What is Deflation?

We found an article this morning written by an anonymous risk manager which explains deflation in easy to understand terms. Given the ongoing battle between deflationary forces and inflationary forces, we thought this would be a great article to post.


"Deflation is the contraction (reduction) of money and credit. It occurs when the economic system is carrying too much debt to be supported by the level of income generated by economic activity. It occurs because too much debt has been incurred to create unproductive assets that don’t generate income. Deflation is a corrective process, it’s simply the market not being able to service debt, so we must forfeit.

Since central banks and accepted economic theory are all about creating debt to grow (artificially) economies, periods of inflation (creating money-debt and credit) last a long time: Debt is accumulated incrementally until there is too much of it. So people don’t really understand the tells of deflation.

For example, the things that drive currency movements are quite different. If we’re in an inflationary period (expanding credit) and we get a good economic number, people expect the value of the dollar to rise: A growing economy will attract investment so foreigners buy dollars to invest in US stocks. If you get a bad economic number on the margin, you’d expect the dollar to fall as the opposite is true.

We just this morning saw a disappointing durable goods number. If we were in an inflationary period, you would see the dollar fall. The number actually made the dollar rise by 30 basis points. Why?

In deflation, there’s too much debt. If the economy is slowing down, it makes it more difficult to pay back that debt and you would expect more to default. The more debt that forfeits, the more dollars are destroyed. The more dollars destroyed, the more they’re worth.

Central banks of countries with massive external debt (the US) are desperate to create inflation (keep credit from contracting), but the mechanism to do that is broken (because there’s too much debt in the system).

It is important to always ask the question why something is happening rather than just observe patterns because patterns can change depending on the environment."

Consumers Continue Reducing Debt

The main constraint on spending going forward will be the desire to beef up savings and reduce debt burdens. However, with layoffs slowing down, it is only a matter of time before the economy starts to generate positive job growth. While a larger portion of incomes will likely be deposited into savings accounts, it's hard to imagine the savings rate will increase dramatically from here. From its low point of under 1 percent in early 2008, the savings rate has risen to almost 5 percent over the past three months, which is actually a full percentage point above the average that prevailed between 1994 and 2008, although below the 7 percent average during the 1980s. We suspect that households will want to build up a larger cushion of savings to guard against possible adversity and to replace some of their wealth lost to the housing and stock market declines in 2008.

As people become more optimistic, personal spending may begin to improve. Also, the debt side of the household balance sheet is being rapidly brought down. Households started to seriously reduce debt burdens late last year, but their efforts have proceeded at an astonishing pace in recent months. In July, consumers paid down an unprecedented $21.6 billion more debt than they took out, following six consecutive monthly paydowns averaging $14.2 billion. At the end of the month, consumer debt stood 4.2 percent below the level of a year earlier. That's a swing of about 10 percentage points from the 5.2 percent average growth rate in consumer debt that fueled spending during 2007 and early 2008. Needless to say, the debt pullback has contributed significantly to the spending retrenchment that has since occurred. (See chart for details)

To be sure, not all of the debt paydowns reflect a newfound sense of frugality on the part of households. A good deal of it simply reflects tighter lending standards by risk-averse banks and other institutions striving to restore profitability. To this end, credit card rates have been lifted, stiffer fees have been imposed and credit limits have been lowered. But there is little question that households have greater access to credit now than was the case during the height of the credit crisis late last year and earlier this year.

Indeed, it may well be that the astonishing reduction in consumer debt this year has as much to do with banks writing off bad loans as it does with households paying off their obligations. As the chart shows, the rate of bank chargeoffs of consumer loans has surged over the past year, reflecting the heightened stress on households budgets amidst huge job losses during the recession. During the second quarter, nearly 10 percent of credit card debt was written off, the highest since records first began in 1985. That trend likely continued into the third quarter, and may have accounted for the lion's share of the record debt paydown in July. If so, that would explain why nonrevolving credit fell even as auto sales spiked under the cash for clunkers program.

Economic Activity Stabilizing

Recent reports from the 12 Federal Reserve Districts indicate that economic activity continued to stabilize in July and August. Relative to the last report, Dallas indicated that economic activity had firmed, while Boston, Cleveland, Philadelphia, Richmond, and San Francisco mentioned signs of improvement. Atlanta, Chicago, Kansas City, Minneapolis, and New York generally described economic activity as stable or showing signs of stabilization; St. Louis remarked that the pace of decline appeared to be moderating. Most Districts noted that the outlook for economic activity among their business contacts remained cautiously positive. The majority of Districts reported flat retail sales.
Residential real estate markets remained weak, but signs of improvement continued to be noted. Chicago, Richmond, Boston, and San Francisco observed an uptick in sales over the last six weeks, while sales in the Philadelphia District were described as steady. Most Districts noted that demand remained stronger at the low-end of the housing market. Boston, Cleveland, Dallas, Kansas City, Richmond, and New York indicated that the first-time home buyer tax incentive was spurring sales. However, Philadelphia did note an upturn in sales at the high-end of the market. Reports on house prices generally indicated ongoing downward pressures.

