Deflation or Inflation? The Answer Will Come Soon

* Inflation/Deflation debate:  


The most bearish folks I follow out there is the gang known as the Elliott Wave group. Here is a synopsis from their recent market letter which, in my opinion, summarizes the case for lower stock prices and deflation:


” Our view is the opposite from that held by the army of inflationists who have been arguing that the dollar will collapse into oblivion as the Fed prints money and throws cash from helicopters. Credit can contract faster than money can be printed, which is one of the several reasons that deflation should unfold before the possibility of inflation rears its head.” (end of comment)


On their point about the contraction of credit, the credit markets are far bigger than any central bank’s balance sheet. And if credit started contracting too fast, I do agree with their assertion that the central banks will be powerless to stop it.


* Supporting the deflationist view, in last week’s Barrons, there was an article about the Euro-zone banking sector, and cited some interesting statistics on the EU banks. Here is a list of exposures to the PIIGS by country, and the amount of capital which these banks have:


Country      PIIGS exposure        Bank Capital  (all in €’s)


Germany       703 billion          565 billion


France        911 billion          579 billion


UK            417 billion          725 billion


Switzerland    58 billion          145 billion


Totals      2,612 billion        2,929 billion   (including other countries)


In short, France and Germany lead the league with PIIGS exposure. The Barrons article was surprisingly bullish, citing how beaten up the bank stocks already are, and how a 25% write-down would still leave plenty of capital. In my opinion, what the article misses, is that the banks will start to pull back on all sorts of lending activity, if they are writing down 25% of their PIIGS exposure. And if the banks are taking these losses, what happens to the local businesses which will also be taking losses on their Accounts Payables with the PIIGS. In other words, the problems do not stop with loan losses, as there are many ancillary costs which will create a negative feedback loop into the EU economies. These risks are deflationary!


On the other end of the spectrum is Jim Paulsen of Wells Capital Management, who will forever be my poster child for his stupidly ignorant bullish opinions. CNBC had elevated him to a guest host this morning, and while I did not have a chance to watch CNBC this morning,  CNBC loves to paint the bullish picture, and he is definitely in that camp. he is a sign of the “long and wrong” who will be wondering “which way did he go George, which way did he go”, when his portfolio is 30% lower this year. He is also the dope, who a month ago, smugly said the Greek problem is so small, and it will not affect anything else. 


On the inflation side of the equation, I will quote an article from Murray Pollitt, which I read this weekend: 


“The world is split between the Western world on the one hand and the rest of the world (R o W) on the other. For more than a century the Western world (less than a billion people) has consumed perhaps 90% of the world’s copper, oil, steel, in fact pretty well everything. Now the R o W (over five billion people) is clearly consuming far, far more of everything – probably well over fifty per cent of the world’s steel, for example. But the production side of the equation hasn’t changed much, pretty well across the board. Except for gold where, as mentioned above, serious decline is taking place. (end of comment)


So while the developed world will watch their economies contract, and governments will nationalize banking sector losses, it is likely that commodity prices will be on the rise, creating relative inflation in these asset categories. This is why it will be impossible to declare inflation or deflation the winner, because both will have their place in the sun. Pollitt’s piece, which was in support of gold, cited that gold production has been down for the past 15 years, but I think the point which is well made, is that there should be significant demands for commodities, regardless of what happens within the developed world. 


As I have said in the past, I believe that deflation and inflation will exert itself in a variety of ways. Deflation will come about through a contraction in credit and from losses on portfolios which have yet to have their day of reckoning. The question is how well the various governments of the world allow their banks to hold these assets without realizing losses, and then to determine who is going to absorb these losses. Spain has been in the press recently as they are working towards resolution of ‘cajas’, which are the equivalent of mutual savings banks. Spain, whose budget situation is precarious, is really not in a great position to absorb these losses.


* A reader writes in with the following comment on Friday:


“Rick – I think you hit upon a point in the second part of your blog that most of the financial media as well as many economists completely miss. The crisis in Europe is often portrayed as a problem that is caused entirely as deficit nation’s inability to balance their budgets. They are portrayed as the “poor” nations versus the “rich” nations of central Europe. To the average person this would seem correct, If I have a lot of debt and my neighbor has great savings, therefore, I am “poor” and he is “rich”.  But there is one thing that most fiscal deficit nations share a commensurate large trade deficit. The relative wealth the surplus nations maintain is driven by relative high levels of net exports. 


Capital must flow continually into the trade deficit nation in order to maintain Balance of Payments. The simplest form or capital flow is purchasing  the debt of deficit nation. The rich European Banks/Countries have been subsidizing consumption in deficit nations for years.  Much the way Japan and now China have subsidized US consumption.


