I hope readers enjoyed the Sirtaki video in my last post. I found the last scene of “Zorba the Greek” inspiring. It’s nice to relax every now and then, notwithstanding full awareness of the global debt pile. Unfortunately, at the end of the day, we all need to remain focused on the affair of wealth preservation. This post will be on the serious side.
I’ve writen on the matter of deflation before. But that was months ago, and both posts were in Spanish. My views, however unconventional, have not changed. The degree of conviction behind them is high. Deflation is a negative outcome only because of accumulated debt. In a debt free economy, supply side induced deflation is a “goodie”, not the ogre they try to sell us. It might as well be a “goodie”, because deflation will be a lasting episode, and not the fleeting situation politicians try to convey.
Sick aggregate-demand induced deflation, is certainly not as good. But it is the pathology of aggregate demand itself that should worry us, and not merely deflation. Deflation is only one of its various negative consequences. Actual deflation has roots both in the supply and demand side. Deflation is a undeniably a relevant phenomenom, but it is over-rated as “crucial”, because it impacts the effectiveness of traditional keynesian monetary easing recipes. ¡Isn’t that a pity!
Yes, deflation is relevant as a game spoiler for keynesians and Princeton sect economists. And it influences both the long term investment strategy, and the tools available to politburos of Central Banks. QE is doomed in this context, because any new money that we generate, has flown, and will flow, into financial markets, parking itself either in bank reserves, bonds, or equities. It will not access the real economy. It will not reflate the stream of goods and services, unless we accept Weimar style money printing (and thankfully we are not there yet). There is no glide path to debt reduction with mild reflationary policies. We have to focus on the real stuff. In a deflationary environment, money printing only gives your some extra time.
1.- Demographics. The more I look at it, the more I see demographics playing a major role in deflation. And regardless of how you try to cut it, demographics are not going to support reflation in the world economic system.
First of all, rapid population growth is coming closer to an end. We could be no less than twenty years away from peak population. We are seven trillion people on mother earth, and, regardless of what U.N. official estimates say (see chart), I don’t think we can grow that figure to the 10 billion mark.
In the medium term, and after one or two more decades of growth, I see more downside than upside to current projections. Seventy years without war, or a serious epidemic desease, has to be close to “as good as it gets”.
Moreover, a lean and mean global economic environment, together with some educational improvements in the third world, will continue to put a limit to birth ratios (see how this is happening already in India).
Young couples are increasingly aware of the liabilities that come with a large family. If population doesn’t grow, aggregate demand only grows with sustainable supply increases in output (Says law), and, importantly, the average age of the consumer, moves up. Those are substantial and unconventional (non Malthusian) changes in the economic landscape.
A rapidly growing population increases aggregate demand, while a stable or, in the medium term, declining population, contains it (see slide). Think about the implications for housing or autos a decade or two from now.
Also, propensity to consume varies with age (with a negative correlation). If we are older, rationality in consumer decisions gradually outweighs emotional buying, Above all, an ageing population increases the elasticity (and cross elasticity) of the demand curve for most products and services.
Raising prices is a tough proposition with a mature client base. And the increases in cross elasticity (variation in the quantity demanded due to variation in price, or accesibility to alternative products for the same need) are the most important factor of price constraint for a producer. Cross elasticity is a lot more dangerous than elasticity itself. ¡It doesn’t just threaten the producer’s P&L, it threatens his franchise, his business model!
Second, average life expectancy is going to continue to increase, until the economy is unable to support the cost of the medical treatments required to extend life. I see the limit to life in economic factors, more than in the ability of science to cure, or at least contain mortality induced by illness of any kind.
Science will enable life expectancy to soar, and the problem will be generating the amount of money required to make use of it for all the population. Because living longer is a priority, the population will reroute consumption from cars, and gadgets, to life extension. That will further invert the population pyramid, and decrease demand for conventional sectors such as autos or housing. Would you rather own a second house for weekends, or live longer?
A corollary to this is that public healthcare will be unable to assume the cost of all the new treatments required to prolong life. People will have to fund this themselves, and this will be a factor of austerity for people in their fifties and sixties. They will have to decide what to spend in ordinary consumption, and the amount to save for retirement and “medical treatments”. Obviously, underlining that potential development is tantamount to a “strong buy biotech, and sell autos and homebuilders” recommendation. The market obviously already knows that, but I think it is a permanent long term factor. On weakness (I see bloated prices right now), buy biotech!
2.- Workforce developments. It is not only population growth and average age that count. The percentage of the population employed is a second factor that comes highly correlated with subsequent deflation. History shows that when dependency ratios fell collectively, inflation reared its ugly head. Remember what happened when women incorporated massively to the workforce. Nowadays, dependency ratios are on their way up (workforce proportions tend to decrease) in a steady manner. In the US they have lost five percentage points in the workforce total (down from 67% to 62% of the population) over the last five years. Worse figures apply for other developed nations. The chart shows Europe or Japan will continue to endure serious deflationary forces in the foreseable future.
Technological innovation reduces the amount of labour per unit of output, and learning takes longer (sometimes until the very high twenties), inplying a labour force gradual downsizing. At the same time the percentage of people above 65 continues to mount. Everything suggests the dependency ratio (percentage of non working people) is on its way up.
3.- Supply side productivity growth.- The economy is behaving more and more like the semiconductor sector. Moore’s law is not applicable to other sectors in all its strength, but technology keeps reducing average and marginal costs. In a competitive environment, with low entry barriers, and plenty of productive resources available worldwide, the road map for product and service prices, (assuming constant prices for labour and capital) is the marginal cost of production. We should be getting more for less every year, and not the other way around.