Reports on commercial real estate markets indicated that demand for space remained weak and that construction continued to decline in all Districts. Atlanta, Philadelphia, Richmond, and San Francisco reported that vacancy rates increased, while rates held steady in the Boston and Kansas City Districts and were mixed in New York. Commercial rents declined according to Boston, Chicago, New York, Philadelphia, and Richmond. Rent concessions were reported in the Richmond and San Francisco markets, and Richmond noted that some landlords had postponed property improvements in an effort to conserve cash. Construction remained at very low levels, with modest improvements noted in public construction in the Chicago, Cleveland, and Minneapolis Districts.

Information taken from most recent Federal Reserve Beige Book report.

Long Term Chart Revisited

Above is a long term monthly chart of the S&P 500 Index going back to 1995 to present, which was first posted back in April of this year. The chart is helpful because it is a big picture view of the market. (Click on image for larger view)

As a refresher, notice the red and blue price lines right below the monthly chart of the S&P 500. These lines basically measure average prices over a rolling period of time, in this case monthly. The red line measures a shorter term average price and the blue line a longer term average price. The newest monthly pricing data is added and the oldest monthly pricing data is dropped from each average each month. These lines essentially show us if prices are moving higher on average or lower on average over a longer period of time. When the red line (shorter term average) crosses the blue line (longer term average) to the downside, prices are moving lower on average and vice versa when the red line crosses up through the blue line.

Back in April, both the red and blue lines of this chart were moving lower, despite the recent 20% rally in the index. We also stated that based on the current readings, it would likely take several months of stable prices or base building in the index before the red and blue lines begin to stop moving down and then begin to curl upward as they did in 2003.

Well, here we are several months later and, as of August 31st, the short-term moving average just slightly crossed the longer term moving average indicating a change in trend in the average price of the index. Instead of moving lower on average, prices are now moving higher on average, given this particular indicator. Although the fundamental backdrop of the economy may still be suspect, the market believes a recovery is on the way. While there is no guarantee a change in trend is here to stay; in the past this moving average "crossover" has represented a long-term favorable trend change for stocks. With this trend change typically comes a change in psychology. Instead of selling every time the market moves higher in anticipation of lower prices, market participants are now buying every time the market moves lower in anticipation of higher prices. Institutions have also shown modest accumulation in recent weeks.

We believe we have returned to more normal market conditions; barring any major crisis. Corrections in the markets should be viewed as a chance to opportunistically rebuild allocations for long-term appreciation. Of course, if market conditions change drastically or the environment becomes more volatile, it may be appropriate to revisit our outlook.

We have experienced volatility surpassing anything in history followed by one of the fastest and most powerful rallies in the markets on record; which in and of itself is absolutely astonishing. Our view as to why the markets have shifted so quickly is the possibility that market participants are now ignoring any bad news and possible unknowns based on a collective belief the US Government will continue to backstop the markets and economy. While this is a move toward a more socialistic society, it adds a backstop to the markets. The perception is that they (the Government) will do whatever it takes to move the country back on a path to economic growth; in addition to protecting capital markets from any future crisis which may develop.

In addition to a Government backstop, company's earnings comparisons for the next several months should be relatively easy given the awful earnings posted in the second half of 2008 and cost cutting measures most have taken over the past year. It is very likely a majority of companies will have much better than expected earnings results in both the 3rd and 4th quarters of this year.

Finally, on the political front, there is a feeling that many democratic, hot button political issues, such as health care reform, could be dead. Many believe that Obama's honeymoon is over and he is going to have to move toward the middle or risk losing the upcoming election in 2010 and control of Congress. This is also helping markets and investor psychology as there is a sense it will be difficult for any major legislation to pass.

There is a wildcard to throw into the mix - the consumer. It is hard to know to what level the consumer will spend heading into the holidays and into 2010. Some economists believe spending will return to a modest level in the coming year and others believe it will take an improved housing and job market for consumers to feel more confident. It is difficult to predict how this recovery cycle will play out as US consumers lost trillions in wealth over the past few years. The next few months of economic data should give us some clues into the recovery cycle.

Enjoy your Labor Day weekend!

New Home Sales

Although new home sales jumped by 9.6% in the most recent month and the pace of home sales accelerated to 430,000; the chart below (which doesn't included the latest data point) shows just how far new home sales have declined over the past 3 years. The decline in home sales is the most severe on record and the chart bears the steepness of the decline.

According to most reports, many the new home sales can be attributed to the $8,000 tax credit implemented earlier this year. The program has helped to boost the housing figures since its inception in mid February. What will be interesting is to see in the coming months is what happens to new home sales when the tax credit program ends in November? It is possible the finalization of the program could bring an end to the recent uptick in home sales, which continues to remain underwater compared to last year’s levels. In comparison, rate of sales of new homes in 2008 were approximately 12.5 percent higher on average and median prices that were 10 percent higher at $230,000. (Click on chart for larger image)