Ok  – so whats important about this? If equilibrium is to come about, surplus countries may suffer the same economic consequences as the deficit nations. Their Banks and Central Banks hold the deficit nations’s debts. Their banks have lent to industrial corporations that produce exports. Exports industries employ significant portions of the workforce.” (end of readers comments)


This is a conundrum which the “rich” like to portray as a “poor” or indebted problem. The rich are starting to realize that they have created a mountain of debt upon which they have built their banking system and export economies. The problem today, is that the export driven countries are starting to realize that they cannot continue to lend money to the deficit countries who, also happen to be their best trade partners. As the mountains of debts get bigger and bigger, the problems become so large, that the lenders cannot pretend that the debts are good any longer. The biggest lender and exporter is the Chinese, who are relying on their IOUs from the US and the Euro-zone. For the time being, they are able to use the dollars and euros to purchase commodities and resources in size. Still they have $2.6 trillion of foreign currency reserves, and could be holding the biggest “Old Maid” card in history. 


Invariably, this brings me back to the US, as the most egregious debtor and trade deficient nation the world has ever known. While everyone debates the EU, the real problem is the US. These problems have yet to percolate up to the surface, but they will. If the US wants to prevent a run on the dollar, and a debt conundrum like Greece had, the Fed should monetize about $500 billion of debt a year. This would keep pressures away from the debt markets, and while deflation is forcing various aspects of the economy from becoming inflationary, like housing, which comprises 40% of CPI, the Fed will be able to hide behind modest inflation statistics in their pursuit of easy money.


Anther reader writes in with this comment:


“When I worked in politics in the early and mid 1980s I remember how the papers and politicians often bemoaned the Reagan deficits as a burgeoning calamity. Along came Clinton and the “Contract with America” congress and they were able to balance the budget.  Do you really believe these deficits are that insurmountable? 


We needed this deficit spending to halt the panic. I wish the money had been targeted to the middle and lower class who would have spent it on stuff instead of Wall Street and bankers who spent it on fluff, but the money had to be spent one way or another to reverse an uncontrolled spiral. I wish we had gotten more out of the spending like new ports, roads, energy grids…


Yet the money was spent and the panic subsided. 


Why do you believe these deficits are so insurmountable? Isn’t it possible that if we stop spending on two stupid wars that are getting us no where, raise the retirement age minimally, and rev the economy back up to full production so that the Government can collect its maximum revenue (taxes), we can make this deficit talk subside. The Dollar is likely to remain strong because the other options are so ugly.


The economy has been built upon allowing folks to spend their income years ahead of actually earning that income. In the 1940s we created HUD which allowed folks to buy homes when before they would have had to save up the total cash price to acquire the property. In the 1950s we created credit cards, allowing people to spend ahead of earning once again. In the 1970, 1980s and 1990s we made it less and less expensive to borrow against the equity in your home, once again allowing access to earnings that have not occurred yet. We are out of options on how to continue this kind of phony economic growth through personal debt and must now consider public debt or realize this system does not work at all.” (end of readers comment)


I think you answered the question by the end of your comment. “We are out of options” and the system is about as leveraged as it can be. The last domino to fall will be the US/EU’s debts with China. Stay tuned, it is going to get more interesting before this party ends.  


* Trading Points: 


Over the last 2 business days in the rest of the world, a few notable pieces of news are pushing the risk markets lower:


1> The ruling party in Japan, the DPJ, has lost its majority in its parliament, as a few members of an alternative party quit the DPJ block. This creates more uncertainty about how Japan is going to move ahead. While this had little market impact, as it came out Sunday evening, it is notable that it creates uncertainty, and uncertainty, always translates into higher yields and lower prices on assets;


2> The ECB warned that there could be 195 billion Euros of additional write-downs taken by Euro-zone banks, over the next 18 months. While we knew some numbers like this were likely, it does not help to have the ECB put this into a press release;


3> China warned that industrial output is slowing. I am not sure which story has more to do with this mornings weakness, but the two play together to paint a bearish mosaic.


On these headlines, the recent pattern is asserting itself: stocks lower, Euro lower, and gold higher. I will interject a comment about the US stock market, from purely a technical perspective. As I have said before, my long term view is strictly bearish, as I view the March 2009 to April 2010 rally as an interruption in the bear market which commenced in 2007. Short term, however, the markets do have a number of options. The first is the S&P will proceed below the recent low at 1040, and plunge below 1000, and not recover. The second scenario has the S&P trading back up to a multitude of resistance levels, starting with 1105, and going on up as high as 1174. Because the downside risk is great, but the cost to being wrong if the market first trades higher is significant, I have chosen to play the market via June Put options. The market should tip its hand pretty quickly. If it is going to make new (recent) lows, it will do so today or tomorrow. For those interested in following along with my shorter term time horizons, ask to be put on my Real Time distribution.