Concern over deflation has started going mainstream. This is not a simple concept to embrace, especially with the backdrop of an easy Fed and massive government spending. But that is the paradox of easy money in an era of over-indebtedness. Identifying why this is happening allows us to formulate a sensible, constructive investment strategy during this very unusual time.
With confidence weak and high levels of debt to income, easy money does not prevent dollar hoarding and debt reduction. People are not induced to take risk or borrow money, even with very low yields on savings. This puts downward pressure on the demand for goods, services, and investment, resulting in an embedded deflationary bias in pricing. That includes both consumer prices and nominal interest rates.
Deflation is the scourge of central bankers, rendering them useless (which they probably are anyway) as society embarks on a rational policy of saving and reducing debt. In previous blog posts I have mentioned Ben Bernanke’s 1999 paper entitled “Japanese Monetary Policy: A Case of Self-Induced Paralysis”, which lobbed hefty criticism at Japanese policy-makers for being too rigid during their decade-long battle with deflation (that’s now two decades and counting). I highly recommend reading the section “How to Get Out of a Liquidity Trap” starting on page 14. Call it the Bernanke Playbook.
Here is a link to the pdf file of that paper if you are interested.
This type of hubris keeps us thinking that simply the “right” monetary policy, or even the right policy-maker can fix our problems. Markets spin with talk of the Fed initiating what is dubbed QE 2 (the first quantitative easing was the $1.25 Trillion purchase of mortgage-backed bonds), a sort of monetary nuclear option to obliterate the threat of deflation. Recently the Fed announced they will use the receipt of interest and principle from their mortgage portfolio to buy U.S. Government bonds to maintain the size of their balance sheet. While not at a full court press as of yet, the Bernanke Playbook is getting more attention. (see it referenced here in Paul Krugman's blog)
The Bernanke Playbook has not been fully initiated yet, likely because it is too politically challenging for the Fed to engage any further in the outright purchase of Treasury bonds or pursue more unconventional asset purchases. They are letting the economy bleed out as many bad credits as possible, while staying very accommodating to prevent a liquidity crisis that could boil over into further insolvency.
But why then is the economy so sluggish, and why is job creation missing? Remember something I mentioned in a previous blog post: Every recession since WWII has been accompanied by growth in private sector credit. If we are confused by the current progress of recovery, it is because we are simply not wired for this environment. It’s very hard to grow when credit is contracting.
All questions regarding tax policy, capital spending, jobs, bank lending, etc. have more or less to do with this largely unprecedented reduction in private sector debt, or deleveraging, in a consumption driven economy.
Interestingly though, the process of saving more and reducing debt is extremely rational and almost too much for us to handle. Strategic default and foreclosure, for example, while ethically disturbing, is very rational behavior, given the structure of housing finance and mortgage contracts in this country.
So what is the endgame here? In truth, the end will justify the means as less leverage and more equity in the economy decrease risk and increase future wealth creation. However, the means carry all the risk and that is our primary concern. At the top of the list is whether private sector credit is simply transferred and concentrated within the government. That will only increase the risk of a systemic breakdown (e.g., a failed Treasury auction) in the future. We need to see total debt levels, i.e., private and public debt, reduced. If that results in sluggish growth and a long trough in this depression-like environment, so be it. Be conservative and patient in your investments.
This is what we are closely watching. Deleveraging is the “boogieman”, striking fear into the hearts of central bankers and policy makers, because it can spiral into deflation, potentially unrestrained by any policy initiative.
Below are some numbers and more pictures to help explain what is happening. I intended to publish this earlier in the summer, when the Fed released the data, but the next set of numbers is not released until September 17th anyway. That will update us for the 2nd quarter, but I think these numbers tell the story.
Out of roughly $55 Trillion in total outstanding U.S. debt:
Total U.S. debt reduction in 2009: $201 Billion
Total U.S. debt reduction Q1 2010: $260 Billion (5.1 X the run rate of 2009)
Household sector debt reduction 2009: $240 Billion
Household sector debt reduction Q1 2010: $98 Billion (1.6X the run rate of 2009)
Financial sector debt reduction 2009: $1.5 Trillion
Financial sector debt reduction Q1 2010: $646 Billion (1.7X the run rate of 2009)
State and Federal debt INCREASE 2009: $1.5 Trillion
State and Federal debt INCREASE Q1 2010: $506 Billion (1.3 X the run rate of 2009)
It is also interesting to note that debt reduction in the small business sector since the beginning of 2009 has been entirely offset by increases in debt financing done at the large company level. The banks are not increasing lending to small businesses, but the capital markets are open to companies with access. In other words, easy money is not trickling down to where it needs to go.
