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Correct an Investment Advisor



September 05, 2009 – Comments (5) | RELATED TICKERS: GE , QQQ , XOM

Here is a rough draft of a monthly letter I am writing.  It needs two edits yet, one facts and theory, one spelling and grammer.  Have at it.  What are your opinions about this and could I explain a few things better?



Deflation v Inflation

Much has been discussed, pontificated on and blogged about regarding deflation and inflation over the past year, so I thought I would join in.  The current prevailing wisdom is that we are on the cusp of global inflation.  To be especially hard hit are nations where they have printed money and gone deeply into debt to escape the financial crisis, such as the United States.  While I agree that there will be inflation ultimately, as it is almost (or maybe it really is and we just are not told) government policy to promote at least small levels of inflation, I am not certain I am on board with the prevailing wisdom as to why and when there will be inflation. 

Inflation, it was said by Milton Friedman and Anna Schwartz that "inflation is always and everywhere a monetary phenomenon."  Whether or not that is actually completely true has come into some doubt, though it is clearly largely true.  What most people believe, is that with more money in the global financial system or any national financial system, it only follows that there will be inflation ultimately.  This is common economic sense.  However, there might be mitigating factors which could spare us from inflation in the short run and lessen it in the long run, at least for monetary reasons.

Let's first talk about the short run, say the next two or three years.  Is it likely that there will be inflation of any consequence?  Many inflation hawks point to money being printed in nations such as the United States for the clear answer that "yes, there will be inflation."  However, those people chronically overlook the obvious fact that there has been so much demand destruction in the global economy that at least for now, there is no driver to use the money that has been printed, thus low demand appears to be creating at least a temporary hedge against inflation. 

Here lies another rub; most of the money that has been "printed" really has not been printed at all.  Most of the new money has been "made" in the form of loans, much from China to America.  While that has infused Chinese savings into the global economic system, that money really is not new, and it is largely likely that markets, at least somewhat, always accounted for that money in the pricing mechanisms for currencies.  In essence, the bonds issued to China, among others, by the western nations that found themselves on the wrong side of the financial collapse, created deferred money not immediate money into the system.  That "newly printed" money will not hit the system for a decade and more.  Thus, there is a strong reason to believe, that if short term money creation is tempered, inflation is not such a threat in the short run. 

One way of course to avoid massive money creation going forward is to move towards more balanced budgets in the borrower nations, such as the United States.  Unfortunately, to maintain short term standards of living in the U.S. and influence elections, we will run deficits.  What we can hope, is that the plans that emerge over the next year or so, include mechanisms for unraveling the debts of the future and using the new money not exclusively on social programs, but on ways to improve productive capacity and create jobs so that money creation can once again occur the right way, which is when people buy and sell to and from each other.

There are other arguments I am aware of against monetary inflation, these in the long run.  As emerging nations get more entwined into the world economy and start both buying and selling, they will need tradable currency.  Because, emerging nations generally do not have tradable money, they use some other nation's currency for trade, for example the U.S. dollar.  Thus, the emerging economies will create demand for more money. This increasing demand for money will go on for decades.  We also know that China, an emerging economy itself, is buying much of its natural resources and commodities from other emerging economies.  Go back a paragraph and you will realize where that money will be coming from again (China's current currency reserve is mostly American money since we have been buying everything from shoes to machines from them) eventually, America. 

By borrowing money from China, the United States has in effect made certain that the dollar will remain the world's reserve currency by itself, or at least a super major currency in a small exclusive basket in the future.  This seems counterintuitive, however, there is very little reason to believe that China would want the U.S. currency to depreciate much, thus there will be no currency war.  This is very important because the reserve currency or reserve currencies receive the free ride of the planet.  That is, if a nation's currency is the reserve currency, in essence exerting some form of monopoly pricing pressure on its money, then, it will artificially be priced higher than it is actually worth based on that nation's real net worth- mitigating inflationary forces.  Because I believe we now know that the dollar will remain at least "a" reserve currency for decades (the bonds sold to China mature in ten to thirty years and likely will be refinanced at some point).

So if there is not likely to be short run inflation, will there be deflation? My unwavering answer is yes, unless the government really does start printing a bunch of money.  Helicopter Ben could absolutely throw a monkey wrench into the semi-orderly unwinding of commerical and residential real estate, and the attached assets, which should all be falling in price over about the next three years (there is a glut of both commercial and residential real estate mortgage resets that will occur during this time frame and lenders want cash down to make a loan now, which many do not have).  If the government further props up assets that are finding their equilibrium prices at lower levels, then we will have a recipe for inflation, greater and sooner than it should arrive.  

