FORECASTS & TRENDS E-LETTER

by Gary D. Halbert

August 24, 2010

IN THIS ISSUE:

1. The Inflation/Deflation Debate

2. Why Governments Love Inflation

3. Deflation Beyond Lower Prices

4. The Shock Doctrine

5. What You Should Be Doing

Introduction

Much has been written about the inflation/deflation debate, mostly by people who want to sell investors their particular investment solution. Fortunately, there have been a number of other, more scholarly articles as well that avoid the hyperbole and just get down to a basic analysis. However, there seems to be no general agreement on which of these scenarios may lie in our future, if not both.

Since I own an investment management firm, my staff and I often hear from clients about their concerns for the future. Right now, many are concerned about whether were going to experience inflation, deflation or a combination of the two in the years ahead. Thoughts of our economy becoming mired in a Japanese-like deflationary spiral fuel some concerns, while others fear that Ben Bernanke will fulfill his caricature of printing dollar bills and tossing them out of helicopters.

I have not written much on the subjects of inflation and deflation due to the glut of information already in publications and on the Internet. However, considering the feedback Im getting from clients, I think it might be time for me to weigh in on the debate. You might be surprised at where I believe were headed.

In this weeks E-Letter, Im going to discuss my own thoughts about the inflation/deflation debate. However, rather than put things on a global scale as some noted analysts have done, I think its more important to get down to a personal level. What does inflation or deflation mean to you, as an investor and a consumer?

The Inflation/Deflation Debate

Most of the time, debate among economists centers around Keynesian vs. Austrian, or more stimulus vs. less stimulus. Today, however, the discussion seems to be boiling down to inflation vs. deflation. Unlike some other more esoteric economic issues, the answer to the inflation/deflation question may have a more profound effect on your financial destiny than any other issue, so its important to be paying attention to the discussion going on in economic circles.

I think that we can all agree that, in a nutshell, inflation is the state of too few goods being chased by too much money. Deflation, on the other hand is just the opposite where there is less money chasing an abundance of goods. Inflation makes prices go higher while deflation lowers them. Back in the 70s and 80s when we were introduced to double-digit inflation, most of us learned to be wary of it. However, we dont know how to react to deflation, since most of us have never seen it in action.

Actually, thats not quite correct. Most of us have experienced deflation caused through productivity gains and lower manufacturing costs. For example, you very likely paid a lot less for your newest computer than you did for its predecessors. The same goes for most other high-tech goods such as DVD players, cell phones, big-screen televisions, etc. etc. Increased productivity and technological advances pushed prices lower even though the newer products have more features.

Likewise, moving manufacturing facilities to countries with lower labor and other costs allows for lower prices than available from domestic production, in some cases. Forgetting for a moment the political and social implications of moving jobs offshore, lowering manufacturing costs leads to a form of price deflation (think WalMart). This, along with productivity gains are the good kinds of deflation.

Considering our limited exposure to these phenomena, when the subjects of inflation and deflation come around we tend to fixate on the price of goods rather than the broader economic issues. In inflation, prices go up while in deflation, they go down, so whats not to like about deflation? Being savvy consumers, wed obviously like prices to go down rather than go up.

However, as we continue the analysis of inflation and deflation, its important to remember that were talking about the structural kind that affects the entire economy. For example, structural inflation and deflation affect not only prices, but also wages, production and the overall money supply. In a deflationary environment, the cost of goods would be lower, but so would your wages, most likely. Not so attractive any more, right?

Deflation also usually involves lower demand for goods and services. One reason is because of lower wages as mentioned above, but another is a tendency of consumers to wait on making purchases because theres an expectation that the prices will be lower in the future. Thus, true deflation is typically associated with a depressed economy. In fact, the last time we experienced true deflation was during the Great Depression of the 1930s. Will history repeat itself? Only time will tell.

Why Governments Really Love Inflation

One of the biggest arguments in relation to the possibility of future inflation is that governments, it is said, love inflation. The reason for this belief is that inflation helps governments pay off current debt by increasing prices, income levels and eventually, tax revenues. As inflation pushes the GDP level higher, debt levels become a smaller percentage of GDP, making them appear to be more sustainable.

Long ago, John Maynard Keynes said the following about governments and inflation:

By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.

It works like this: If the government borrows $1,000 today and pays it back a year from now (assuming no interest), but the economy experienced 10% inflation over that time, the purchasing power of the money paid back would be 10% less than the amount owed, or $900. Thus, while the nominal value of debt is the same or higher due to interest, the purchasing power of the debt can be reduced by a government engineering inflation.

Of course, Mr. Keynes and our example assume a rather static level of debt but thats not whats going on now. Our GDP is growing at an anemic pace while our national debt is on steroids. Though government spending through various stimulus programs has attempted to kick-start the economy, it hasnt worked yet. The result is a massive amount of debt and a weak GDP, not a good combination. If inflation makes existing debt easier to repay, then a deflationary scenario while still increasing debt is a recipe for disaster. Is anyone in DC listening?

