My Diary 338 --- Inflation or Deflation, One Cut and Done, A Slo

 

My Diary 338 --- Inflation or Deflation, One Cut and Done, A Slow Recession, Golds and Devaluation Currency

October 8, 2007

How fastest the world can be changed? In just couple weeks ago the world seemed to be on the edge of a credit implosion and severe recession. But look at now, many global equity markets are making new highs and bad news on the subprime crisis is no longer being a woes for the market any more with latest stronger than expected NFP number.

 

So it all seems like we should refocus on reflationary strategies, but many statistical indicators are clearly showing the cyclical tendency of the  world economy is leaning toward disinflation or deflation, not inflation due to a simple reason --- the bursting of the US housing bubble is a deflationary shock to broader economy.

There are several fundamental topics to be covered today, which have profound investment implications, so let's jump right in.

Inflation or Deflation

From the stock market crash of 1929 to the Thai baht devaluation of 1997, the history proves to us that every bursting of an asset bubble or financial crisis has always been followed by a drop in inflation, regardless of what the central bank did.  And this is because asset price deflation usually is followed by a period of economic weakness, which in turn restrains the business sector’s pricing power. At that point, monetary easing is often a “have-to-be” response as lower interest rates are needed to halt any further deterioration in aggregate demand. Otherwise, deflationary pressures could accumulate quickly, leading to a downward spiral in economic activity.

The recent Fed rate cut fits this classic scenario perfectly: Realizing that U.S. business activity was being threatened by the subprime meltdown and the subsequent burst of credit disintermediation, the Fed moved quickly and aggressively to ease into the crisis in order to stem further weakening in aggregate demand.  Moreover, according to the Bloomberg, all the G7 headline inflation is falling and the width of price increases, a measure of how prevalent price inflation is among the major developed countries, has also been turning lower. These information definitely does not  suggest inflation ahead. In fact, I think what the Fed has done is likely to buffer the growing deflationary pressure of the US economy... if this is a correct observation, then it is not correct to think the recent rate cut is inflationary.

 

One Cut and Done

Over the weekend, the global market seemed pleased with the NFP number. The Fed Vice-chairman seemed to suggest that the economy was getting better and the Fed might not need to make any further rate cuts. These all sound to me like a “one cut and all done” deal. But I would like to have a reality check and there are a few numbers of findings on my table now.

First of all, good news are average hourly earnings were up by 4.1% yoy and growing at a 5% CAGR for the last few months (so consumer spending should be fine for the next few months), and jobs growth in August were revised up substantially (A nice swing!).

 

However, we should make a note here that empirically, the monthly NFP is probably the single most misleading statistic which is often subject to massive revisions. Interestingly, the market doesn’t pay close attention to the revisions. In addition, the 110K job numbers may not be worth for a glass of champagne as the US economy needs somewhere around 150K to 200K new jobs to simply maintains the employment level, as we add that many new job seekers each month. This below trend job growth is actually consistent with the unemployment rate, which has risen to 4.7%, +0.3% above the current cycle low of 4.4% at March 2007. We know that a rise in the unemployment rate often (but not always) signals a recession is in the future, or a statistical fact is an average of 100K new jobs implies that economy is allowing down.

Thus, when Mr. Donald Kohn said in Philadelphia that the US economy will return to "moderate" growth after "near-term weakness" and avoided any indication the Fed is preparing to lower rates a second time.  I don’t agree with him, even he is the Vice chairman of FED… What am I doing here (haha!) and here are my reasons: 1) As noted above, under normal situation, Sep jobs report would be considered weak; 2) Housing problems and its negative impacts are not leaving us soon; 3) The last cut did not lower rates as 10yr rates were up by 17 basis points as of today. I think the Fed definitely wants long-term rates and especially mortgage rates to come down as lower mortgage rates will help stem the housing valuation slide.

 

A Slow Recession

Many analysts pay a close look at the US consumption as a leading indicator of recession, as consumption represents about 70% of GDP. However, according to a research by two Novel winners (Friedman and Modigliani), consumption is the smoothest component of the economy. And historical data also shows that nominal consumption has never declined on a yoy basis, even in recessions.

I open my economic book over last weekend, and I found the definition of “recession” is not measured by a general shortfall in consumer spending, but by a mismatch between aggregated supply and demand. Now, by using this definition, we can somewhat identify what really makes this recession different from past. In past recessions, there were generally some portions of the economy that grew beyond the respective demand for their products or services and/or a bubble in some sector burst. Such an event happened relatively quickly, and it took some time for there to be a shift of employment to other sectors and the economy to start growing again.

But housing sector is different. There is no mark-to-market pricing as basically every house is special because the house owners know how much time and effort they put into maintaining the house. And under many situations, as long as ppl are patient, they will get a good price for their home. And they are reluctant to sell at a reduced price and that is why housing market is “sticky” during the downturn compared with other asset classes, like stock and commodity.

In the reality, what matters to the broader economy is not how many numbers of homebuilders lose money, but an average house buyer who is trying to sell or refinance a home. But he or she finds out that in the neighborhoods, the value of their home come down - perhaps substantially. Let me quote what Gary Shilling said couple day ago -- "57% of mortgage customers with ARMs were unable to refinance into new loans in August, given their low initial down payments and falling prices that have put their equity in negative territory. Estimates are that the cumulative loss on subprime mortgages will be $164 billion in home equity and cost financial institutions $300 billion.” So $464 billion gone … then one more complex issue is even the distressed homeowner wants to renegotiate with the terms, how can one find the CDO investors who own their mortgages and who turns out to be European banks or some Eastern governments? …Bring a bomb and ask for 50% discount of housing payments will not work well in this situation, I believe.

 

 

Golds and Devaluation Currency

We all know that gold prices have risen about $80 or 15% since August 16 and the rising gold prices are an indication of the return of reflation trades. Today, my CIO shows me a $1000 forecasting by Barron’s.

Now how does the $1000 gold price fit into the inflation and deflation thought? Firstly, a weakening US Dollar is unambiguously bullish for gold. But more importantly, I think competitive devaluation remains the key theme in the currency world as in a deflationary world, no country wants a strong currency; even the US. As a result, if everybody wants to lower the value of paper money, then the real money (gold) will be pushed up.  Another factor to count is most central banks have already liquidated their gold reserves to a very low level. For example, China only holds 19.3 million ounces of gold, which accounts for only 1% of its total reserves. With reserves piling up rapidly, it is inevitable that China will diversify part of its foreign exchange reserves into gold. Finally, I think the inherent tendency of capitalism is deflationary as in theory, a pure capitalist society is perfect competition. The question is whether a central bank could create generalized inflation at all or whether the fiscal policy is excessive or not.

 

But, many academics have shown to us that the general trend in the world economy since the 1980s has been a move ever closer to a state of so-called “perfect competition” or free market system. This determines that the general trend in the world economy since the 1980s has been disinflationary rather than inflationary....now this is just some random thoughts regarding $1000 gold price.. long-term it could be there, but not in the next 12 months...

 

Good night, my dear friends