Knocking at Deflation’s Door

John Mauldin | Thoughts from the Frontline
September 27, 2002

Today we are going to examine a war going on in the central banks of the world. The central banks of the world continue to do what is necessary to make their respective nation's products attractive to the American consumer, doing the best they can to make their currencies cheap. There are increasing calls for the US to let the dollar fall as a weapon in the war against deflation. Both can't happen at the same time. You don't want to let your investments get caught in the crossfire. There will be casualties.

I am working later than usual on this letter, as thinking through the implications of a number of reports I have read this week is giving me some cause for concern. I am somewhat envious this evening of Roman soothsayers. I think it would be easier to analyze sheep entrails than the conflicting economic data coming out this week. At least we would have lamb chops afterward.

However, difficult data has never prevented us from trying. I hope today's letter will help you understand why interest rates and the stock market keep going down, and will continue to do so.

Even the Pros have Trouble

The investment climate and the rules associated with them have changed. If you are still investing under the old investment rules, you are having trouble.

You can take some small comfort in that the professional management world is having problems as well. I am not referring to buy and hold managers, who don't even try to make money in bear markets, and for the most part, don't have a clue. I am talking about active market timers and hedge fund managers. These are professionals who are really attempting to make money in this market.

I remember writing in 1999 that this next decade would be the decade of the market timer, as bear markets have been in the past. I was wrong. While this bear market has not been as bad for market timers as it has been for traditional money managers, it could not be called good for them.

I called my friend Roger Schreiner today. He tracks 639 market timing programs. I asked him how many were up for the year. I knew the number would be bad when he started counting through his list by hand. Only 56 market timing programs showed positive returns, or less than 9%. The median program was down 6%. This is certainly an improvement over the actual markets, but down is still down.

I really confess amazement at that number. Given the number of bears in the market timing crowd, I would have thought significantly better than 9% would be profitable.

Equity hedge funds are only doing slightly better. These are managers that can go both long and short. The average long-short hedge fund is down a few points, and only a few are anywhere close to their historic averages.

I believe this is because the many of the fundamental market relationships upon which trading systems are based have changed. To get an insight into the changes, let's first go to Japan. I will need to quickly review the scene for new readers, but we will get to the point shortly.

Land of the Deflating Sun

Japan is in a decades long recession/depression and is currently in a deflationary spiral. Excess capacity means lower prices means less profits means fewer jobs means less consumption which leads to lower prices because of excess capacity and so on. It is a vicious spiral. Japanese exports to the US fell again this month, and any thoughts of a recovery are only in the dreams of politicians.

Japan is in a liquidity trap. That is a condition when interest rates are as low as they can go, but since deflation is even lower, the real cost of money is high. It leaves a central bank powerless, as they cannot lower rates to stimulate spending.

It has been well known for some time that Japanese banks are essentially bankrupt. Their bad loans far exceed their capital. In my opinion, the principal reason for the Japanese economic crisis is their refusal to force banks to deal with bad loans. They simply would not force much of their elite to "take their medicine" and thus the average Japanese citizen has been badly hurt.

I have stated many times that the Japanese central bank, along with the government, is the only management team which could make Xerox management look competent. They do a dance that Greg Weldon calls "the Ostrich," as they continually stick their head in the sand to avoid facing reality. Only now, reality is beginning to really get scary.

At the recent Jackson Hole Federal Reserve conference where Alan Greenspan gave the speech declaring the bubble was not his fault, there was another academic paper presented. This one seriously suggested a "fool-proof" method for the Japanese to escape from the current deflationary liquidity trap in which it finds itself. It called for setting price levels, depreciating the currency below any conceivable equilibrium level, and then setting a fixed exchange rate to guarantee the lower level. This should boost economic activity and prices, and once things were moving along, the central bank could abandon the price targets and once again target inflation.

BCA Research tells us the representative from the Bank of Japan did not endorse this, but admitted that extraordinary measures were needed, such as the direct buying of real estate or stocks.

Let me translate the above economic language. The presenter seriously suggested that Japan consciously destroy its currency and its buying power, create enough inflation to insure a period of sustained rising prices, and then induce a recession to control the inflation. There are several important things to note from this.