It is preposterous to target 2% inflation in a world with constant technological innovation. It goes against the nature of the system; keeping the inflation target alive requires a permanent monetary distortion of the underlying real economic activity. Zero inflation is a much better target. I think zero inflation and 2% rates is a more balanced and realistic world, than zero rates and two percent inflation. And I know debt sustainability is incompatible with that.
Maintaining an obsolete inflation target is bad enough, but it can get worse. We keep on lowering rates to fight deflation, and I buy the Fisher argument that lowering rates brings down inflation, because of the tendency of the wicksellian rate to merge with the real, central bank imposed, interest rate. ¡We generate deflation lowering rates! Central banks shoul read some literature from the new fischerites. The strategy is damm wrong, and the tactics are wrong as well.
4.- Global liquidity and the subsequent asset price starting point. Pumping liquidity into the financial system has altered the financial markets’ pricing dinamics. Sometimes, price formation has even been directly influenced (read manipulated) by the POMO desks (or the “plunge protection team at the NY Fed”). In this context, financial prices are bloated and do not reflect reality. Downside risks abound for both bonds and stocks.
Any future financial correction will alter the wealth effect induced by Bernanke, and add to the perception of deflation. And it is sure to come. Look at agriculturals, metals, gold, energy etc… They are showing us the way… down. Equities and bonds will follow as soon as debt accumulation is perceived as unsustainable, or the population decides not to pay (greek or haircut their debt). Take a fresh look at Shiller’s PE for US equities (direct from his website)
In this context financial markets are sure to contribute to deflation in the medium term. We do not know when, but we do know the future long term direction of bonds and stocks: down, or at least not up! Five and ten year average price estimates for stocks and bonds are a disaster.
Stocks are on their last hurray for joint valuation based, and strategic reasons. But bonds are not far behind. A deflationary environment protects them in relative terms, but credit risk premiums will soar. We have gravely mispriced them. Look at the ten year bond spread between swiss government bonds (in CHF), and French government bonds (in EUR). It is very volatile, but stands around 50 bps! Other credit spreads are also untenable.
5.- Debt overhang and ZIRP.
The debt overhang is a dominant deflationary vector. It generates deflation, decreasing aggregate demand growth of the economic players that see themselves as overleveraged. If you combine overindebtedness with zero interes rates (needed to extend and pretend its sustainability), you also decrease aggregate demand by transferring purchasing power from savers and pensions to debtors. Indebted players can hardy contribute to aggregate demand, and in order to keep them alive as financial zombies, we deprive savers of legitimate income, driving down their purchasing power.
So, instead of one, we have two major population clusters (the indebted and the elderly) unable to contribute to a healthy, sustainable (not keynesian), aggregate demand expansion. To make matters worse, in the US, pumping liquidity into the system has ensured house affordability decreases again, beginning in 2012. Yes, the same mistake as during the last decade. Allowing home price increases above inflation, stabilizes mortgage debt, but decreases the purchasing power left for young couples in their high spending age.
The deflationary environment is here to stay, regardless of some inevitable ups and downs driven by extreme ongoing monetary policy dislocations around the world. The standard Central Bank triple target of financial price enhancement, deflation fighting, and currency beggar thy neighbour policies, is as quixotic and unsustainable as Jordan’s peg.
This media cheered awakening will last no longer than those featured in the flying over the cuckoos nest movie. Current policies are unpalatable long term. Even when seen from a short term perspective, they obviously don’t make any sense at all, unless your main concern is kicking the can forward, and preserving the illusion of debt sustainability. I’m afraid debt serfdom is alive and well. Economic policy continues to serve creditors, hardly unnerved by the conspicuous consequences of destroying aggregate demand, distorting resource allocation, and departing from social fairness.
There is a consequence for everyting both in physics, and in life. As Isaac Newton stated in his third law, For every action, there is an equal and opposite reaction. Deflation is a relevant input in our wealth preservation quest. It makes ZIRP a good outcome provided you can insure the return of your investment. If deflation is set to continue we can adapt to ZIRP, or even a mild NIRP, and still make real money every year. We have to change our mindset, from inflation fears to deflation tactics.
Some investment ideas:
1.- I still think equities, particularly US equities, are a screaming short. But timing the top will not come easy, so you have to keep some dry powder for the day of reckoning. I will keep trying with stops, and will only commit when market technicals give me the all clear signal. That means you have to keep losing small money in order to be there for the big one.
2.- Bonds make a lot more sense than it seems. Financial media still underline the attractiveness of equities as if we were in a reflationary environment. I don’t see it happening, so I think bond shorts are dangerous right now. Real interest rates are still positive almost everywhere, despite negative nominal yields becoming the norm. High yields are unsafe, and credit risk yield enhancement is very dangerous, but otherwise, stocks offer a terrible risk adjusted reward when compared to bonds. I know everybody emphasizes the opposite point of view. Call me a contrarian if you wish.
3.- Currency wars give us a chance to make some money. I am still targeting at least 9 as a EURSEK realistic and safe price expectation (a three to four percent minimum potential return). I know the Riskbank will not be happy to read this, and they are powerful, but that’s the way it is. It may take time to play out. In the 9,50 to 9,65 area I think one can lever up the trade with a moderate risk.
USDSGD is coming up on my radar screen as an interesting trade. Still working on it, but I do not think current USD strength against the Singapore Dollar, is sustainable. On top of that, I think the US economic growth outcry will simmer down as the year progresses. A strong dollar is not of great concern, because of the closed nature of the US economy, but economic growth expectations have been greatly exagerated. I do not believe USD rate rises have significant potential, until the neofisherite paradigm works its way into mainstream economics. On the other side, I fear the USD squeeze in international finance. USD strength may not be over just yet.
That’s all for today. I found this great cartoon I’d like my wife to see. Smiling still comes for free in this unfair world. My apologies to Mr Krugman and sect.