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Albert Edwards: "We Are Now Only One Cyclical Downturn Away From Outright Deflation"
Albert Edwards is out with an interesting twist on inflation/deflation. In his latest letter he notes "I have stated openly that I expect the UK 1970s experience of almost 30% inflation to be repeated in my lifetime. I also expect this to be reached in countries that got nowhere near this 30% rate in the 1970s (e.g. the US and Europe, which both peaked around 15% ? somewhat surprisingly Japan also hit almost 30% in the 1970s)." Yet he counters: "But despite my belief that we will see a paradigm change over the next decade or so, I continue to retain our heavy overweight for government bonds. Recent inflation and monetary data continues to make me feel we are now only one cyclical failure from falling into outright deflation." So for the time being, Edwards is long bonds. The question is when will the secular inflation thesis become dominant and when will "rapid nominal GDP growth [appear] dragging bond yields higher." Yet at the core of any debate is the ongoing paradox of market schizophrenia: bonds continue pressing lower arguing for accelerating deflation even as stock surge higher in anticipation of inflation and the reduction of debt through surging prices and excess liquidity. Are bonds and stocks right in principle, yet disagree in terms of timing? And if so, why do stock (which tend to have a much shorter investment horizon) price in inflation first, and bonds second? Is Albert right, or is the market simply reacting to unprecedented Fed intervention without any guidance on how to make proper asset allocation decisions? If, as we expect, Greece collapses soon, that may be the tipping point that accelerates the resolution of that fundamental quandary.
Among the economic observations Edwards uses to back up his thesis, he points to the just released CPI data...
The release of March?s US CPI inflation data emphasised that, despite the massive monetary stimulus from the US and elsewhere, the dataflow is still entirely consistent with a slow grind towards outright deflation. Core CPI inflation in the US slipped to only 1.1% yoy in March but minus 0.2% on a three-month annualised basis ?- a new low for the last few decades. Similar benign trends are also evident in the eurozone while Japan remains locked in seemingly endless and intractable deflation
...and the generally accepted insolveny of the entire world (which not even Ben Bernanke refuted when this statement was made by Ron Paul)...
Although the insolvency of industrialized governments has been highlighted by my colleague Dylan Grice, the ongoing decline in core inflation continues to underpin government bond prices. Equity investors who think this is good news should note evaporating inflation is a restraint on top-line revenue growth at a time when margins are already looking stretched ?- i.e. companies are far more reliant on revenue growth to advance profits than is cyclically normal at this stage in the cycle.
What is the appropriate asset allocation based on these observations:
The $64,000 question is whether it is still correct to stick with our winning ?Ice Age? strategy to overweight government bonds given that both Dylan and I see the likelihood for a structural take-off in inflation before the decade is out. But I remain o/w bonds. Our long term inflationist views are not at all inconsistent with the mounting near term risk of a dip into outright deflation as/when the current cyclical upturn falters.
On the Japanese case study. We are confident Richard Koo would have something to say here:
One of the key things to remember in Japan?s lost decade was that,
however low bonds yields got, they were able to go even lower in the
following cyclical downturn. The long bull market in US government
bonds continues to see a pattern of lower cyclical lows and lower
cyclical highs. In that sense a technical analyst would define the bond
bull as fully alive with all its faculties fully intact.
Anyone looking at equity (or bond) rallies (or drops) should once again refer to Japan:
While in Japan through the lost decade(s), cyclical recoveries were indeed accompanied by decisive but temporary rises in bond yields (see chart below), this was a phenomenon as equally fleeting as the cyclical rallies in the Nikkei. The key thing for survival was to identify the long-term structural trend of lower yields and lower equity prices.
Yet inflation is almost a certainty... Eventually:
Similarly, the key asset allocation decision is to identify whether the current sell-off is cyclical or structural. I have stated openly that I expect the UK 1970s experience of almost 30% inflation to be repeated in my lifetime. I also expect this to be reached in countries that got nowhere near this 30% rate in the 1970s (e.g. the US and Europe, which both peaked around 15% -? somewhat surprisingly Japan also hit almost 30% in the 1970s).
But despite my belief that we will see a paradigm change over the next decade or so, I continue to retain our heavy overweight for government bonds. Recent inflation and monetary data continues to make me feel we are now only one cyclical failure from falling into outright deflation.
For the time being, dwindling inflation will restrain the pace of the nominal GDP rebound currently underway. For the eventual big sell-off in bonds we foresee, I would expect to see a repeat of the left-hand side of the chart below ? i.e. rapid nominal GDP growth dragging bond yields higher.
The conclusion: a subsequent downturn is already in the seeds of the ongoing ravaging deflation. What will the response be? Is that where CB last push for a last stage gasp in (hyper)inflationary experimentation?
The dwindling of core inflation in recent data releases on both sides of the Atlantic reemphasizes the fact that it is in the early phases of a cyclical recovery when inflation falls the quickest. This is because the cyclical depression of unit labour costs at the start of the recovery allows companies to slash prices if they so wish. Evidence of core inflation?s ability to subside even further is seen clearly in the current unprecedented decline in unit labour costs. All these developments mean the upward pressure on yields from the excess supply of paper and the cyclical upturn is being restrained. But, as we saw repeatedly in Japan, the impact of a lower low in inflation was never fully reflected in market prices until the subsequent downturn. That should come sooner than most suppose.
