Biflation: inflation in the things you need, deflation in the things you don’t
I am going to be speaking on a panel on “Investing in Inflation” tomorrow. And I thought I would put forward some ideas here regarding what I intend to say. The key word describing where we are is biflation, meaning inflation in some things but not in others. I tend to think about in terms of inflation in the things you need on a daily basis like food, gas, education, and healthcare but no inflation or even deflation in the things you don’t need every day like cars, refrigerators, iPhones, computers. Here’s why.
We are living in a global world now. Not only is it global but it is an interconnected world too. That means it is a lot easier to arbitrage your local infrastructure. I think of the Internet this way. I can buy a lot of things from some guy in Ontario, Canada that I used to have to buy locally. I can buy stuff from Seattle-based Amazon in the DC area, shipped out of Kentucky, made in China by a German company just as easily as I bought products made more locally 30 or 40 years ago. That’s huge in terms of bringing down prices. It’s the ultimate competitive environment where you have people leaving the fields of Vietnam or China or Mexico to find work in a factory in those countries for incredibly low wages, competing against workers in Germany, Hungary, the US or Japan. Naturally, this is going to put downward pressure both on product prices and wages. Think Braun razors, Sony DVD players, Volkswagen cars or Apple iPhones. And if prices don’t fall, we don’t buy.
On the other hand, this global-ness isn’t a big factor in commodity prices. When demand for food and energy ramps up, you can always get stuff from abroad, but this has always been the case. And the fact is, these are things we desperately need, not things we can cut back on. Supply is constrained by nature’s abundance. There is a good harvest or a bad one. Supply is also constrained by how long it takes us to build up the infrastructure to get these resources. That’s what we see in oil and gas for instance irrespective of the peak oil argument. So, you get these enormous price spikes and waves of secular price increases like the one we have seen recently. If prices don’t fall, we still buy.
At the same time, when it comes to things like education and healthcare, outsourcing and globalization are not as potent a factor since these are functions that are unusually constrained by geography. Sure, you can import teachers, doctors and nurses who cost a fraction of the price but you would have to do that on a wide scale in a country like the US to have an impact. And then you would also have to deal with organized labor unions too. The fact is these are fields where you have captive audiences and so the price for these services rises at a much faster clip than for other services where global wage arbitrage is a bigger factor. And here again, if prices don’t fall, we still buy.
This is why I tend to see our environment as inflation in the things you need, but deflation in the things you don’t. What does that mean for the economy and investing then?
I say it means a developed economy populace that is income constrained and uses debt as a necessary supplement to fill the gap. This is also a populace which is forced to cut back when the price of food and energy rises. The result is a period of sub-par growth, uneven consumer price inflation and fits of recession. Government will counteract this by staying as easy as possible, with an emphasis on monetary policy over fiscal policy in applying stimulus.
From an investing standpoint, that means policy is actually geared toward asset price inflation. If the fiscal is in neutral or contractionary mode compared to the norm, then the monetary agent will counteract this. But the monetary agent cannot add net financial assets to the system. It merely swaps assets. A central bank creates reserves and buys existing assists, thus swapping one financial asset, base money, for another. There is no net change in net financial assets in the private sector when this happens. Fiscal policy is by nature a way of adding net financial assets to or subtracting net financial assets from the private sector. When the fiscal agent spends, it adds net financial assets and when government taxes it drains net financial assets. The bottom line here is that stimulative policy cannot increase net financial assets without reflationary fiscal and so, to the degree you get policy support – and we will get it – it will be geared toward supporting asset prices in order to facilitate more private sector credit creation. That’s what QE is all about and that’s what the ECB’s OMT program is all about: keeping assets elevated enough to prevent a debt deflationary cycle.
But this is not a recipe for a bull market. When the economy is in the up-phase, the reflationary policy will work and you can follow the cyclical pattern by rotating between sectors and asset classes depending on where momentum is. For example, it was bank stocks and cyclical companies in 2009, followed by bonds when we had a pre-QE dip. But then QE brought the broader market back into play and so retail and technology came into play. But as the economy has started to roll over, the most speculative asset classes have gained favor with people getting into leveraged loans, high yield and pre-IPO companies. That’s classic business cycle stuff.
But this is an asset inflation driven investing climate that cannot be sustained by the fundamentals given still high levels of private debt and limited policy space. That means that when contractionary fiscal finally overwhelms expansionary monetary policy, stocks and other risk assets will suffer. In 2013, people will be raising cash and shifting into government bonds as the weakness of QE and expansionary monetary is clear. High yield bonds and high beta stocks ail get crushed first. Retail and cyclical companies like the DuPonts and the Dow Chemicals will also fall. And eventually the selloff will be broad-based with financials, REITs and homebuilders taking an especially severe beating if the writedowns are as large as I believe they will be.
So, investing in inflation means following the momentum of asset price inflation and diversifying into alternative asset classes as a hedge against currency depreciation. But, the macro backdrop is inherently deflationary because the business cycle’s credit accelerator has been switched off due to high private debt. So, investors need to rotate more actively and they also need to be aware that recessions carry an especially potent asset deflationary risk. In Europe, policy uncertainty makes this even more tricky, as it’s not even clear how government bonds will trade until you know the policy response. Play the upswings but protect your wealth. This is still a secular bear market.