In a deflationary period - Cash is King
For years we have said that with the Federal Reserve and the world’s central banks "printing money," and bailing out the banks and big financial institutions as a response to the credit crisis - all that easy money and credit would lead to inflation. But in the past year, we have also been warning that before that inflationary period hits us, we are very likely going to slid into a deflationary period. Therefore, we believe that we will see BOTH deflation and inflation in the next couple of years.
We say this because typically in periods of inflation, we see money supply spike, interest rates skyrocket, commodity and stock prices climb and consumer prices relentlessly rise. Today we are not seeing any of these factors – in fact the opposite is happening.
In the US, the M3 money supply (the total amount of money available in an economy at a particular point) has been declining at an annual rate of almost 10%. Professor Tim Congdon from International Monetary Research says “It’s frightening…the plunge in M3 has no precedent since the Great Depression. The dominant reason for this is that regulators across the world are pressing banks to raise capital asset ratios and to shrink their risk assets. This is why the US is not recovering properly,"
If this were an inflationary period we would be seeing the stock markets rising. On June 14, 2000, the S&P 500 was at 1470.54 – today, 10 years later, the S&P 500 is at 1091.60 – down 378.94 points or 25%.
In this was an inflationary period we would see commodities on the rise, but recently they are declining.
In every bull market, near its peak, the mass investors are convinced that it will continue higher. We saw this with the tech stocks in 20000, we saw it with real state in 20007, and we saw it with oil and commodities in 2008.
The bottom line is that the credit markets have dried up - to the point where the only active creditors today are sovereign banks. We are now seeing countries such as Greece, Spain, Hungary, and Britain (the list is growing by the day) all focusing on austerity programs as they have reached the limit where they cannot simply print their way out of debt. In the US, congress will have to follow this same austerity pattern or the masses will throw them out of office.
In the past we have made the argument for inflation, noting Fed chairman Ben Bernanke’s well documented motivation to have the Fed "print" money if it appears deflation is starting to take hold. His "drop money from helicopters" analogy is designed to prevent outright deflation, and lead to inflation or even hyperinflation as the dollar is devalued.
We still believe that inflation will be a big factor down the road, but not in the near term. While Bernanke uses the analogy of having a “printing press,” in reality the Fed increases the money supply by buying up IOU’s. Also, the government can get involved and issue Treasury bonds and then the Fed can buy these, which also increases the money supply. The reality is they cannot endlessly continue this process because when the supply of credit is far bigger than the supply of money, which is the case today, credit can contract faster than new bonds can be printed. The end result would still be deflation.
In summary, we are saying that we still expect to see inflation and even hyper-inflation, but we do not see that happening until deflation has done its damage. If we are correct in this prediction, then we need to understand what deflation would mean to the economy, and what sectors would get hit the worst and what ones could survive.
If we do get a dose of deflation, then we could expect to see some serious bank failures. We would also see unemployment climb dramatically, likely to over 15 -20%. With deflation, prices fall, and consumers (those that still have a job) do not consume because prices are falling and they want to wait for a better price.
If we do get deflation, we can expect to see the US dollar continue to rally because the dollar is the currency that the debtors owe so they will need dollars to pay their debts; and creditors are owed dollars, so they will want to be paid back in those dollars.
If deflation is truly coming, then as investors we want to be in a very strong cash position (or Treasury bills) and have physical gold. As we have said many times, in deflationary period Cash is King and Debt Kills. Therefore pay down your debts as aggressively as you can afford to.