It’s also important to highlight that total debt is declining (government borrowing is not keeping pace with the private sector reduction), albeit at a very slow rate. That is a good thing from my point of view and we need to keep a close eye on that. We are also watching the transfer of mortgage debt financing to the balance sheet of GSEs. Here I am talking about the increase in debt levels for Fannie Mae and Freddie Mac since they were placed into the conservatorship of the Federal Housing Finance Agency in 2008. The once assumed guarantee of the Federal Government is now explicit. This is where the risk from consolidating debt at the government level is most concerning.
Now some pictures and notes.
People are simultaneously saving more....
and reducing debt....
In addition to reducing debt, households have gone from being net sellers of Treasuries two years ago, to buying almost 20% of new issuance in the 12 months ending in Q1 2010. Some may argue with the wisdom of buying Treasuries, given current interest rates and deficits, but clearly the household sector is trying to save without adding risk. From the late 1940s to the late 1990s, the household sector owned between 20% and 30% of publicly held Treasury debt. Today it owns about 10%, up from 4% in 2008. Could the household sector be the new marginal buyer, replacing foreign capital? Consider that potential trend, given how low interest rates are today.
Bank credit, the lifeline of small businesses, is shrinking.
As deposit growth is a function of credit expansion, we would expect deposits to start shrinking as bank credit continues to contract. Notice that deposit growth turned negative somewhere between 1992 and 1995. However, it was not preceded by a contraction in credit. What happened is money temporarily moved out of the deposit base into the broader economy, providing fuel for a capital spending boom that resulted in the tech mania of the late 1990s. The chart below, depicting the velocity of money (representing how quickly money is circulating in the economy), clearly shows this.
The other side of this “rainbow” is signaling exactly the opposite effect of the mid-1990s, as money is leaving the wider economy through deleveraging. Money (read credit) that was once flying around the economy is coming home to roost in the form of excess reserves at the Fed. Advocates of hard money expect to find their pot of gold at the end of this rainbow to keep money supply growth under control in the future. While not an advocate of the gold standard or the Federal Reserve for that matter, Milton Friedman said in an August 2006 interview that only a major financial catastrophe could bring about a radical change in how monetary policy is administered, so as to reduce the risk of policy mistakes. He died less than three months after that interview, on the eve of just such a crisis.
And to sum it all up....
That little downturn at the top is what we have to show for our efforts, but at least it’s going in the right direction. Confirmation that we had too much debt lies in the fact that debt levels are starting to fall, seen in the chart above relating total debt to national income. Remember, growth will make this line fall even further. If we reach a point of sustainable debt levels, possibly we will see that growth.
Clearly, deleveraging can explain, in large part, why the current recovery is so weak and ripe for a prolonged recession. But is that something to fear?
As I said before, the process itself carries all the risk, as any shock or further loss of confidence (no jobs, further debt trouble in Europe or Japan, war etc.) could quickly intensify debt reduction, as the private sector could go beyond saving excess income and into asset liquidation. On the other hand, if the so-called “bad” credits (such as credit used for consumption and sour real estate investments) can bleed-off without causing a disorderly unwind of the entire debt structure, the economy and markets will eventually face less risk and a more robust future.
So we have a rare, so-called outlier, event taking place right in front of our eyes, i.e., the deleveraging of the U.S. economy. We know from history that events thought to be statistically improbable are by far the most consequential when they occur. The obvious reason for this is that society doesn’t prepare for what is mistakenly thought to be highly unlikely. That makes sense, but financial and social matters tend to ignore probabilities. If you see something coming, but do nothing about it, it is irresponsible. In other words, don’t just lie in fear of the boogieman. Confront him.
Here’s how we are confronting him. We are intensely focused on our EVA strategy, which is vitally important in today’s world (a subject for an upcoming blog). Our equity holdings have been outpacing the market lately while overall returns are somewhat moderated by our sizable bond and cash positions (i.e., we don’t go down as much and we don’t go up as much). We are ahead of the overall market in our model portfolio year-to-date because we are doing more with less by holding cash. We are more protected, taking much less risk by being 50-55% invested in the stock market, but good performance in that select group of EVA-producing equities is driving solid returns overall. The cash position is an intentional allocation aimed at protecting capital, as the risks of deflation and falling asset prices loom large. It is not a permanent condition for us, but we need to see this “once in a century” type event play out. Certainly with the upcoming elections in November, which may prove volatile, this is a good time to stay patient and conservative.
Please let me know if you have any questions or comments by visiting our website at www.FalkerInvestments.com
Peter J. Falker, CFA
8/24/2010
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