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Deflation Is the Elephant in the Room


See it, even if you choose not to believe it.


Editor's Note: Todd posts his vibes in real time each day on our Buzz & Banter.

"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 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 cumulative imbalances in the global marketplace, shifting social mood, and the sovereign sequel to the first phase of our financial crisis (see: A Five-Step Guide to Contagion).

Between the bear market in China-last night's rate cut notwithstanding-uncertainty in Europe, stateside budget gaps, and global austerity measures, and despite the Herculean efforts of central banks around the world, it appears we're on a collision course with an inevitable destination.

To that end, I will pull a few observations from three of my past columns with hopes of providing some context for our forward path.

The first article was written on June 21, 2006. As penned at the time:

I won't pretend 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 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.

After that column posted, following an additional 15% haircut for commodity prices, asset classes across the board enjoyed a spirited sprint higher. That was the "blow off" phase of the rally, the "panic" portion of the denial-migration-panic continuum that defines all market moves, and we know what happened next.

On February 20, 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.

The banking system, stymied with credit contagion, is not operating normally and this discussion is delicate. Hidden behind rumored stimulus, proposed bailouts, 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 long ago observed, "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 unwind 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 drugs with hopes that the pain will pass. The latter matter continues to be the diagnosis of choice 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 last vibe has been repeated many times in Minyanville through the years (see: The Short Sale of American Icons).

It's short, sweet and 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.

This Grand Experiment has been a dozen years in the making; it's cumulative, global, and quite dangerous.

It's why Minyanville sounded the alarm with regard to the solvency of the financial industry as the banks raced to all-time highs and why we 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 garner page views; 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 "the financial views you need to know before you know you need them." I offer this through that lens, and 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.


Twitter: @todd_harrison

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