When will inflation arrive and what will cause it?  I would anticipate inflation in about three to seven years as the global economy reramps driven by emerging markets (China, India and Brazil with their neighbors and trading partners in particular) and as financial assets finish their unwind and finally turn up.  We should expect to get a pop in commodity prices down the road as depleting assets are not set to be replaced due to the financial crisis.  One example of where to expect price inflation due to a supply/demand imbalance in a few years is natural gas.  Natural gas wells deplete at about 20-25% per year and we have for the most part stopped drilling new ones and probably won't start broad scale new drilling for a couple years.  Similar examples can be found in oil, minerals and other hard goods.  Agriculture in two or three years projects as having a major supply/demand imbalance as well which could drive food prices up.  All and all, from what I can tell, it is not so much the money supply we should worry about (though it could become a problem as mentioned above quite easily if governments do not hit the breaks on their spending or get a return on their investments), but the scarcity of natural resources that should keep us up at night.

Our short term investment strategy (for investment advisory accounts, others please call to discuss rebalancing) is to be on the far conservative edge of our asset allocations again, after a few months of having been more aggressive.  If the markets continue to trend up short term, I believe we can make that money back by saving our assets on any subsquent drops.  In the intermediate term, I am looking for opportunities to find low hanging fruit as it blossoms (finds lower prices to settle at) which we can hold until it ripens.

The Depression

The same TV talking heads who had a hard time calling a recession a recession until there were two quarters of negative GDP are now having a hard time calling what is going on economically a depression, even though we have now had four quarters of negative GDP.  Folks, it's a depression.

Read this:

Scary stuff.  That article should help explain why after getting more agressive for a few months this spring, I am back to being pretty hunkered down.

More next month.

5 Comments – Post Your Own

#1) On September 05, 2009 at 7:35 PM, portefeuille (98.83) wrote:

The same TV talking heads who had a hard time calling a recession a recession until there were two quarters of negative GDP are now having a hard time calling what is going on economically a depression, even though we have now had four quarters of negative GDP.

The same TV talking heads who had a hard time calling a recession a recession until there were two quarters of negative GDP are now having a hard time calling the end of a recession the end of a recession until there were two quarters of positive GDP.

This "edit" would of course slightly alter the "spin" of the article ...

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#2) On September 05, 2009 at 7:46 PM, kirkydu (89.86) wrote:

LOL. Nice. Just got back from walking the puppy, I'll work on this a bit and post the final Monday night.  Hopefully get a few more thoughts.  I see a couple grammer typos.

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#3) On September 05, 2009 at 8:30 PM, ikkyu2 (98.54) wrote:

You should start with a definition of inflation.  Your article presupposes that the reader knows what it is, and then when you use the term you use it in at least three mutually exclusive senses.

Here's a concept that may help you out.  It may just serve to annoy you, however, in that case please ignore:

In August I have one dollar.  I can use it to buy a pint of oil or a loaf of bread.

Instead I choose to hold on to my dollar.  I retain it until December at which time I wish to spend it.  In December, the price of oil has collapsed.  I can now get 2 pints of oil for my dollar.  However, there has bean a wheat shortage.  I can only get half a loaf of bread for my dollar.

Meanwhile, Helicopter Ben has inflated the M2 money supply with repo agreements to 120% of what it was in August.  Yet owing to the credit crisis, I cannot get a loan, cannot buy debt, and in fact I suspect that much of the assets on banks' balance sheets that make up M2 and M3 could not actually be realized even at fractions of their face value.  These facts make me wonder about the true worth of the dollar in my hand.

Now go define 'inflation'.  Make sure it's a meaningful term for the arguments you're trying to make about it. 

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#4) On September 05, 2009 at 9:40 PM, starbucks4ever (65.10) wrote:

How does your model account for the impending collapse of China?

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#5) On September 06, 2009 at 2:30 AM, kirkydu (89.86) wrote:

ikky, I thought about that, I'll put in a little on that.  Though I don't know exactly what you mean by about mutually exclusive.

Impending collapse of China.  Adrian Van Eck would be proud of you Z.  I don't think that will happen though.  I think the U.S. and China are in this together and will come out of this twenty years from now the two richest nations on earth.  Both are transitioning right now, and it took a depression to get it done.  Hey, that sounds like I have a conspiracy theory doesn't it.  Well, I du.

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