We Cant Have Both- Or Can We?

Economic headlines today are dominated by talk of both inflation and deflation.  Since those two terms are essentially opposites, we should only experience one or the other, not both.  Today I will offer a discussion on the potential for inflation, deflation, what this means to you, and how you may be able to profit as a result.  First, some definitions:

Inflation

An inflationary environment is a result of a currency becoming worth less and less over time.  As a result it will take more dollars to buy the same amount of goods.  Over the past 100 years we have generally experienced slow and steady inflation.  Some periods, such as the decade of the 1970’s, are examples of high inflation.  Many factors can affect the rate of inflation, such as central bank money printing, interest rates, and supply and demand for resources.  Inflation is measured by CPI (Consumer Price Index) .  CPI can be misleading as to the true experience of consumers, as the numbers have become manipulated over time, with gasoline costs and food being excluded.

Deflation

In North America we have rarely experienced a deflationary environment over the past 100 years.  Deflation can occur when the economy has been overheated, due to excess stimulation via spending and borrowing, and eventually the bubble bursts.  When an economy slows down, demand for resources slows as well, resulting in lower prices.  Lower prices are good for consumers temporarily, but can cause us to wait for even lower prices, and delay purchases, which hurts businesses.  When business slows down, workers are laid off, and this can result in a recession or depression.

Most central banks would like the economy to experience a “goldilocks” scenario. with slow and steady inflation around 2% per year.  Too much inflation or deflation can be a bad thing.

What are we Experiencing Today?

The old saying “may you live in interesting times” could certainly apply to what is happening today.  There is both a strong case to be made for both inflation and deflation.

The Case for Inflation Today

As a result of the U.S. real estate bubble in the early to mid- 2000s, artificially low interest rates, and financial engineering by wall street, the world economy almost fell off a cliff in 2008 .  Nobody really knows how bad it would have gotten.  In any event, in order to save the economy, the U.S. started printing money like crazy.  Paying attention to mainstream media would lead us Canadians to believe that we have been immune to all of the nonsense going on down south.  In fact, in Canada we have been devaluing our currency as well, and piling on debt that will be difficult for future generations to repay.  In fact, almost every major economy in the world has been printing money and increasing debt dramatically, including the EU, UK, China, N.America, and Japan (the worst offender).  It seems to be a race to the bottom.

As a result of this unprecedented global money printing, one would naturally assume that inflation would result.  For example, in the US, they have essentially quadrupled the balance sheet, by printing excessively.  However, when we look at CPI numbers, inflation is relatively tame at around 2%.  How can this be?  The answer has to do with something called the velocity of money.  In Code Red. John Mauldin uses the analogy of water when referring to money.  Most of the money being pumped into the system is still sitting on bank balance sheets, like ice, and not working it’s way through the system.  That is because there is not sufficient growth in the economy to lend, to consumers and businesses, to spend and expand.  The demand is simply not there.  But eventually, when the economy does fundamentally recover, that money should start working it’s way into the economy, causing a multiplier effect.  Inflation should result.

The Case for Deflation

Today I believe the case for deflation is much stronger than for inflation.  China is the world’s largest consumer of raw resources, and as recent stats show, Chinese demand is slowing greatly.  Lower global demand means lower prices.  Lower commodity prices means less profits for commodity-centric nations such as Canada.  This general slowdown could keep the prices of oil and gas, copper, iron ore, nickel, etc. down until China goes through its cycle and demand picks up again.

In addition, some analysts believe that we are nearing the tail-end of a commodities supercycle. which started around the year 2000.  If this is true, we may be in for many years of depressed commodity prices, until global demand picks up again.

Who Wins the Tug of War?

So, who wins in the tug of war, inflation or deflation?  I would seem that today we are in a stalemate.  True, central banks have pumped a potentially inflationary powder keg into their coffers.  The only issue is that there is no economic stimulus to light the powder keg.  Until that catalyst occurs, it would seem as if deflationary forces rule the day.  Central banks cannot lower rates any more to boost spending, as they are close to zero.  Sure we pay less at the pumps, but at what cost?  In Canada, the result could be less money spent on oilsands expansion projects, less mining activity, and lower demand for ancillary businesses such as restaurants, clothing stores, etc.  Then, once the excess starts to work its way through the economic system, demand picks up again, that powder keg of liquidity just might get ignited.  This could result in an incredible inflationary boost the likes of which we have never seen.  In that type of inflationary environment, real assets such as real estate, energy, farmland, precious metals, etc, have historically demonstrated themselves to be excellent investments.

My best guess is short term deflation followed by a lot of inflation.

How to Prepare Your Investment Portfolio

If my humble thesis plays out, and we start to experience deflation, that would be a negative for Canada’s stock market.  As the TSX is more than 25% resource-related companies, it is heavily dependant on commodity demand and prices, so this may be a place to either lower exposure or avoid for the time being.  However, the aftermath of a sharp decline could also present unprecedented buying opportunities.  If you employ money managers, in the form of mutual funds, stock brokerage accounts, or the like, you may prefer to hire those with the ability to raise cash levels, not necessarily managers who are always “all in”.  Unfortunately, most managers seem to fall in the latter category, so make sure you are very selective.

As Warren Buffett once said, “Diversification is protection against ignorance”.  The reason this comment is so relevant today is because there is so much uncertainty as to timing.  We don’t know exactly when deflation or inflation will occur.  So we protect ourselves through proper diversification.  For some ideas on diversifying your portfolio properly read this article .  Proper diversification does not mean a basket of 20, 50, or even 100 stock positions.  That is the type of diversification that could cost you dearly.

Summary

Global economies are setting us up for potentially wild swings in investment portfolios, the likes of which we have never seen.  The best way to protect yourself, no matter what happens, is to get educated, anticipate, diversify properly, and generally be prepared.

If you have any questions regarding how to prepare yourself, complete the no-obligation form here .