Fundamentally, deflation is the driving force in many economies as poor capital allocations of the past need to be worked off, in my view, potentially pushing us into a depression. However, I believe expansionary fiscal and monetary policies have been offsetting these fundamental forces by pushing up commodity prices, enabling inefficient business activity, and inflating financial assets. These effects from monetary policies increase the risk of hyper-inflation if extended and amplified, in my view. In summary, I believe the combination of fundamental economic forces and activist policies push us further and further into a world of volatile prices and uneven economic activity.
In this entry I again 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."
My conclusion is that while inflationary fears are justified for basic necessities, like healthcare, food and fuel, the broader trend is deflationary as growth in wages, commodities, and asset values moderate and even decline. The Federal Reserve has been focused on broad measures of inflation, which include material weighting of asset values and wages, and thus I expect the Federal Reserve to launch another round of quantitative easing should these factors continue to weaken, possibly at the expense of higher prices for fuel and food, which may further erode real economic activity.
Summary Table
| Segment | Trend |
| Commodity | Abating Inflation Pressure |
| Wage-Price | Abating Inflation Pressure |
| Financial Assets | Inflation |
| Tangible Assets | Deflation |
| Currency | LT Inflation, ST Deflation |
| Fiat | 2012 Inflation, 2013 Possibly Deflation |
| Goods and Services | Abating Broad Inflation Pressure |
Commodity
The pace of growth of commodity prices has been moderating, likely due to weakening demand in Europe as the debt overhang and austerity measures begin to bite. It remains unclear whether the slowdown in Europe spreads to China and resource-rich countries like Brazil should commodity prices continue to fall.
Wage-Price
The rate of growth of wages has been moderating to under 2%, putting pressure on spending despite some improvement in the number of people employed. The slowdown in wage growth in itself is deflationary, but its impact is likely uneven as higher prices for necessities like fuel, food and healthcare force both higher consumer debt, aided initially by low interest rates, and stronger deflationary pressures in more discretionary segments.
Financial Assets
Financial assets are modestly inflated, based on historical valuations of total market capitalization to GDP and the Shiller PE ratio. The current ratio of total market capitalization to GDP is above 95%, relative to a historically fair value of 75-90%. The current Shiller PE ratio is about 22x, compared to a historical mean of 16x. The market is relatively over-valued largely due to aggressive monetary policies, in my view, pumping up liquidity in the markets. Furthermore, should the economy slow in order to allow for what I consider to be an over due capital rationalization, the total market capitalization likely retreats 40-60% as both the GDP and earnings compress. While the equity markets may remain fairly-to-overvalued for some time, I believe there is an inflating air pocket under supporting these valuations as GDP is artificially increased through monetary actions.
| Valuation | Ratio = Total Market Cap / GDP |
|---|---|
| Ratio < 50% | Significantly Undervalued |
| 50% < Ratio < 75% | Modestly Undervalued |
| 75% < Ratio < 90% | Fair Valued |
| 90% < Ratio < 115% | Modestly Overvalued |
| 115% < Ratio | Significantly Overvalued |
Tangible Assets
Home prices continue to deflate in the country, despite historic low mortgage rates. While there are numerous investors trying to "call the bottom" on home prices, I believe it is difficult to argue for higher home values should monetary policies allow interest rates to rise. As people lose more equity in their homes it is difficult to see from where additional spending can be funded, in my view. Judging by the April Homebuilders' Index reading of 25, anything below 50 is considered negative, a recovery in the housing market is a long way off.
Currency
The longer-term trend is a weakening US dollar, likely driven by the expansionary monetary policy. This longer-term trend adds inflationary pressures to the economy. Shorter-term, however, the US dollar has strengthened as other regions have weakened and pursued more aggressive monetary tactics. This recent strengthening has added deflationary pressures to the economy as the prices of imported goods become relatively lower.
Fiat
The US economy continues to benefit from overwhelmingly inflationary fiscal and monetary policies. Deficit spending, fueled by both relatively low tax rates and stimulus, has enabled economic activity to remain elevated, in my view. Furthermore, expansionary monetary policies have enabled poorly performing businesses to remain in viable and has added to the money supply.
While fiscal and monetary policies have been inflationary, they potentially turn deflationary in 2013 when significant tax increases and spending cuts are expected to come into effect.
Goods and Services
As I discussed in March, investors should look at the inflation of goods and services through two lenses. The first is the traditional inflationary measures impacting the consumer, which are the CPI and Personal Consumption Expenditures Price Index (PCEPI). These are the measures on which the Federal Reserve typically focuses when determining monetary policies. Both show a trend of abating inflationary pressure.
The second, and better measure of the impact of monetary policies in my view, is the AIER Everyday Price Index (EPI), which highlights increased volatility of prices and higher inflationary pressure on middle to lower class income levels. The EPI increased 8% in 2011, relative to a 3% increase in the CPI, and increased 1.3% and 1.1% in January and February. The increases in the EPI are also moderating, although AIER expects them to continue to accelerate throughout this year and next. Based on the moderation of commodities, I expect the increase in EPI may moderate as well.
The last point on goods and services is a possible signal that demand is slowing. Industrial production declined 0.2% in March. This data may be a blip, but it is worth following as a sign of whether the economy is again cooling.
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