Understanding the Deflation / Inflation Problem

The world, not just the Western developed nations, will hit another 2008-scale wall as early as 2012 and as late as 2013, with Europe leading the way, and the Middle East in a race for rapid implosion. We are now in greatest danger of deflation, your favorite assets declining in value, deflating your wealth. We will soon thereafter be in a process of rapid inflation, where the things you want the most will get massively more expensive, even while your existing assets continue to shrink in purchasing power.

Imagine a frozen ocean of debt as far as the eye can see.  Yet not enough heat to provide fresh water to promote life. If no energy is applied, water will continue to freeze. If too much energy is applied in the wrong places, floods of liquidity occur just where you do not need them. Today, governments are adding water but it's freezing immediately. Governments are simply incompetent to guide private industry, and they cannot be sustainable engines of productive growth. Like an addict's fix, state-favored corporatism and socialism have temporary benefit, but long term physical damage.

Today, seemingly endless pools of liquidity are tied up in an unwillingness to invest in productive projects, because the productivity of those projects is in grave doubt. Globally, cooling is massive, and ultimate warming will be massive as well, and not in a good way.

Politics will Change Exactly Nothing

America has a $15 Trillion problem AND a $52 Trillion problem. So we must urgently act as a country, and none of the political operatives and candidates quite "get it" strongly enough to really do something about it. No one is a strong enough leader to do the right things.

The Democrats' only approach is to tax and spend more. Tax increases will indeed have to happen everywhere, especially at the State levels, but they will solve nothing and further encroach public, unproductive spending into the private economy which is the engine for all. These taxes will all be spent reactively, not proactively. The debt and unfunded mandates problems are too large already to be absorbed by any tax increase on the rich. Only Jubilee forgiveness can address the debts, and only complete abrogation can address the excess mandates. Such a broad reset, essentially a societally-sanctioned massive default, will ever be impossible for politicians of all stripes. So inflation will be the eventual chosen remedy.

As in Reagan's day, reducing taxes before actually reducing spending is the age-old "do-gooder" trap for everyone. Debt goes up, is funded by sucking liquidity from the private economy it is supposed to help. Unlike Reagan's day, everyone's debt capacity is maxed out, while the banks hoard capital for the rainy days to come, resulting from bad assets and future expectations of rising costs of capital.

Conservatives will get no thatcherite leadership nor power to do the tough things that matter, because those tough things will hurt. A lot. Suicidal sacrifice is hard. Better to be blamed for the hurt when it becomes inevitable, better to kick the cans down the road so long as this is still possible. But conservatives in America are no longer even trying to get back to founding principles, they are just slowing socialism down a bit. Romney is just another middle-of-the roader  who wants to “go along to get along.” Time and events will pass him by, and he will "lead from behind" reacting to events just as Obama has done.

None of the political parties in America want to face the fact that the US Federal Government is in the second stage of a terminal financial death spiral. The “can cannot be kicked down the road” anymore, because the “road” turned into gravel when our Total National Debt exceeded GDP at roughly 15 TRILLION dollars. The next leg of this road is a muddy road leading into a swamp.

Middle of the road solutions will not avoid the pain of adjustment. Growth will not come in the face of over-indebtedness everywhere. America has the resources to wind up on top of all the global challenges, but is strong only relative to the mess existing for all the other countries. More deflation ahead for now.

Understanding the Solutions

The frozen ocean of debt will melt someday, unleashing massive waves of liquidity that cannot be held back or channeled when they come. Such asymmetrical excessive infusions do not stimulate. They will instead lead to dramatic inflation and the destruction of relative buying power. But that inflation day is not yet. In a first stagnation phase, the economies of the world will further freeze in a continual slow burn like Japan, reducing liquidity and causing classic asset deflation, making the affordability of future inflation even harder.

Austerity is a foregone conclusion, but austerity from holding down spending growth is not enough. Real cuts in non-productive bureaucratic costs must be made. A full restructuring of tax systems and private economy incentives must take place, or else the austerity and cuts will choke the productive economy just as it is frozen today. Despite fixes, America and Europe will re-enter recession in late-2012 and it will get worse in 2013.

