Good Evening: After a couple of weak rally attempts that failed last week, U.S. stocks were able to put together a decent rally on Monday and Tuesday before languishing today. Fears of both a punitive Chinese monetary environment and an overly restrictive U.S. regulatory environment have receded enough to enable shares to make some headway this week. Whether or not this uptick in risk asset prices is anything more than a bounce from oversold levels is still an open question, one which may depend upon how investors believe the macroeconomic issues caused by the seemingly global over-reliance on debt will play out. It could be fire (inflating our way out through currency debasement), or it could be ice (a deflationary deleveraging process). We might even experience a touch of both via a revisit to the global stagflation seen in the 1970’s, but the biggest long shot of all would be for the global economy to march merrily forward as if nothing happened during the past decade. To better assess the investment perils of this debate, it might be instructive to entertain the views of both Bill Gross and Liz Ann Sonders. It’s only a guess on my part, but perhaps a crucial piece of this forecasting puzzle has to do with last Thursday’s vote in the U.S. Senate.
The biggest news this week was a decision by the central bank in Australia to keep its policy rate on hold. Since the land down under has benefited from a combination of 1) less debt and a sounder banking system than many other developed nations; 2) a resource-based economy that feeds developing nations like China; and 3) a central bank that has actually shown a spine by raising rates in recent months, most economists and investors had expected the RBA to hike them again on Tuesday. “No worries” may not have been in the official press release, but the RBA kept rates right where they had been yesterday. That the RBA passed when markets had already built in expectations for a rise may mean little more than a simple decision by the RBA to wait for more information before it resumes tightening. With its largest customer ( China ) also moving to make money more costly these days, the decision to stand pat is understandable. But it also had immediate, market moving consequences.
The Aussie dollar tumbled yesterday and today, global equities jumped, and commodity prices soared on Tuesday before retreating today. Seeing a central bank pause during a tightening cycle, especially one with a relatively tough reputation, apparently helped cause risk appetites to growl. A similar reaction to an official policy move was seen on Monday when the markets viewed the Obama administration’s budget proposal with skepticism that any real budgetary discipline would be enacted during a Congressional election year. Toss in the somewhat oversold technical picture after last week’s drubbing, and stocks were ready to bounce.
Unfortunately, there was little in the way of follow through today. U.S. equities opened lower and then drifted sideways for most of the session. Today’s economic news was mostly a non event, though I should point out that yesterday’s news (pending home sales and auto sales) was on the weak side. Equities finished mostly lower, though the NASDAQ did scratch out a fractional gain. Treasury yields rose between 2 and 8 bps after falling by lesser amounts yesterday, while the greenback managed to recoup on Wednesday the minor losses registered earlier this week. As the asset class under the most stress (-10% to -15%, depending upon the index) in the wake of China ‘s move to rein in lending, commodities were the biggest winners in this week’s rally – until today. After leaping more than 3% to begin the week, the CRB index gave back 1% today.
The debate about whether the ultimate result of the 2007-2009 financial crisis will be either inflation or deflation has been raging since Lehman went the way of the dinosaurs. The LEH bankruptcy and the subsequent liquidation in capital markets around the world in 2008 gave early credence to deflationary arguments. In 2009, however, global stimulus efforts by governments and Quantitative Easing moves by central banks helped reflate both risk asset prices and the media profiles of those expecting an inflationary outcome. Now comes new evidence, courtesy of private sector research.
As you will read in the pieces by Bill Gross and Liz Ann Sonders below, two new studies offer historical insights about debt, financial crises, and the deflationary/inflationary consequences to nations throughout the centuries. Both “Growth in a Time of Debt”, by Reinhart and Rogoff (of “This Time its Different” fame), and “The looming deleveraging challenge”, by the McKinsey Global Institute, attempt to give the forces behind our Great Recession some historical context. Both studies seem to argue that debt levels in many nations are very high and that the painful process of deleveraging is only just getting under way. This deleveraging, argue the authors (with nods from both Gross and Sonders), will at least hold back GDP growth, and could — according to Sonders — lead to deflation. Chalk up a win for those expecting an icy resolution to the late financial crisis, right?
Not necessarily. Some of the outcomes cited in these studies are of the inflationary, even hyper-inflationary, variety. How do we know which outcome will occur in each country this time around? The authors argue that “initial conditions” (i.e. debt levels entering the crisis) are very important. I agree, but I think another important “initial condition” is being overlooked by these financial historians: The currency regime in place during the crisis and aftermath. Hard currencies (e.g. various forms of the gold standard) framed the backdrop of many of the crises listed in these studies, and hard money regimes tend to foster deflationary outcomes when debt chokes the system. But fiat currency regimes, especially ones with central banks that operate high-speed printing presses, offer governments policy choices.
According to Sonders, the choices facing overly indebted societies are essentially three: 1) a deflationary default on the debt, 2) inflating away the debt, or debauching the host currency to accomplish the same outcome, and 3) belt-tightening until the debt can be paid back. Countries that issue debt in currencies other than their own (like Greece and the other so-called PIGS of Europe ), the ones who have no central bank to call their own, do not have the inflationary option. It is either tighten the fiscal belt or turn out the pockets in default. But countries like the U.S. , U.K. , and Japan are fiat currency nations through and through. The last semblance of a gold standard bit the dust when Nixon closed the gold window in 1971. What’s more, they each have central banks that have been as unafraid to employ Quantitative Easing as their politicians have been afraid to impose fiscal discipline. With a natural fear of deflation and an inbred aversion to belt-tightening, the politicians in fiat currency nations might find the inflationary course a hard one to resist. The economic end game of either fire or ice may come down to the choices made by each nation’s central bank.
(Re)Enter Chairman Bernanke, whose time as Fed Chair was just last week renewed for an extended period. Reluctantly renominated by President Obama, Mr. Bernanke’s confirmation in the U.S. Senate was closer than the final tally revealed. It is unknown just what behind-the-scenes promises (if any) were made to rescue Mr. Bernanke’s nomination from the clutches of a filibuster, but tight monetary policy was likely not among them. The political intrigue may even be a moot point, since Mr. Bernanke seems to fear deflation more than almost any sitting senator. One begins to wonder if he really will ground his fleet of money-dropping choppers come March. Even if he does so for a time, can there be any doubt that new sorties will be ordered as soon as the U.S. economy shows any sign of stalling?
History may side with those who argue that massive indebtedness around the developed world will lead to either stagnation or deflation, but if so, where is it? Deflation should be rampant right now, but it isn’t. Various price indexes are rising and even bank lending standards are starting to thaw (see below). “Just wait until the stimulus runs out”, cry the deflationists. “What if the politicians and central bankers keep stimulating?” is the rejoinder from the inflationists. As for the investment implications of this debate, Mr. Gross and Ms. Sonders both counsel caution. The PIMCO CIO’s advice to avoid the bonds of nations within his “ring of fire” is sound — especially if the flaming ring he envisions is set ablaze by wanton money printing and fiat currency debasement. Remember, not for nothing is Mr. Bernanke called “Helicopter Ben”.
— Jack McHugh
Bernanke Confirmed by Senate for Second Term at Fed
Australia’s Stevens Waits for World’s Central Banks
Obama Proposes $3.8 Trillion Budget Focused on Jobs
Fed Says Fewer Banks Tightened Standards for Lending
Debt: What Is and What Should Never Be — by Liz Ann Sonders, Charles Schwab & Co.
Investment Outlook: “The Ring of Fire” — by Bill Gross, PIMCO