First, this was presented in the context of a Federal Reserve sponsored forum. It makes one wonder whether the Fed was sending yet another message. Second, this was not some minor adjustment that was suggested. It is major economic medicine, and if you are an average Japanese citizen is not what you want to hear. If there was a message, it was that Japan is in serious trouble and that only drastic medicine can save it. Think chemotherapy. The patient may live, but it is certainly anything but pleasant. Doctors, and central banks, do not suggest such measures unless the patient is otherwise terminal.

Japan is the world's second largest economy. It is the chief source of deflation in the world, and the Fed is telling them they need to do something before they drag the world down with them.

Then this week the Bank of Japan, after 10 years of sitting on its hands, says it will start buying stocks directly from banks. Think about that for a moment. If Greenspan were to announce the Fed was going to buy stocks in order to shore up the economy, there would be a huge outcry. It would be a mistake of the largest magnitude for the Federal Reserve to buy stocks.

Let's look at what the Bank of Japan will likely do. Japanese banks do not mark the stocks in their portfolios to market price. They are kept on the books at the value at which they are bought. Since the Japanese stock market is down 75% from its high (not counting actual bankruptcies and mergers), many of the stocks in the portfolios of banks are carried at losses. The banks have also many stocks they have held for decades which are still showing a profit. But if they started to do any serious selling, they would drive the stock market down much further.

The banks desperately need cash to be able to write off bad loans. I have seen serious estimates that banks will need at least four years worth of earnings to be able to handle their bad loan portfolios. But to go for four years showing no profits would depress and further weaken an already devastated banking sector.

There is evidently no appetite in Japan for the government to do as we did in the Savings and Loan crisis -- simply taking over banks, letting the taxpayer foot the bill and selling the profitable portions to solvent banks. That hurts shareholders, of course, but it puts the banks in the hands of new management.

Japan will do what it must to make sure the elite save face and also save their personal bank accounts. The Bank of Japan will do what it can to save the current management and the large shareholders.

Here's what they will do. They will first buy stocks in which the banks have a profit. This will allow the banks to sell stocks in which they have a loss to the public. The profits and losses match, showing no loss to the bank. They then have cash to write off bad loans. This also has the "advantage" of injecting significant liquidity into the economy. While not as direct as the Fed paper suggestions, if aggressively applied, it will achieve the same outcome.

It is not the correct thing to do. But Dennis Gartman cogently argues that given the Japanese unwillingness to do the right thing, it is better than nothing. From the standpoint of an American (or for that matter, anyone but a Japanese citizen), and given my stake in seeing the world economy avoid a deflationary implosion because of Japanese intransigence, I would have to reluctantly agree. However, it is indefensible to allow those responsible for the problems to not only escape responsibility, but to profit from them. If I were a Japanese voter, I would be in the streets, manning the barricades. I guess that's just the 60's Flower Child coming out in me.

However, this is not the troubling aspect of the issue. I am firmly persuaded the Japanese care not one whit what the Federal Reserve or any other government or central bank thinks. The "solution" proposed by Fed academic clearly shows the serious level of concern at the highest levels of our government. This concern is shared in many quarters, both liberal and conservative, and in many countries.

That the Japanese are actually planning to do something shows that the concern is not misplaced. If they have come to the point where things are getting so bad they will be forced to do something, then it is serious.

One last important point, which we will re-visit later, is that the means suggested by the Fed and evidently agreed with by the Bank of Japan is that to combat a deflationary spiral you need to devalue you currency. Factor in that the Prime Minister of Japan also wants to see the currency drop against the dollar, as do the major exporting businesses, and it seems clear the direction of the yen is headed down. Then why has the yen gotten stronger of late? We will come back to this question, as it holds one of the keys to the new investment rules.

Competitive Currency Devaluations

Stephen Roach of Morgan Stanley points out that the US consumer was responsible for 64% of the growth in the world's economy from 1995-2001, roughly twice what our share of world output was during the same period. The world economy is dependent upon the US consumer. As the US economy has slowed down, the world is slowing even more.

