The Return of the Phantom of Deflation
Uncertainty overseas and stateside show we're on a collision course with an inevitable destination.
"Last dance with Mary Jane, one more time to kill the pain; I feel summer creepin' in and I'm tired of this town again." --Tom Petty
Albert Einstein once said that the definition of insanity is doing the same thing over and over again and expecting a different result.
We've covered numerous topics in our time together, including the cumulative imbalances in the global marketplace, the shifting social mood, the sovereign sequel to the first phase of our financial crisis and the Phantom of Deflation. (See: A Five-Step Guide to Contagion)
That last dynamic is perhaps most daunting. Between the bear market in China, uncertainty in Europe, stateside budget gaps, upward taxation, and austerity measures, it would appear we're on a collision course with an inevitable destination. To that end, I will draw from three of my past columns with hopes of providing some context for our forward path.
The first article was written on June 21st, 2006. I was reminded of those thoughts when I picked up The Wall Street Journal last week and saw Inflation at 44-Year Low splashed loudly across the front page. (See: The Phantom of the Market)
As I wrote at the time:
"I won't pretend that all is well in the world or that the worst is behind us. I'm simply looking to shake shekels from the tree and pocket them before the Phantom returns to his rightful home.
Who is this Phantom I speak of and what does he want? For me, it's a simple yet unpleasant answer; the type of discussion that nobody wants to have until we actually see his shadow.
He is Deflation; painful, all-consuming, watershed Deflation. While the mainstream media continues to monitor inflationary pressures -- and yes, this exists in some corners of the economy -- this particular Phantom won't discriminate between victims. The weakness we've seen is the probability of this demon being priced into the collective mindset."
To be sure, after that column posted and following an additional 15% haircut for commodity prices, asset classes across the board enjoyed a spirited sprint higher. We know now that was the "blow off" phase of the rally, the "panic" portion of the denial-migration-panic continuum that defines all market moves. We all know what happened next.
On February 20th, 2008, we offered that policymakers were navigating the increasingly complex landscape in a manner that would further crush the middle class. (See: Our Wishbone World)
And I quote:
"Let's look at both sides of the great debate. To the left is the socialization of markets, nationalization by governments, and a road to hyperinflation. To the right, we have asset class deflation, risk aversion, and the unwinding of the debt bubble.
If the Northern Rock nationalization is the first in series of similar steps, we could conceivably see the stateside assumption of mortgage debt by the US government. This would hit the dollar and spike equities, at least until interest rates rose to levels deemed attractive as an alternative investment.
That is the hyperinflation scenario, one that is presumably preferred by the powers that be as an alternative to watershed deflation. The "haves" would fare better than the "have nots," which would include the former middle class that suffers as a result of moral hazard as the costs of goods and services skyrocket.
The other scenario is the draining of liquidity from the system, which would ignite the fuse for a higher greenback as currency becomes scarcer. Asset classes across the board, from commodities to equities, would deflate and impact the top tier of our societal structure that is tied to the marketplace.
This is, quite obviously, problematic for many policy makers and the constituencies that bankroll them. Deflation in a fractional reserve banking system means that they have, for all intents and purposes, lost control of the economy. It is an admission of defeat, albeit one that may be unavoidable.
Last week, while dining with Minyanville sage Mr. Practical, we were discussing the congressional testimony of Fed Chairman Ben Bernanke and Treasury Secretary Hank Paulson. We arrived at the conclusion that they must see what we see but their hands are tied with regard to how they publicly posture themselves.
"The banking system, stymied with credit contagion, is not operating normally and the communication thereof is delicate. Hidden behind proposed bailouts, stimulus packages, super-conduits, term auction financing, mortgage rate freezes, foreclosure freezes, and working groups are politicians attempting to engineer a business cycle that long ago lost its way.
As Mr. Practical observed as we surveyed the situation, "None of these plans will affect the larger deflationary credit contraction. Debt deflation is occurring outside of the Fed's control at the world's money center banks, where supply and demand for credit has undergone a rapid and significant decline."
This process will take years to manifest but will ultimately yield positive results. The destruction of debt will allow world economies to build a solid foundation for future expansion that is entirely more secure than what we currently have in place.
Deflation will cause paper wealth to evaporate and rich nations will be forced to pour real money -- as opposed to cheap debt -- into developing economies as a redistribution mechanism. While the path might be painful, the destination will be a sustainable starting point for future generations.
There is a marked difference between taking our medicine -- which is a function of time and price -- and injecting the system with drugs with hopes that the pain will pass. The latter matter continues to be the diagnosis of choice, as evidenced by current events, but the patient would be well served to understand the prognosis.
There are no easy answers but there are certainly simple truths. The sooner we prepare for the worst, the better we can in good conscience hope for the best."
The next vibe has been repeated many times in Minyanville through the years, most recently in last week's column. (See: The Short Sale of American Icons)
It's short and sweet but sums it up:
"There are two alternative forward paths: On one side, debt destruction, asset class deflation, and an outside-in globalization once the dust settles. On the other, we continue to give the global drunk another drink with hopes he doesn't sober up. The sad truth is that he one day will and our children will be forced to pick up the bar tab if we don't change our ways and soon."
Here's the bottom line, and please don't shoot the messenger. This Grand Experiment has been ten years in the making; it's cumulative, global and quite dangerous. It's very much the reason why Minyanville sounded the alarm with regard to the solvency of the financial industry as the banks raced to all-time highs and warned of a "prolonged period of socioeconomic malaise entirely more depressing than a recession" in the summer of 2006. (See: The Upside of Anger)
We didn't share those thoughts to scare people or make a name for ourselves; we offered them because we believed them to be true. Yes, we were -- and quite possibly may still be -- early, but a forward lens is the only lens when navigating financial markets. While our editorial mandate is "truth and trust," our stylistic approach is "where news meets opinion." I offer this through that lens, as one man's humble opinion.
There are trades, there are investments and there is financial staying power, and there will certainly be sharp rallies on the way to our final destination. One thing is for certain: by the time the deflationary dynamic is self-evident, the opportunity to proactively prepare your portfolio will have already passed.
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Todd Harrison is the founder and Chief Executive Officer of Minyanville. Prior to his current role, Mr. Harrison was President and head trader at a $400 million dollar New York-based hedge fund. Todd welcomes your comments and/or feedback at firstname.lastname@example.org.
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