As the market's goal lately (at least in stocks) has been to destroy the bears, followed by a complete anihilation of the bulls, we observe that fewer and fewer outright bulls are left standing. The inflection point is fast approaching when pretend economics and deferred reality will crash. Until then, we expect many more musings on this age-old debate, in which the Fed continue to play a central role with its unprecedented response. The real question then becomes: what will Bernanke (or his successor) do, after the double dip is realized and the "subsequent" downturn is among us. That's when the inflationists will once again come out full force, and this time with much more ammo. After all the Fed's balance sheet is "only" $2.5 trillion right now (pro forma for all MBS settlements). We are confident that the Fed's printing press has much, much more ink.
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i was thinking of the imf rescue. i think we saw central bank intervention in the euro. the reason this happened is it was threatening the rally hence it would mean deflation.
the bernanke/ central bank plan depends on inflating our way out. so imf to rescue. deflation will show that thewhole system is insolvent/ ponzi.
Yes, lets all lend our money to bankrupt institutions and governments due to an expectation of deflation that has NEVER HAPPENED ONCE since we went full fiat.
How stupid can you get?
Real estate prices never went down either - until they did.
Having "deflation" in one sector is different from having deflation in ALL sectors. The former is a result of a sector overheating, the latter is a result of monetary contraction, which ain't happening by any means.
Unless I missed the news, and it turns out today is "opposite day".
And yes, real estate prices HAVE gone down in the past. 1982 rings a bell. We haven't had ANY deflation since we went fiat almost 40 years ago. Only bouts of slower inflation.
dollar deflationists are a stubborn bunch.
ka-poom is coming.
I agree, and if deflation is such a big issue, why the hell is EVERYTHING green, as currencies do the curly shuffle?
interesting. so you are saying once currencies are no longer pegged to anything, there is no such thing as deflation?
Then, my conclusion, and perhaps yours, is that the inevitable consequence of QE and reserves created from nothing is either a mild or virulent form of hyperinflation, and by that I mean a deliberate debasing of the currency, rather inflation attributable to insufficient production of goods.
I dont understand why the concern over greek default as there are bigger states inthe US about to "fail". Neither will fail cause if they were why are the markets completely ignoring these risks on the equity side?
Keep reading ZH. You'll understand that today's equity markets have nothing to do with rational expectations. Still, your original question is excellent.
Investors ignore massive problems of the states because they are :
1 ignorant, or
2 sure that Ben's printing press will cover all domestic problems until hyperinflation buries us all.
Greece is important only because if Greece defaults and/or leaves the EU it sets off a chain reaction of dozens of other deadbeats racing to do likewise. Game, set, match for all the ponzis. Here's the punchline.
If the forces of darkness "save" Greece, they still have to deal with a large and growing contingent of choosy beggers around the globe. There is essentially an infinite number of principalities, municipalities, and sewer districts eager to be the next Greece.
Ben and Timmy are juggling buzz saws. Pop a cold one and enjoy the show. It may get messy, but you won't be bored.
king albert in a can = agreud.
I have stated openly that I expect the UK 1970s experience of almost 30% inflation to be repeated in my lifetime. I also expect this to be reached in countries that got nowhere near this 30% rate in the 1970s (e.g. the US and Europe, which both peaked around 15% -? somewhat surprisingly Japan also hit almost 30% in the 1970s).
The inflection point is fast approaching when pretend economics and deferred reality will crash.
Great data points and a likely scenario. We crack, deflate, then surge into HyperInflation.
The $64,000 question is whether it is still correct to stick with our winning 'Ice Age' strategy to overweight government bonds given that both Dylan and I see the likelihood for a structural take-off in inflation before the decade is out. But I remain o/w bonds.
Of course the author knows that this is deliberate central bank policy, but I remain confused as to why no one ever states so. The moment the outcome becomes blatantly obvious, even to 30- and 40-something credit bubble-baby fund managers, all bets will be placed accordingly and the outcome will fulfill itself.
Our long term inflationist views are not at all inconsistent with the mounting near term risk of a dip into outright deflation as/when the current cyclical upturn falters.
I agree, the only question is one of timing. And that timing is also, for now, up to the central bankers, and therefore known only to them and their friends and family list, otherwise called "Wall Street". As the debt-to-GDP and other measures become more and more damning, even that timing choice will be stripped from them, and then it will be the turn of the "legislators", also in the service of "Wall Street", to take control by any means necessary.
One of the key things to remember in Japan's lost decade was that, however low bonds yields got, they were able to go even lower in the following cyclical downturn. The long bull market in US government bonds continues to see a pattern of lower cyclical lows and lower cyclical highs. In that sense a technical analyst would define the bond bull as fully alive with all its faculties fully intact
And that is why I still believe it is wise to hedge your inflation portfolio with a substantial amount of cash and easily liquidated cash equivalents. Given the huge, structural, global fiscal challenges that are obvious to everyone, there are really only two bets: severe deflation, and a currency collapse / hyperinflation. Hedge one with the other and hope to see tomorrow. On Japan specifically, however, it seems that the endgame of Japan Scenario might soon be revealed as sovereign default.
