The purpose of this post is to examine six indicators to analyze the probability of deflation and how they relate to your investment allocation choices.
A favorite quote of mine comes from contrarian investor Humphrey Neill, who said, “when everyone thinks alike, everyone is likely to be wrong”. There is an almost universal belief that we are headed towards inflation because of the Federal Reserve and their expansionary monetary policies. I contend it would be prudent to keep an eye on deflation too, especially since it is the most destructive inflation trend.
What is Deflation?
Deflation occurs when the general price level of goods and services decrease. This is the opposite of inflation, where price levels increase. Deflation increases the value of money or cash because it allows you to buy more with the same amount.
Deflation is the most dangerous inflation trend. Deflation is connected with a shrinking economy, high unemployment, collapsing revenues and profits, falling wages, and a propensity to hoard money instead of investing for the future.
Possible Causes of Deflation?
1. Decreases in the Money Supply
Many economists believe the Great Depression of the 1930s was exasperated by the Federal Reserve reducing the money supply. A falling money supply translates into less money in the pockets of consumers and investors, causing economic activity to diminish.
2. Too Much Debt
Leverage works both ways. It can boost returns in good times and magnify losses in bad times. An economy, government, industry, company, or family can be destroyed with too high a level of debt.
If an entity can not service its debt because of rising interest rates or falling revenue it will have to default or implement austerity measures. Either option reduces economic activity and can put downward pressure on prices.
Innovations and technology can have a profound effect on prices. Think about how much the computer has changed our way of life. From manufacturing to office work, almost every aspect of our lives changed. These technological advances have allowed us to make more for less, putting downward pressure on prices.
Deflation and Investment – Six Indicators To Watch
1. Difference between the 10-Year Treasury Bond Yield and the 10-Year Treasury Inflation-Indexed Security Yield (TIPS).
This will provide the inflation rate the market is discounting or expecting over the next 10 years. Treasury bonds do not adjust for inflation but TIPS do. Therefore the difference between the two yields represents the inflation expectation embedded in the market.
2. Money Supply
The Federal Reserve provides up to date statistics for Money Stock Measures including annual rates of change. This is the life blood of the economy, making it worth watching.
3. Money Velocity
The velocity of money measures the average turnover of the money supply. Wikipedia defined money velocity as “the average frequency with which a unit of money is spent on new goods and services produced in a specific period of time”.
The Federal Reserve can increase the money supply, but if it is not circulated it does not increase economic activity. If the money is hoarded, for whatever reason, it could have a deflationary effect on the economy and prices.
4. U.S. Dollar
A falling dollar increases demand for our goods because they are less expensive, and in the global markets a rising dollar makes our goods more expensive and less attractive to foreign investors. A soaring U.S. Dollar Index could be a sign that deflationary forces are increasing.
5. Gold and Silver Prices
I watch both the absolute prices of Gold and Silver as well as the relationship or ratio between the two precious metals. In general, gold and silver do well in inflationary environments. A sustained downturn in precious metal prices could indicate a deflationary environment.
The trend in the ratio between the two metals can provide important information. Silver is more economically sensitive than gold. If silver is falling faster than gold it may be indicating underlying weakness in economic activity and/or deflationary forces.
6. TED Spread
The TED Spread TED is the difference between the 3 month Treasury bill rate and the 3 month London Interbank Offered Rate (LIBOR). The size of the spread represents the perceived risk in the banking system. The larger the TED spread the greater the perceived risk in the banking system.
Deflation can be devastating to the value of collateral held by banks. If banks are reluctant to loan to one another it is an indication of the perceived credit worthiness of the banking system. This makes watching the perceived risk to the banking system a valuable deflation and investment metric.
Deflation and Investment Today
Many economists fear hyperinflation from the huge increase in the monetary base. The Federal Reserve has staved off deflation for several years by printing money. But the unprecedented increase in the money supply has not produced the intended the results.
This chart shows the velocity of money continues to collapse and currently (December 2013) turning over at the lowest rate in 50 years. The economy should be brisk and inflation rising at an alarming pace after the gigantic increase in the Federal Reserve balance sheet. Instead money is being parked in the banks that are reluctant to lend in an environment of high scrutiny from regulators.
The high level of debt in our society and the falling velocity of money should cause investors to consider deflation and investment policy. No one can know whether we will experience deflation. But the warning signs should cause us to watch the indicators carefully and and pay greater attention to the possibility of deflation.
A deflationary recession or depression would be very painful to those holding debt and illiquid assets. The federal government would be one of the hardest hit by deflation because of the massive 17 trillion (and growing) debt.
If we were to have a deflationary event; CASH IS KING! Cash becomes more valuable as asset prices decline. Of course debt becomes more onerous because it does not decline. We saw this happen to millions of people in the housing crash as values crashed below their mortgages.
There are two possible scenarios should we experience deflation. The positive path would be for it to cause the government to make the structural changes needed for a sustainable fiscal policy. The negative path would be to print LOTS of money and destroy the dollar and the middle class.
Which one do you think the current government would choose?
Related Reading: Perceived Risk vs. Real Risk: A Key to Successful Value Investing