary position of the Fed may lessen.
(2) Fiscal stimulation retreating to austerity - As I outlined in Taxmageddon, at the end of 2012 the US economy is set up to bear significant tax increases and spending cuts. As witnessed in Greece, and increasingly Portugal, fiscal austerity likely results in slowing GDP.
Likely Results in Falling Prices.
(1) Financial markets - Based on the 10-year average earnings, the PE ratio of the S&P 500 is over 40% above the long-term median. While this measurement does include the fallout of the dotcom and housing bubbles, depressing earnings, it does suggest the market does not expect another bubble to burst. I believe the main reason why the equity markets are this high is because of the actions of the central banks and governments.
(2) Commodities - Print more paper money and there is more currency per hard assets like gold, oil and copper, driving up prices. Driving up prices on major resources of the economy (see chart below) results in companies attempting to pass along these rising prices (consumer inflationary) and aggressively cutting costs in other areas (deflationary), enabled by technology advancements, access to lower cost labor, and falling financing costs. As the effects of an expansionary monetary policy diminish the more volatile commodity prices may begin to fall, reducing the bottoms-up inflationary pressure. The annual growth of PPI for crude materials has slowed to below 5% after remaining well above 15% for most of the past two years.
Sold Gold.
Because of my growing worries about deflationary forces driving future market movements, I decided last week to sell my ~5% position in gold. I fully recognize that actions taken by the central banks could offset deflationary pressures, but I simply feel more comfortable following fundamentals rather than possible government actions.
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