Opportunity Still Plentiful, Regardless of Outcome

I received a question from a reader wanting me to explain in detail what I thought would be required for me to believe in the hyperinflation scenario as opposed to my long held belief of a secular deflationary outcome. Here was my response, in detail, as requested:

Dear Reader,

It is partly a psychological issue and deflation is being forced upon us by structural changes that are out of the Fed's control. One such issue is the retiring boomer generation. They all need to sell their assets over the next 20 years to fund their retirement, this will create lasting downward pressure on real estate and equity assets. The younger generations have terrible balance sheets and those need to be repaired before they can even think about making major purchases or investments. This could take quite a few years.

As has been discussed, much of the credit creation by the Fed and the expansion of the government balance sheet is not making it's way into the economy. It is all being pushed on financial institutions to keep them solvent. But credit is being destroyed at the same pace. Events like Lehman's bankruptcy caused $400 Billion in CDS obligations that most could not pay. The ripple effects on the derivative markets are enormous. There are $1 quadrillion (thousand trillion) in notional derivatives and counterparties to some of this are disappearing, meaning insurance that a lot of companies may have had against falling asset prices are now non-existant. Banks are still not in a position to be lending money. Not until they can hedge their risks properly in a functioning market for derivatives.

The assumption is that once the credit markets heal and banks are able to lend, there will be lineups by consumers and businesses to borrow money. This is a dangerously flawed assumption. Asset prices are rising nowhere in the world. There is absolutely zero motiviation for anyone to borrow money for expansion at this time. In other words, the engine for the velocity of money is broken. Why buy something now, when you can almost assuredly buy it later for less?

In a normal market, prices would be falling much faster right now and 'later' would arrive with quite a bit of pain, but in a short period of time. There is still quite a large pool of capital waiting to be deployed, but it is waiting for a price that accurately reflects a realistic economic environment in the next 5-10 years. So yes, in a normal market we should expect to see buyers come back to the market and pick up bargains. This would cause the inflationary pressures and if borrowing costs were left too low for too long, hyperinflation would be a realistic expectation.

But this is not a normal market. Government is actively intervening to ensure 'later' doesn't arrive for those who are waiting with their savings. So the savers will wait. We also have economists, analysts and pundits spewing rediculously rosy expectations about the near future. Analyst expectations estimates have been missed by the widest margin ever. It's only until the last week that a recession has been priced in to markets for the rest of '08. Analyst expectations still need to be slashed considerably for '09 and '10.

There is an incredible amount of debt out there and an incredible amount of leverage, but there are also a lot of savers, and they are to be found all over the world, now that we are globalized. They will come back to the markets if they feel like they're being paid to take the risk. But the key is the balance sheets of our younger generations (under 50 yrs). They need to be repaired in order for consumption to reignite the economy. Unfortunately, without jobs, they can't fix their balance sheets. And good paying jobs cannot be created until there is appetite for investment. A Catch-22.

So those are a few of the things that need to be addressed before we can 'beat' deflation and for the velocity of money to start moving once again to a point where we start seeing inflationary pressures in the asset markets. I have been on the deflation side of the trade for quite a while now, and still believe it is in the future. It is the natural way out of this. But government could try some things that could result in the inflation scenario playing out longer term. I don't advocate they do this by any means, but as socialists they will likely try. Here is what I think would be required to happen in order for some sort of a recovery.

- some sort of aknowledgement that we are in for a very long period of economic contraction and for forward estimates to reflect this outcome so it can be properly prepared for
- more transparency of bank balance sheets including level 3 assets being marked to market. Governments are attempting to encourage this now, by giving banks billions of dollars to write off bad assets. They will likely need twice as much as they've been given to accomplish this. At that point, they'd be able to lend again
- government would need to make significant infrastructure investments in transportation, energy and water thereby ensuring job creation. Re-education programs would also be required for former autoworkers and other marginalized American manufacturing workers
- government would need to dramatically reduce spending in social programs and accompany this with significant tax cuts for businesses and individuals
- barriers to foreign investment should be eliminated without exception
- consumers need to tighten their consumption habits, eliminate debt and ensure they have current education
- at this point, consumers would be far healthier and be able to again borrow money
- the combined effect of all the above would be devastating for asset prices - they would likely need to fall another 50% from current levels to throw out an arbitrary number
- banks would again be able to lend, consumers would again be able to borrow, and the appropriate infrastructure would be in place to provide positive investment opportunities in new efficient industries

If all this were to happen, I could see potential for a legitimate recovery by mid 2010. But I must stress that doing this would not fix most of the larger underlying problems, and would actually make some of those problems worse. It would likely be met with another, equally as difficult period a number of years later when some of those other problems start manifesting. What are some of those problems?

Problems that would be left unaddressed include our dependence on government spending, that while out of control now, would be even further out of control by the time they attempted something like the plan above. Related to that problem, our confidence in paper currencies would be seriously shaken by then if perception of government’s ability to repay their debts deteriorates. It would also be fair to assume the central banks would be too slow in raising interest rates (they’re always too slow on both sides) and speculation could grow wildly, causing another bubble to be inflated and subsequently popped a few years later. So the issue of interest rate micro-management would not be addressed. Neither would the issue of fractional reserve lending, which naturally causes instability in the banking industry. We will also have a litany of moral hazard problems coming home to roost as people will surely abuse the government guarantees currently being handed out worldwide.

This would then look very similar to the outcome of the 1930’s depression, where between mid-1932 and early 1937, the Dow Jones Average actually rose 473%. Only again to lose 50% of that in the next 15 months. See chart here.

So there you have it. Under the right set of circumstances, our elected and unelected officials could guide us toward a mid cycle recovery. But ultimately, the structural problems need to be dealt with, and knowing the ideological background of those officials, they will not be dealt with. There is too much debt, yet none of the decision makers see that as a problem. Essentially, we’re making the exact same mistakes that were made in the 30’s, and of 90’s era Japan, so expecting a repeat of the 30’s or Japan would not be out of the question. Just for fun, were the current crisis to play out like the 30’s, it would look something like this:

- continued deflationary pressures until Q2 2010
- this would correct some of the imbalances and bring investors back to the market for a very large rally into Q1 of 2015
- continued volatility, yet essentially flat prices for another 5 years

Unfortunately, there is little chance things happen ‘just like last time.’ It is even possible that our rally from the lows in 2003 until 2007 was the equivalent to the ‘32-‘37 rally and our current crisis is more like 1937. Comparing the Nasdaq now with the Dow of the 30’s would confirm this, yet using the S&P would not. It is all so subjective that drawing any conclusions based on this would not be advisable. For me it is a useful exercise to help remember that even if we do enter a second great depression, there will still be opportunities regardless of inflation, deflation or something new we’ve never seen before.

I hope that answers your question.