Pomboy: Deflation, Not Inflation, Is The Greater Threat

I am a big fan of Stephanie Pomboy’s economic commentary, even though she has steadfastedly managed to duck my meeting her every chance she gets — conferences, dinners, drinks — I even heard she once hid behind a column in Vail to avoid me ; )

No matter, I still find her work outstanding. Her most recent commentary on Deflation was right up mny alley. Its discussed extensively in Abelson’s Barron’s column this weekend:

“THE INDOMITABLE STEPHANIE POMBOY, who beguiles us week-in, week-out with her feisty, funny and very much with-it MacroMavens commentary, is a member of the small but hearty camp (number us among them) who believe that the immediate threat is deflation, not inflation.

As, among other things, the glistening rise in gold and the heavy shorting of long-dated Treasuries strongly suggest, she notes, the popular investment view is pretty fixated on inflation. And Stephanie mulls whether Jeff Lacker, president of the Federal Reserve Bank of Richmond, “isn’t sure the Fed will be able to make a graceful exit before all inflation hell breaks loose,” shouldn’t we all share his concern? Her answer is a qualified “no.” Qualified because she believes there’ll be inflation, but it’ll be in assets, not goods.

For she’s convinced the consumer’s new-found prudence is no passing fancy, but a behavioral sea change, and that the repair of consumer balance sheets so badly thrown out of whack by a quarter of a century of credit overindulgence will continue. So while equities and commodities, as their recent explosive runs demonstrate, may run hog-wild, the massive decline in consumer credit represents a daunting barrier to a kindred climb in consumer prices. Yet despite mounting evidence of the new frugality on the part of the populace, Stephanie points out, retail stocks are posting their strongest relative performance since March 2007, and junk spreads are the narrowest since October 2002. “Investors,” she shakes her head, “are discounting an environment in which retail sales register 3%-style annual gains.”   (emphasis added)

As we noted recently, its even worse than that. The markets have, as is their occasional wont, decoupled form the fundamental economic reality.

Pomboy continues:

To notch such an increase, she gauges, retail sales, now declining at an annual rate of $331 billion, would have to make a U-turn and rise $470 billion! As she says, “An $800 billion swing? You’d have to be certifiable to bet on that.”

Stephanie felt “there’s no way professional investors are betting real money (even if it’s other people’s money) on such an outcome. Is there?” So she went back to the drawing board hoping to arrive at a less frightening conclusion.

Specifically, she turned to what she calls the “broadest proxy of risk appetite,” namely stocks versus bonds, to discover what types of gain in overall consumer spending it implied. The divergence between the two, she explains, is at extremes last seen when consumer spending was chugging along at a 6% clip.

“To reach that milestone today,” she sighs, “would require one whiplash-inducing U-turn if ever there was one, with the present $165 billion annualized decline in spending giving way to a $779 billion gain.” Even these days, that’s a big number.

If the demand for credit revives or employment and income begin to grow, neither of which seems to us likely to happen anytime soon, Stephanie says that’ll be the time to start worrying about inflation in the traditional sense. At the moment, the only serious inflation is in stuff like financial assets, because all the surplus “liquidity” that has been pumped into the economy has nowhere else to go.

She tabs the equity rally as exceedingly long in the tooth. Earnings expectations, she submits, “have never been so far afield of economic reality, and the market’s banking on a $1 trillion spending swing over the next 12 months.”

I cannot disagree with anything she has stated, except the historical factors that suggest that Bear Market rallies that follow collapses can easily run 18-24 months.


All Hail the Hero
Barron’s September 21, 2009

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