In the end, persistent deflation is the midwife of hyperinflation. Governments will not survive a persistent deflation, certainly not government which is borrowing more money into the future and not less.
Scroll down to the second chart on this page, the one titled "Argentine Inflation 1995 - 2009"
http://www.itulip.com/forums/showthread.php?p=106493
Then, if you can stand it, check out the next chart, titled "Argentine Exchange Rates 1995 - 2009"
we are in the ka part of ka-poom, i have a feeling this phase will soon be over, then the currency melt-down begins in earnest.
"Yet at the core of any debate is the ongoing paradox of market schizophrenia"
This segues perfectly into my theory on The Double Whammy Economy: simultaneous deflation and inflation. The economists keep arguing because they never considered it possible that both could co-exist in a destructive vice-grip on the real economy.
The reason why statistical measures of inflation are stuck near zero (core CPI, core PCE) I believe is because deflationary and inflationary forces can cancel out in the numbers. But of course the effect on the economy is being totally masked and far from being benign is the most malignant threat to the health of consumers and small business.
Economic data is indicating that the Double Whammy Economy is now in full flower. Nobody will deny the creeping deflationary forces extant: incomes and wages are deflating in real terms continuing a 3 decade trend. That's why productivity is soaring. Employment in general is deflating and starting to pick up again despite 2.5 years of layoffs (ADP data, recent new jobless claims, Gallup survey of underemployment). Real Estate is still deflating with new announcements of a second massive foreclosure wave, failing HAMP program, and Robert Schiller's prediction of further price declines. Same is applying to commercial real estate with historically high vacancy rates for New York offices. Retirement assets are deflating as well: pensions in trouble, medicare and social security adrift, 401Ks hanging precariously on an engineered market rally. Meanwhile the cost of living and doing business is inflating as a side effect of Fed/ Treasury policy to reflate the markets, which is succeeding and far outstripping growth prospects. Energy, raw materials adn food are up (not reflected in core CPI). Consumer credit and banking fees are high and rising. Health insurance, insurance costs in general are spiraling as are import prices (0.7% in a month), education and tuition, transportation, telecommunications to name a few. But the 800lb gorilla will be federal, state and local taxes which are looming and inevitable. So are new exotic taxes being proposed such as VAT, banking, luxury, and gasoline taxes. Healthcare reform raised some taxes already.
Small business is having trouble passing costs on to a constrained consumer. Hence the vice grip. Consumers are also in the grip and have limited and costly access to credit.
I always thought this chart of household expenditures in Weimar Germany was interesting. It looks like inflation in food, deflation in housing. Sounds familiar.
http://www.nowandfutures.com/images/WeimarHouseholdExpenditures1912_1923...
For a frugal household with no mortgage or other debt, some of the biggest unavoidable expenses are insurance - home, auto, health - plus property taxes. Not a lot of deflation going on there. Yield on cash or equivalent savings is measured in bps, and anyone still holding on to stocks as a retirement investment must really believe God loves them, because getting out at the top will be like catching a bullet in their teeth.
+1 Caviar
and when either deflation or inflation drops the rope in the tug of war (J. Rickards analogy) one or the other will move at hyper speed.
I believe deflation is only relevant if the money supply is fixed, like to gold?
We look at currency as it applies to our personal needs, not to the way markets operate. What will happen when the rest of the world decides they don't need/want the trillions of dollars they hold...I dont believe the household will be relevant in the equation.
Nice description. Stagflation is a margin squeeze.
Man you are telling me!
I'm one more layoff away from outright deflation myself!
Here is how simple it is.
Which economic situation suggests deflation ?
1) Economy A has overall debt of over $50 Trillion that is paid by a declining annual cash flow base of $2 Trillion. Perhaps 30% of the debt holders will be wiped out, which will render the economy less $15 Trillion than initially surmised. The net effect translates into the remaining $35 Trillion debtholders enjoying more haircuts , with an annual income of $1.2 Trillion.
2) Economy B has an overall debt of $50 Trillion and overall income is expected to jump to $7 Trillion over the next decade, whereby the leverage effect will more than double the outstanding debt levels, all of which is easily serviced.
The fact is that until the US Govt. puts into effect an economic tax structure that will allow produced goods to be sold at a minimal to no tax component, there will be a definative bias to outright deflation.
Outright debt destruction will out pace money printing by a wide margin.
No doubt one wants substantial physical gold holdings in a stable, free financial zone..
So where is that? - Singapore, Dubai, Uruquay, Panama, Hong Kong...?
and what is the solution for storage? can you trust ANY deposit box companies with substantial gold holdings
or do you entrust your physical gold to a bullion management company that stores it for you in Canada, for example Sprott?
or are Perth Certificates good enough?
Answers would be much appreciated
Bloomberg this am: Greece economy the size of Massachusetts, Portugal the size of Indiana's.