Because of the disastrous effects of the current combination of potential deflation and ever-increasing government debt, some analysts have floated the idea that the federal government will attempt to engineer some inflation in order to reduce the effect of the higher debt. However, monetary policy by itself, without accompanying economic growth, is unlikely to produce the desired result.

The more realistic course of action is that the Fed will continue to have an accommodative monetary policy primarily to escape deflation rather than trying to engineer inflation. Yet, a recent research paper by James Bullard, president of the St. Louis Fed, said that Fed chairman Bernankes expectation for interest rates to stay low for an extended period of time might actually increase the chances of deflation.

The bottom line is that while inflation may help ease the government debt burden, it has to be accompanied by economic growth. Looking at the US economy, were likely to have a hard time producing strong economic growth, much less growth sufficient to inflate our debt away. There are simply too many headwinds to have robust economic growth. Consumer demand is down, unemployment is high and wages are flat. Does that sound like a good combination in which to introduce inflation? Hardly.

Having said all of the above, we cant rule out inflation entirely. However, its not likely to be the kind that would be very helpful to the government in repaying its debt. One possible source of inflation could be the current easy money policy. The Fed has committed to printing money for however long it takes to come out of the present mess. Another might be creditor nations requiring higher interest rates on Treasury securities as the federal government debt burden grows.

Legendary investor, Warren Buffett, has gone on record that he is definitely in the future inflation camp. In a New York Times op-ed piece a year ago, he warned of massive government stimulus combined with greenback emissions, which he defined as the various forms of fiscal and monetary stimulus. The result, according to Mr. Buffett, will be a falling dollar and severe inflation.

While Buffetts prediction for inflation is unwavering, its not something he sees for the immediate future. Other analysts agree that fiscal stimulus wont lead to short-term inflation because much of this money is finding its way into banks, but they arent lending. Eventually, however, this mountain of cash will have to make its way from bank reserves into the economy, which is likely to be inflationary. The question is when this might happen.

The Case for Deflation

Those who see a deflationary future point to the fact that US households are in a deleveraging process that will continue to sap money away from consumption. That, plus a greater propensity to actually save money could result in the situation where too many goods are chasing too little money the official formula for deflation.

The dearth of bank lending for households and businesses is another factor in favor of deflation, according to some. Businesses need capital to grow and individuals need credit for major purchases. With banks holding to tight lending standards, when they lend at all, significant growth cannot occur, as I have pointed out often over the last several months.

One of the biggest factors I see in favor of deflation is that there is no other piggy bank from which to fund consumer spending. Think about it, we enjoyed economic growth in the late 1990s due to the wealth effect from a buoyant stock market. Once that bubble burst, the Fed kept monetary policy free and easy so that a housing bubble could be built.

In both situations, consumers had a ready source of cash for consumption. Today, I dont see the source of another pot of cash for consumers to spend. While some might argue that the stock market could again be inflated to produce another wealth effect, I dont know that the public will be buying stocks en-masse after two major bear markets in less than a decade.

As I have mentioned in previous ELetters, Investment Company Institute (ICI) statistics show that retail investors (individuals and households) are still net sellers of equity mutual funds, not buyers. Its going to be hard to inflate the stock market without individual investors. Thus, with wage growth essentially flat and credit hard to get, I dont see where consumers are going to get the money to increase consumption, and this helps make the case for deflation.

Going back to our discussion of how governments love inflation, we have to also conclude that they hate deflation. Thats because in deflation, the debt is paid back with more valuable dollars in the future. While inflation benefits the debtor at the expense of the creditor, the opposite is true in deflation. Thus, with foreign governments owning so much of our outstanding debt, a deflationary scenario would actually benefit foreign holders of our debt.

Thats why Ben Bernanke and his cohorts at the Fed will do anything in their power to prevent deflation, including cranking up the printing press. Even so, Im not sure Bernanke can stave off the deflationary dragon even with his mighty printing press. The US economy is fragile, and the stock market is susceptible to any major shock to the system.

Based on the most recent economic reports, the Feds easy money policy isnt working. While it is flooding the market with liquidity, banks are not lending and most of this money is just piling up on banks balance sheets. Some say this is actually decreasing the money supply, which would be deflationary in itself. Thus, look for the Fed to be preoccupied with preventing a Depression-type deflationary spiral, with little regard to the inflationary pressures its policies may cause in the future.

A final note about deflation is in relation to predictions that the US will become like Japan. There are some writers and analysts who believe that the US will fall into the same deflationary trap that has had Japan in a quagmire for more than a decade. There are actually many similarities between the US situation now and Japans economic malaise of the 1990s, but there are also some very important differences.

Considering the various factors related to the Japanese and US economies, I dont believe a Japan-like scenario is in store for us. The monetary policy and regulatory response to the subprime crisis was much swifter in the US than in Japan. Deterioration of asset prices, especially housing, was far more pronounced in Japan, falling by around 80% in urban areas.

There are also cultural and demographic differences. Japan has a much older population, on average, and Japanese households are also far more inclined to save than US households. While the jury is still out as to whether the US propensity to consume will continue in all demographic subgroups, I think that we can at least say that consumption will rebound at some point in time.

