Altus Insight - October, 2014

The Altus Insight
Market news, commentary and relevant topics for today’s alternative asset investor

Date: October 31, 2014
FR: Forrest Jinks
RE: Deflation. Is it Possible?

This is part one of a two part series on deflation. Part two will be sent out in the next Altus Insight.

Long time readers of the Altus Insight will know that since the bottom of the crash we have made investment decisions and structured our investments based on the possibility that the economy could experience either severe inflation or outright deflation. Since that time it could be argued that we have experienced both, with substantial inflation in asset prices and almost no growth across the rest of the economy. But the world is clearly not through dealing with the effects of the Great Recession and the US is not out of the quantitative easing period, so the rest of the story remains to be written. At Altus we realize any attempt to predict the future would be an exercise in futility but we also realize we can take the input we have been given and guide our investment decisions based on the POSSIBILITIES created by that input. The current situation and the actions being taken by governments and central banks within the existing economic framework are such that we continue to believe there is a strong POSSIBILITY that our economy will experience inflation OR deflation outside the historical bounds of normality. Over the past couple years we have had several articles discussing inflation but have spent less time considering deflation with its possible causes and results. This month and next we will try to make a little sense of the deflation possibility.

Possible Causes of Deflation:

Velocity: Many economists and analysts continue to predict severe inflation due to the massive creation of money undertaken by the Federal Reserve. On the surface this makes sense: 1. Inflation is the devaluation of a currency, 2. the greater the supply of something the less value of that something, 3. therefore the increase in supply of that currency should result in that currency experiencing a decrease in value (inflation). This simplistic A = B, B = C, therefore A = C equation is missing a key component. The devaluation of the currency is not based on the amount of currency in circulation, but is rather defined by the total “money” in the economy, with the key difference being monetary velocity. Velocity is the rate at which money is spent in the economy. That is to say if the same dollar is spent four times within a year it has a velocity is four times that of a dollar that is only spent once in a year.  This is shown by the Money Exchange Equation identity M * V = P * Q, where M is the currency in circulation, V (Velocity) is the number of times each dollar is spent within a year, P is the average price of goods and services sold within that year, and Q is quantity of goods and services sold within the year. This is an identity, not a theory, meaning it is true by definition as opposed to describing any particular economic activity.

Circling back to the discussion about inflation caused by an increase in the money supply we can see by looking at the Money Exchange Equation that if V (velocity) is decreasing faster than M (money) is increasing then P*Q (generally assumed to be GDP) will go down. A decrease in GDP is deflation. It just so happens that the velocity of money has been falling consistently for nearly two decades. According to data provided by the Saint Louis Federal velocity is down 46% percent since 1997 and down 10% since 2009 alone. All other things being equal, which of course they never are, the country would have experienced 2% annual deflation since 2009 based on the velocity of money. The increase in money in circulation thanks to the Federal Reserves has largely just offset the drop in the velocity of the money within the economy. Now that the Fed’s latest quantitative easing is winding down, what will offset the declining velocity? In reality no one knows the answer to that question. Yet.

Dollar Strengthening: Just as inflation can be defined as a decrease in purchasing power of a unit of currency, deflation can defined as an increase in the purchasing power of that same unit of currency. A strengthening dollar, by definition, is an increase in purchasing power. And right now the dollar is strengthening and should be expected to increase further going forward due to two different factors.

First, even as the Federal Reserve slows the rate of its asset buyback program, and therefore new money entering the economy, other large economies, specifically Japan and the European Union continue to pump their currencies into the economy. While sparing readers the more particular details of how this results in a strengthening dollar, simple supply and demand provides a high level understanding. More Yen or Euros (increased supply) without a corresponding increase in demand results in a decrease in value/price of the Yen or Euro versus other currencies, the USD in particular. Unless of course there is a corresponding increase in supply of USDs at the same time so that the currencies are devalued simultaneously. That has been the case for the past several years, but with the creation of new dollars slowing the Yen and Euro will pull ahead in the race to the bottom and the dollar will continue to strengthen relatively.

The second factor is the so called “flight to safety”. Flight to safety is a rush for stronger or more stable investments during times of volatility or weakness in other investments. While many country’s bonds have recently benefited from money moving out of assets considered risky into bonds considered to be safer, no country has seen demand for its bond increase as much as the US and Germany. Increasing demand equates to increasing bond prices (decreasing yields), again due to simple supply and demand. Decreasing interest rates (yields) generally accompany an increase value of the currency. The demand for German bunds increases the price of the bond (therefore reducing the yield) but because Germany is part of the EU monetary union the increase in demand for their bond isn’t enough to offset other factors driving the value of the Euro downwards. Unlike the German situation, demand for US T-Bills does affect the strength of the dollar. Currently demand is strong, and the dollar continues to strengthen. It should be noted that in many situations increasing interest rates lead to stronger currencies as increased investment is enticed to participate in the debt market due to the increase in rates. That is not a flight to safety, it is an effort to increase returns.

Economic Turbulence: The general lack of economic recovery, at least compared to the normal post-recession recovery, has put us in a position where many people feel there is little chance of a business slow down because we haven’t seen a true recovery yet. While not untrue, recessions can also be created due to recalibration or crash of investment markets, as was the case with the real estate crash leading to the Great Recession. By some measures the stock market has reached valuations only seen three previous times since 1900’s; 1929, 2001 and 2007. That alone puts us in rarefied air. It is likely that such a correction would only occur due to exogenous shock, such as assassination of the Archduke of Austria that directly led to World War 1, or to highly unexpected economic data, even if that data didn’t relate directly to the US economy. This second source could again be provided due to a cause of the strengthening dollar. Over 50% of the profits of the companies in the S&P 500 are obtained outside the US. A strengthening dollar makes it harder for US products to compete with products manufactured in countries with weak currencies. This leads to either decreased sales or decreased margins, both of which lead directly to decreased profitability. There are already whispers that the strength of corporate results over the past couple years are due more to stock buy backs than to true business performance. If profits lose their steam at a time when the whispers about the strength of the profits are already occurring, a drop in equity prices could well occur.

A third possible source of economic turbulence directly contradicts the earlier thoughts about a true economic downturn being unlikely. We will discuss oil more in next month’s article but for now we just need to know that US oil production has skyrocketed over the last several years creating a situation where there is currently more oil being produced in the world than the world is consuming (supply/demand means lower prices) and where a vast majority of private sector economic growth since the downturn has been related to the increase in US oil production. This oil, mostly obtained through fracking shale fields, has a much higher cost of production than oil produced by many regions outside the US. As prices fall it becomes less and less financially viable for US producers to continue to expand. Oil prices have fallen by more than 20% over the past several months. Usually a decrease in oil prices leads to economic benefit because of cheaper fuel costs for the end consumer, but when that decrease in oil prices directly leads to lost profits by US companies, accompanied by a reduction in the speed of expansion, the economic outcome might turn negative. Worse, and more and more a possibility as prices continue to fall, US producers will no longer be able to produce profitability which will lead to an outright contraction in production. This means a loss of US jobs, income, and tax receipts.

We will drill deeper into the oil situation (pun intended) in greater detail next month as well as discuss how a deflationary environment may impact our investment portfolios and efforts.

 

Happy investing.

 

Forrest Jinks

Altus Equity Group, LP

off: 707/932-5887

fax: 707/544-2972

www.altusequity.com