Investment Outlook: The Worst Appears Over
By Akber Zaidi
Yorba Linda , CA
The stock market has staged one of the biggest rallies of the last century and people believe that the worst is over. There is talk that the recovery is now sustainable. GDP and consumer confidence have improved from the lows. Corporate bond rates, LIBOR rates, first time unemployment claims have all dropped significantly. The current dilemma for investors is to figure out where we are headed. Are we headed towards deflation or inflation and what assets to hold and when to transition?
The deflationists claim that given the extremely high debt levels in the West, further inflation is not possible. They maintain that private debt which is at 40 trillion and declining will fall faster than government debt which is at 11 trillion and rising. This reduction in debt will slow spending and stifle any future growth. In addition, rising unemployment will contribute to deflation for some time.
Another argument in favor of deflation is that current demographics are deflationary. As a population ages and has fewer children, the older people spend less and there aren’t enough young adults to keep up the spending. Thus, spending declines until the next wave of young adults starts spending again. Japan is a prime example of this phenomenon and has not had inflation for the past 20 years after their stock and real estate bubbles burst.
Currently we have deflation at the monetary level as consumer and wholesale prices are declining over the last year.
The basic argument for inflation is that the government has created and pumped in a lot of money into the economy through bailouts, quantitative easing and purchases of treasuries. The new money has to go somewhere and has to end up in someone's bank account. This creates the scenario of a lot more dollars chasing the same number of goods and services. Prices will rise as more and more money tries to buy the same goods and services. The expansion of money by the central bank is the source of economic booms and asset bubbles. Examples in our own economy have been the tech stock boom and the housing bubble.
By printing money the government is trying to get growth going again. The problem with debt induced economic expansion is that it requires continuous printing and spending to prevent another collapse. Over the past year, central banks have injected trillions of dollars into the banking system and it is only a matter of time before inflationary expectations start escalating. Until now this stimulus money has not permeated through the economy in the West but once it does, prices will start rising and investors will become very concerned about inflation. The Economic Cycle Research Institute puts out a Future Inflation Gauge index to measure possible future inflation. This index leads the consumer price index by about 9 months at this point in the business cycle. The Future Inflation Gauge is now moving back up indicating that future inflation is likely and will show up some time later next year.
The dollar is key to understanding the deflation or inflation debate. The US dollar is the world’s reserve currency. After a century of leadership, it is quickly losing that status. The premium on the value of the dollar is starting to fade as the rapidly growing US debt and uncontrolled spending forces the world to look for an alternate solution.
China and Japan, the two largest holders of our Treasury bonds, are worried about what will happen to the dollar and subsequently their holdings of Treasury bonds. If China and Japan are forced by domestic pressures to stop buying US debt, the Fed will monetize the debt and buy the debt itself with printed money. If we print money to buy our own debt, inflation would rise and the dollar would plunge. We are completely dependent on foreigners to keep buying our debt.
But the world is already moving away from the dollar. Middle East Arab states along with China, Russia, Japan and France are planning to move to a basket of currencies including gold for oil trading instead of using the dollar. This basically means oil will no longer be priced in dollars and dollar demand will drop. With fewer dollars needed around the world, the price of dollars relative to other currencies and commodities will fall. Put another way, foreign currencies and commodities will rise versus the dollar.
So what do we have right now? Today, we have monetary deflation but we also have import inflation as the dollar is declining. We believe we will get neither persistent deflation nor hyperinflation. Going forward we expect a combination of slow growth and rising prices. Global growth will be subdued for a while as governments will increase taxes and regulation. Unemployment will remain high acting as a drag on growth. Once the recovery comes stagflation is likely, with low economic growth coupled with higher inflation.
Deflationists argue that all asset classes will fall in the foreseeable future including real estate, stocks and bonds. They want you to stay in cash. But investors can’t earn any money in cash with the Feds Fund rate at zero. The Fed will keep that rate as low as possible for as long as possible to keep money out of cash and into stocks and bonds. Continuing to hold cash in dollars will only lose purchasing power as the dollar declines.
In an ultimately inflationary outcome it is better to hold assets that will retain their value versus the dollar and to be flexible in investing in other asset classes. Dollar hedges include foreign currencies, land and commodities including precious metals. Gold recently hit an all time high and a rising gold price says the dollar is losing value. Capital should also be allocated to market timing the major asset classes to capture the swings in momentum. At this moment in time momentum and not valuation is in charge as earnings are weak and valuations are high.
The debate between deflation and inflation is being ruled by what happens to the dollar. Global dynamics are shifting and investors should be prepared for a new currency era.
(Mr. Akber Zaidi is President of the Alpha Asset Management LLC, Yorba Linda, CA)