So, while it makes for good headlines in newspapers and online blogs, I dont expect the US to fall into a deflationary spiral similar to Japans. However, thats not to say that the US wont experience deflation. In fact, I think its highly likely that deflation will occur in the near future, if were not already there.

The Shock Doctrine

The bottom line is that the US economy is probably more susceptible to a negative event than ever before. Just looking at the Greek debt issue should prove the point. I doubt that very many economists think that, in a normal economic scenario, the Greek debt crisis would have caused even as much as a ripple in the US stock market. However, we now know that it did, and the primary reason was that the global economy is fragile and investors are nervous.

The situation has become such that the answer to whether we have inflation or deflation could come down to just what kind of an event might occur to trigger a movement one way or the other. There is no shortage of potential shocks to the economy and the stock market, which include:

1. Foreign buyers of US debt demanding higher interest rates;
2. Downgrade of US debt by rating agencies;
3. The US dollar goes into free fall, pushing up prices of commodities;
4. Falling back into a double-dip recession;
5. A spike in unemployment;
6. Unwinding government stimulus too slowly; and
7. Global food shortage due to the Russian drought.

The list could go on and on, but the important thing to remember is that the stock and bond markets are likely to behave unpredictably in the months ahead. Any news could move the stock market in one way or the other, as well as set the stage for future inflation, deflation or both.

I personally believe that were going to encounter a bout of deflation before any inflationary pressures take hold. Im not talking about an extended deflationary spiral like Japan has endured, but probably enough to push the economy back down into at least a mild double-dip recession. While Bernanke and company will try their best to avoid this outcome, I just dont think they have enough bullets in their gun to avoid the inevitable.

However, the long-term outlook is definitely inflationary as the US government tries its best to spend us into oblivion. Whether through printing money, quantitative easing or even new, unproven policies discussed by some economists, I firmly believe that we have an inflationary future ahead of us in the long term.

Even if we do eke out modest economic growth, I expect it to be paltry in comparison with past recoveries, and especially in comparison with some of the rosy scenarios predicted in some of the CBO budget projections.

And heres where my opinion deviates from the crowd. I personally believe that we will see good, old-fashioned 1970s vintage stagflation before were done. Think about it. In the 1970s, inflation was stoked not by an overheated economy, but by the Feds loose money policy and skyrocketing oil prices. Inflation was high and so was unemployment, the classic definition of stagflation.

Fast forward to a year or two from now. Most economists are saying that well continue to have slow growth, if any at all, so unemployment is likely to remain high. When the Feds easy money policy again begins to stoke inflation, Im afraid were going to relive Jimmy Carters worst nightmare.

Worse than remembering the specter of deflation is the thought of the eventual cure. Remember that Paul Volker, now a trusted advisor to President Obama, orchestrated a tight money policy that drove interest rates through the roof in the early 1980s. Do you remember the Prime Rate hitting 21.5%? I do, and it wasnt pleasant. Of course, CD and fixed annuity investors loved it for a while.

What You Should Be Doing

As I noted early on, knowing about inflation, deflation or even stagflation doesnt do you much good unless you also know how to invest your money during these economic conditions. The problem is that no one is going to ring a bell when deflation begins (some economists think its already here). As a result, the markets are going to be moving on any hints of inflationary or deflationary pressures.

Since I have gone on record saying that I expect deflation to be our first challenge, you need to know that deflation is generally bad for tangible assets, commodities and stocks in general. Bonds, however, tend to do well in deflationary times as they represent debt, and debt becomes more valuable in deflationary times.

Over the past year or so, I have discussed various bond programs that my firm offers, so I wont repeat that information. If youre interested in reviewing these programs, just refer back to my September 15, 2009. April 13, 2010 and August 3, 2010 E-Letters. If you decide to seek out individual corporate bonds or Treasury bonds, or even bond mutual funds, you need to remember that bond prices can be just as volatile as stocks in the short-term, if not more so.

If inflation does come calling, tangible assets and commodities will likely gain new respectability, as will equities. Bonds, however, begin to suffer as higher interest rates push bond yields up and prices down. We continue to believe that the actively managed equity programs we offer provide a good long-term exposure to stocks, but with the ability to move to the sidelines should we encounter a resumption of the bear market.

Gold, of course, has always been known as an inflation hedge, so it could do quite well in an inflationary environment. However, some of the calls for gold to be thousands of dollars per ounce are a bit out of line, in my opinion. Even in an inflationary environment, I advise you to keep gold to a small percentage of your portfolio.

If there was ever a market environment that called for the ability to go to cash and keep your powder dry while waiting for opportunities, its the one were likely facing now. During deflationary times, stocks are likely to suffer while bonds should do well. During inflation, stocks and tangible assets should do well while bonds hit the skids. However, we could find ourselves going back and forth between fear of inflation and fear of deflation in the months ahead.

I also think that you should manage your expectations for the stock market even if we experience significant inflation. Recall that this inflation may be 1970s style, produced by monetary policy and outside forces rather than an overheated economy. If the economy continues to grow slowly, if at all, stocks may be lucky to produce single-digit returns.

www.halbertwealth.com/ .

Wishing you profits,

Gary D. Halbert

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