Why Gold will not Suffer as much from Asset Deflation or from General Inflation

If Gold had followed housing inflation, it would have risen less than it has, and would have fallen faster than it has. Instead, Gold has now become a currency. Gold prices are the product of currency purchasing power, and most importantly fear-factors. Those fear factors are not going away in 2012 and 2013.

Optimism factors, on the other hand, will be few. The intractable problems will generate increasing desperate infusions of liquidity and quantitative easing while the western world still can. Such quantitative easing may not stimulate private economies, but it stimulates gold as a store of intrinsic value.

Gold is now tracking the rising total of American national debt. As that debt grows, exacerbated by liquidity infusions and attempts at tax-cutting stimulus, gold is the last resort of value as an alternative to the dollar.

One of the most critical fear-factors is declining trust in the institutions acting as custodians for available liquidity. The distrust is massively increasing around the world, including the big banks which are too big to not fail (BofA, Dexia), derivatives and commodity custodians (AIG and MF Global), and even governments (such as those trapped in the Euro). When the last resort is suspect, everything up the line looks even worse.

The Next Black Swan will likely appear in the Middle East

A black swan is supposed to be unexpected and rare, but we see several on the horizon. Pakistan has long been an unsustainable country with grave risks of a blow-up in leadership at any time, but at least its military tries to keep the country in a peaceful mode. Iran is far worse, bent on impeding and punishing the world economy in a headlong rush for Persian dominance, implemented in a planned anti-Israeli genocide that does not even stem from affiliation with the Arab people. Iran commands a potential chokepoint for Western economies, just as does Indonesia. Foolishly, America has still not properly invested in energy self-reliance. Paradoxically, this may be an opportunity to turn around.

Germany will NOT bail out Europe, whatever happens bailouts will come from America and the IMF

It should come as no surprise that Germany will not be willing to turn itself into the primary guarantor of the entire EU debt mountain, despite lingering hopes in the next months. Germany is not a low-debt country itself, and counting future social commitments is at more than 5x its GDP. Germany will not bail out the southern Eurozone for cultural reasons alone.

But Obama is inclined to play the big money (or more precisely, fiat money) to maintain some stability, as he leads by following Bernanke. And in 2012, his calculation will be to act the hero and not risk a complete blow-up of exposed American banks, even though any intervention will barely last into 2013. The fix will be costly, weaken the US financial position still further, and solve nothing. Another super-expensive kick of the can.

America as a last resort global guarantor through the IMF will involve a partial default of Greece in the form of bondholder haircuts (specific default would damage American banks and holders of derivatives), as well as deeper nationalization of the troubled major banks in Italy and France and perhaps even Germany.

The main point here is that we are not expecting further EUphoria, and we also advise against taking large positions for or against the Eurozone in the first half of 2012, the political risk of intervention and market manipulation is simply too great for anyone but professional traders.

Market Recommendations this week: 

Equities: Fundamental analysis is critical but less secure from volatility and external events than ever before. Invest in day-trade managed funds, not overnight exposures. All derivative investments bear complex risks that are not for the non-professional (and possibly not for those as well). Play volatility gains and losses, not long term positions. The risk of governmental monetary market manipulation remains extreme. 

Commodities: Add to your allocations of Gold, which is a continued buy on weakness. Because of Middle Eastern risk and quantitative easing, even if the dollar strengthens further in continuing times of turmoil, Gold is worth having. Because of custodial risk, certain commodities like Gold should be held in kind.

International: European sovereign risk is not worthwhile even as a short-term gamble. Sell even China short, as continued recession in the West will inevitably pop several Chinese bubbles.

Bonds: Avoid most State-issued and municipal bonds that are badly out of balance. Despite the likelier Federal bailout potentials than is the case in the Eurozone, Arizona is Greece, Nevada is Ireland,  New Jersey is Portugal, Illinois is Italy, California is Spain.

  Onward and Upward !

Wishing you the best investing,

Michael Hentschel, TechVest Econometrics