The problem is that there is no other engine for growth. I have chronicled Japan's crisis. Germany, the third largest economy, is on the brink of a recession and is close to deflation. Europe may slip into recession before we do. South America is in shambles. China and India are working hard to stimulate a consumer economy, but both are years away from being a major force for growth in the world economy

Like a drug addict who needs his fix, it seems most countries want to keep the value of their currencies low so they can continue to sell products to the American consumer. Rather than going cold turkey and trying to boost their own consumption and letting their currencies rise, they keep returning to the "fix" of devaluation -- anything to keep the American consumer spending dollars.

During the 90's, the entire world, and especially Asia, spent huge amounts on factories to build products for America. There is now too much production capacity for current demand. The businesses of each country hope to keep their factories producing, and sell their products at ever cheaper prices. But rather than lower their prices in terms of their local currency, they urge their governments to lower the price of the currency. That way they can continue to pay their workers in a depreciated currency, passing their problems to the employees. Of course, the local currency buys less on the world markets, but the factories are busy. This is a "last man standing" business plan, and has its own set of problems, which are not the concern of this letter today.

The point is, as one country after another, especially in Asia, lets their currency drop, other countries feel forced to lower the value of their currency to stay competitive. This is of course price deflationary in terms of the US economy. It also means our competing companies cannot raise prices, and hurts profits.

The US is now at a trade deficit of 5%. At our current "progress," the world will soon be lending us $2 billion per day to finance our spending. There has never been a currency that did not drop when trade deficit levels have risen to the heights that the US trade deficit is currently approaching. But the dollar, after dropping for the first part of the year, is now down only 3% against a basket of world currencies. This is hardly the stuff of a serious currency correction.

Knock, Knock, Knocking at Deflation's Door

And now we come to the heart of the matter. I have been writing and warning about deflation for four years. There weren't many of us in 1998. Now it is standard fare.

I have maintained in this column that while I think we will experience deflation, the most likely scenario is that it will be mild. The Fed has clearly let the world know they will expand the money supply as much as necessary to keep deflation from becoming serious. The dollar (because of the huge trade deficit) should drop in concert with this policy, thus letting us avoid the worst aspects of deflation.

The important word in that last sentence is "should." There are some reasons to be concerned that this might not be the case.

Martin Barnes of BCA Research is one of the most highly respected economists in the world. He is read everywhere. He is not noted for overstatement or hyperbole, as he is aware of how serious his words are taken. Thus it is with some disquiet I read his recent letter.

He makes the argument that deflation is now at our door, and he expects that we will see mild deflation soon. His argument is that because growth in the US is so low, and because inflation is already so low, that deflation is inevitable, barring a growth recovery not currently on the horizons.

Let me quote: "The Fed will not back away from an easy monetary stance for the foreseeable future. This argues against a major sell-off in bonds, and warns that the dollar is vulnerable on the downside. With regard to the latter, the saving grace is that the rest of the world is also on shaky economic ground and the dollar is still regarded as a safe haven. However, if the U.S. edges closer to a liquidity trap, the authorities will not hesitate to push the dollar lower."

He makes a second point, "While the mixture of deflation and high debt levels poses a threat for the U.S., disaster will be avoided if the real estate market does not suffer a meltdown."

Part of his prescription is for the "authorities" to allow, or encourage, the dollar to drop. This is echoed by Stephen Roach and numerous other thoughtful economists.

Dollar Devaluation Party

OK, let's review. We are getting ready to enter a period of outright deflation. The Federal Reserve recently published a paper outlining what policies could be enacted to prevent serious deflation. Basically it involves allowing the dollar to drop, more fiscal stimulus in the form of budget deficits and tax cuts and expanding the money supply. If this seems like a prescription for inflation, that is because it is.

As I have argued in the past, the Fed has made it plain they intend to keep us out of serious deflation. The logic seems to be that it is better to have the devil of inflation with which we (the Fed) know how to deal, than a devil we can't do anything about. It seems to be a choice between the stagflation of the 70's or the deflationary depression of the 30's.

Now, of course, the Fed and other leaders think they can induce only mild inflation and engineer a new growth economy. I sincerely wish them all the best. I like a growing economy.

But what if they throw a dollar devaluation party and no one comes?

