(CC image by Mario Donati on Flickr)

(CC image by Mario Donati on Flickr)

 

We’ve seen relatively low and stable inflation levels for the last 30 years, so it’s easy to forget that it hasn’t always been this way.  What will the next 30 years bring?  More of the same, a return to the high inflation of the 1970s and early 1980s, or deflation as in the Great Recession of 2009-2010?  Or, could we experience all of the above?  Is your portfolio ready?

My prior post explains the real meaning of the terms “inflation” and “deflation” with several examples.  It also guides you towards making better forecasts of inflation, based on its three main drivers.

When the inflation rate shifts suddenly, it causes major damage to investors who haven’t prepared for these episodes.  Often, it’s the investors with the most conservative approach that are left worst-off once the dust settles.

If my forecast comes to pass, few investors will be spared from the damage.  That’s because the conditions today are ripe for BOTH deflation AND inflation, one after the other.  Only by taking specific steps now, and remaining alert as events unfold, will you emerge with your portfolio intact.

 

Historical Perspective

Prior to 1971, when the United States fully broke all ties between the dollar and gold, consumer prices in the United States underwent phases of high inflation and deflation.  However, when averaging across these cycles, prices maintained stability over the long run.   This happened because the dollar was backed by gold and the supply of gold grew only as quickly as it could be mined and processed.  Overall price levels stayed roughly the same from generation to generation, rather than increasing over time like everyone accepts as normal today.  (Look at how much prices have gone up from 1975 to 2015 – imagine if college was still that cheap today!)

Since 1971, the inflation rate has been less volatile, as the U.S. Federal Reserve has closely managed monetary policy in the United States.  The Fed’s objectives, as defined by the Federal Reserve Act, are to maximize employment, maintain stable prices, and moderate long-term interest rates.  These objectives existed long before 1971, but in the eyes of the Fed’s Board of Governors and the Federal Open Market Committee (FOMC) who are charged with carrying out these goals, “stable prices” now means something very different than it used to.  Today, they say that “stable prices” does not mean actually mean “stable prices” over the long run, but gradually rising prices!  If they really cared about stable prices, you’d still be able to buy a postage stamp for 13 cents or a car for $3,800, as in 1975.

The Fed has managed to keep prices rising gently for most of the last 45 years because it has responded swiftly and dramatically to any threat of falling prices in the economy, whether real or perceived.  By contrast, they react slowly when the economy is booming because they do not want to be blamed for the damage that would occur if they suddenly withdrew stimulus from the economy.  This behavior creates a strong bias towards rising prices rather than stable or falling prices, as we see below.

cpi_graph_70yr

The Fed’s focus has been on using monetary policy to smoothing out the boom-bust cycles that naturally occur in a free market economy.  When the economy starts to contract, the Fed expands the money supply through actions like buying US Treasury bonds (indirectly, because doing so directly would be illegal!), cuts key interest rates, or takes other actions to try to juice up the economy.

On the surface, this seems like a great thing for everyone.  Who cares if prices go up over time, as long as it’s gradual and predictable and there are no major shocks to the system?  If they’ve kept inflation tightly controlled for decades, certainly they can continue to do so?

Not so fast.  This “over-management” of the economy harms us all, especially savers and investors.  It allows bubbles to grow bigger and bigger over a longer period of time, rather than deflating on their own.  We saw massive bubbles burst in currencies (1997), real estate (2008), stocks (1987, 2000, 2008), banks (1980s S&L crisis), junk bonds (1989), and commodities (2008, 2014-15) to name just a few.  These bubbles would likely have still happened without misguided policy from the Fed and the U.S. government, they would just have been smaller and easier to recover from.

In summary, the Fed has kept the inflation rate moderate and positive for decades, but at the cost of pushing more volatility into asset markets.  This is wonderful news for alert traders and active investors, but bad news for savers and passive investors.

 

Current Conditions

Under a “lower-for-longer” interest-rate policy like we observe today, businesses respond by expanding debt, refinancing old debt that they’ll still never be able to pay back, and other financial engineering like massive stock buybacks, all of which are value-destroying in the long run.  They don’t deploy as much capital into real investment that would produce long-run growth and more jobs.  Furthermore, retirees, and savers have to set aside more money when interest rates are low, otherwise they won’t have enough interest and dividends to live on.  Pension funds and insurance companies must set aside more money to meet future obligations.  What does this all mean?  Money sits idle or chases bad investments instead of being invested into job creation, good technologies, or production plants.

