Deflation American Style

     The US is experiencing a large bout of deflation presently brought on mainly through the collapse of asset values and credit via the shadow banking system.  In the 2000’s a lot of the growth in debt was through the shadow banking system – basically non-bank finance companies backed by hedge funds, corporations, and special investment vehicles (SIV).  In the US, like a lot of other places around the world, people and governments levered up on cheap money.  This increase in leverage brought demand forward initially and as time went by it feed on itself to create asset inflation (mainly in real estate, stocks, and bonds).    

     The asset inflation (real estate, stocks, bonds, etc.) is where the easy money showed up first unlike past inflationary periods where it would show up in every day products and commodities that produce the everyday products.  The reason it showed up in assets first this time had a lot to do with China’s increase in production and the deflation that it brought.  Since China was exporting deflation and importing cash they experienced an epic bubble of their own- some say the largest ever.    

     Now that the world appears headed towards another recession what is causing it?

The Cause

• In 2001 after the September 11^th disaster the Federal Reserve fanned the flames of an already hot housing market by lowering interest rates to generational lows.

• US consumers took the bait and started refinancing their existing homes, extracting what looked like equity out to be able to purchase more and more consumer items and upgrade their lifestyles (houses, cars, vacations, etc.)

The Effect

• The consumers took on more debt even when their incomes were stagnating or in a lot of cases declining.  It made them feel richer.  This worked simply because their monthly payments for the same house declined due to a refinance (if they did not extract any cash) or stayed the same or increased slightly (if they extracted cash).

• This increase in demand for everything led to increase demand for items purchased overseas

• The overseas economies boomed because they were able to profit from low commodity prices and cheaper labor to create the stuff we were buying

• The US boomed because demand for low skill labor rose as demand for houses increased  

• China boomed because they were able to profit from the consumerism in the US and the growth in infrastructure projects the Chinese government initiated to help propel China into the modern age. 

• The growth in demand from China led to a growth in demand for all type of commodities.  This gave way to growth in Australia and Canada. 

• Australia and Canada also lowered their interest rates that helped kick off a boom of their own in property prices

Further Effects

      Eventually cheap money burns itself out.  Everyone that can take on debt takes it on.  What are left are risky borrowers and mal-investments.  Even people that were considered good risks during the boom started to become bad risks as the odds of them paying all the bills decreases as the burden increases.  The cycle started to reverse itself.  More and more US property holders defaulted putting the US banking system in question and the shadow banking system on the brink.  This ultimately led to a lot of large banks needing a bailout in 2008 and an unprecedented growth the Federal Reserve balance sheet as they loaned banks and shadow banks 100’s of billions.   The thought was that this liquidity would stop a systemic event where you had cascading bank failures that caused other banks to fail.  The only thing this money did was kick the can down the road.

     Elsewhere other countries flooded their banking systems with extremely large doses of easy money and liquidity. This money had to go somewhere.   In systems like Australia, Canada, and China the money flooded in to help push their property prices even higher since their people still had the capacity to borrow money.    In the US and UK the money went into speculative assets like hedge funds and derivatives and not into the population in general since the population was still dealing with a debt hangover and had little room for more debt absorption.

As the snowball rolls down the hill it grows

      When the finance market cooled in 2008 China dumped an extreme amount of stimulus into the economy which increased China’s appetite for commodities.  It also caused China to build massive amounts of condos that were way too expensive for the ordinary Chinese citizen to afford.  There is a rumored 64 million unoccupied condos in China that were built in the last 3 years with easy money.  There are literally ghost towns designed for 5 to 10 million people where barely 1 million live today.

     The commodity boom led by China’s growth plus lower interest rates led to booms in house prices in Australia and Canada.  All three markets are now experiencing property bubbles that are in various stages of deflating.  This will crush all three markets and lead to long-term subpar performance.

     To recap instead of one market blowing up (US) because of the cheap money policies of the early 2000’s we now have many more markets blowing up because of their own cheap money policies initiated to replace the demand lost from US growth.

The Ultimate Effect

     Instead of biting the bullet and let banks and shadow banks fail in 2008 we propped up a failing system that is looking weak again.  To do the original backstop for the banks the US government had to go deeper into debt.  This time around there does not seem to be the willingness nor the capacity to do the same thing.  Ultimately a lot of these banks and shadow banks will fail.  I have previously mentioned my views on Bank of America and Goldman Sachs in other posts.  I think they will ultimately fail and need to be bailed out.      

    The US government is now considerably weaker also.  They will ultimately need to cut their budget causing the US to go in and out of recession over the next decade as the economy adjusts to not having a big government.  This is a good thing in the long run.  In the short run it is not clear who will pick up the slack.

     The shrinking of the government, lack of demand for loans, deleveraging by individuals, and shunning of credit in all forms are all deflationary.  The only people looking to purchase assets right now are looking to us cash and little or no debt.  They have lots of different assets to choose from.  There are more assets available than demand causing asset prices to decline.    Until we finish going through this process of shrinking government, deleveraging our personal balance sheets, and building up equity our economic growth will be anemic.  

Conclusion

     Overall, the world looks like one big sea of risk with very little positive upside.  At this moment I think it is best to let the markets ride with cash on the side or bearish bets if you are able to take on additional risk.  The US stock market is starting to look attractive but not downright cheap.  Wait a few weeks and I think a definite buying opportunity is around the corner.  Given our decreased growth outlook I would strongly look towards stocks with large dividends to help generate cash flow in a probably sideways market.