Let me explain it this way: if every consumer in America decided it was in his best interest to start saving an extra 5%, the US economy would tilt into recession quite quickly. What would be a good policy for each individual would have negative collective consequences for the economy.

The same applies on an international level. If the drug addicts of the world do not stop the competitive devaluation of their currencies in an effort to keep the American consumer buying their products, then it will be difficult for the "authorities" to lower the value of the US dollar in the fight against deflation.

It will take away one of the major deflation fighting tools in the hand of the Fed, just at the time when it will be most needed.

The problem is that everyone cannot lower their currency at the same time. This means that if deflation becomes an issue, it may be "necessary" for more aggressive easing and monetary expansion in order to stem the deflationary tide. This will create more imbalances that will have to be worked through. Ultimately, aggressive monetary expansion will mean inflation that will not be mild.

Now, before you start heading for the storm shelter, let me point out that none of this is going to happen in the next quarter or probably even begin next year. These things take time to work out. It is quite possible we will continue to Muddle Through for quite some time.

But some of the Fed governors are clearly concerned, or we would not be seeing two governors not vote with Greenspan. The recent economic papers coming from the Fed tells us there is concern about deflation.

The bond market is telling us deflation is coming. Slow growth and a dollar that stays too high in a low inflation environment tell us deflation is coming. Richard Russell stated it well recently when he said his head told him bonds are too high, but his pocketbook made him buy some more municipal bonds.

It is tough to want to buy bonds when every historical indicator is saying they are way overbought. Gartman makes the analogy that when the temperature approaches absolute zero, the laws of physics change. As we approach the absolute zero of outright deflation, the normal historical relationships in the investment world are changing as well. If you are using investment models based upon an inflationary world, you are not going to succeed.

What does this mean in the near future? The Fed is going to cut rates again and again. It will not be to stimulate the economy. Cutting rates for that purpose is pointless at the low levels we see today. The Fed will be looking to combat deflation and help lower the dollar. They should have cut at this week's meeting. They will at the next post-election meeting.

If mortgage rates were to go back up, the US housing market would be seriously hurt, and that is the one thing with which the world cannot cope. Fortunately, it appears likely that mortgage rates are going lower. I rashly predicted a 5% 30-year mortgage in 1998. Now it does not look so rash. It may happen by next spring. If someone is willing to lend me money for 30 years at 5%, I shall oblige them to the fullest extent possible.

Deflation also means that corporations will have no pricing power, and thus earnings are not going to rebound at anywhere near the rate analysts predict. That means more stock market upheaval; more bear market rallies and more ultimate disappointment.

But we will get tax cuts, deficits, lower rates and easy money. All this stimulus means we will likely continue to Muddle Through for the year, albeit at a slow pace. Will it eventually catch up with us? Will we have a Year of Reckoning? In the long run, of course we will. But it could be a very long run. And let me remind you that the world does not come to an end in recessions or even with deflation. The vast majority of us will still have jobs and business will go on as usual. Europe seems to be stumbling along with 9% unemployment and no one is in a bread line.

Absolute Returns

I am not expecting a repeat of the 30's. I do expect that assets will be re-valued, and that we will have to adjust. That is why absolute return investment strategies are so important.

I am writing a book called Absolute Returns . You can see the chapter explaining a secular bear market by going to www.johnmauldin.com and clicking on Absolute Returns. If you are an accredited investor, I also have a free letter on hedge funds you can find on that site as well.

I finished this letter at 2 am Saturday morning. If there are more typos than normal, it is not the fault of my proof-readers and editors, who are properly in bed.

I will be speaking at the Fund of Hedge Funds Forum in New York in two weeks. I still have a spot for meeting with clients or potential clients on the afternoon of October 10.

I will be meeting with one of my oldest and dearest friends this weekend, Bob Mumford. He has been instrumental in the development of my understanding of the nature of relationships which we have with both God and each other. Thinking of this serves to remind me that part of our true wealth is in family and friends. It is comforting to know there is something I have which a central bank cannot devalue.

And finally, I promised my bride months ago I would take her to hear Olivia Newton-John this weekend at the Bass Hall for her birthday. Now that will be a trip down memory lane.

Your "Hopelessly Devoted to You" analyst,

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