We see this most clearly in the velocity of money: the rate at which money, credit, and liquid assets circulate in the economy.  Lower velocity means more money sitting idle instead of being used to purchase goods and services.

A similarly steep drop in velocity happened right before the Great Depression.

A similarly steep drop in velocity happened right before the Great Depression.

 

At the same time, the money supply is rapidly expanding:

m2-60yr

Most measures of credit I monitor are growing too.  Corporate debt, student loans, and auto loans are breaking records month after month.

Yet despite all this credit creation, and consumer prices that are nominally rising, I see deflationary pressures far outweighing any inflationary ones.  Neither government nor the Fed can stop it using their existing tools.

Commodity prices continue to trend downward:

These are two commonly-cited indexes of commodity prices I track. The Dow Jones-UBS index (purple line), has more weight in energy than the CCI (red line).

These are two commonly-cited indexes of commodity prices I track. The Dow Jones-UBS index (purple line), has more weight in energy than the CCI (red line).

 

Gold and gold stocks remain below their 2011 highs:

gold_2006

 

Investors’ inflation expectations keep falling:

infl_exp_5yr_2006

 

Lastly, actual realized inflation continues to fall short of investor expectations:

infl_dev_1_5_2009

 

These charts don’t look anything like what we’d expect to see if inflation were right around the corner.  This is deflation all the way.

 

What’s Next?

When debt builds up in the economy, all is well-and-good until enough borrowers become unable to service their debts.  Debt levels across households, corporations, and governments continue to grow far faster than incomes.  This is unsustainable.  Default rates will reach crisis levels in one area first – state and local governments are a likely starting point, but I cannot be certain which area will tip off the crisis.  It could even be a geopolitical crisis, natural disaster, or any number of events that could set the process in motion.  Timing is even more difficult to predict, but it’s hard to imagine we can go another 3-5 years on the path we’re on.

As default rates rise, the crisis will spread to other sectors of the economy with a speed and severity that will exceed politicians’ and the Fed’s abilities to respond.  Therefore, expect a sudden decrease in virtually all asset prices, with few places to hide.  Gold, income-producing real assets like land and some real estate, will be best protected.  This will be the deflationary phase of the crisis.  (I’d argue the deflationary pressures we see today are a sign that the crisis period has already started!).

But I don’t expect politicians or central bankers to accept this reality for long.  There will be too much pressure on them to act, and to act in ways we have not seen before.

As an example, I believe we are likely to see a large-scale debt forgiveness program for households accompanied by a revaluation of the U.S. dollar at a lower level.  I also think we’ll see a global renegotiation of debts, since a great deal of debt is owed to other governments.   U.S. President-Elect Trump, whether you like him or not, certainly is a man who understands how to renegotiate debt and emerge from bankruptcies.  To make these measures more effective, I also expect governments will initiate capital controls, restricting the movement of money across borders.  We may also see an attempt to introduce regional currencies or a global currency at this time.  These actions will represent the inflationary phase of the crisis.

The length of time we remain in the deflationary and inflationary phases will depend on how effective global policymakers are at achieving consensus during the crisis.  The more rapidly they are able to successfully “reset” the global economy, the faster we’ll move from deflation to inflation and then return to some semblance of normalcy.

 

How To Stay Safe, Or Even Profit, From These Events

If there is one thing all good traders love, it is volatility.  Even in times of crisis, markets remain open (with limited exceptions).  Many of the skills I teach will help you preserve your capital and even make money during both phases of the crisis.  For instance, shorting stocks, buying put options, and trading the VIX in a crisis environment can be immensely profitable!  Keep in mind that these strategies do carry risk, and should be used carefully as your own financial situation permits.

You should also consider owning some hard assets like gold, silver, and income-producing real estate if you are able.  Minimizing your own personal debt will benefit you in a crisis period as well.  Stay tuned for more on all these topics.

Above all else, it goes without saying that you’ll want to take steps to ensure your personal safety, diversify your skillsets, and overall become more self-sufficient.  I highly recommend Jack Spirko’s podcast, The Survival Podcast, for a rational and thoughtful discussion of preparedness topics.  I’ve been a listener and subscriber for many years.

Deflation and inflation don’t have to catch you off-guard.  By sharpening your trading skills, you can use volatility to your advantage.