Counter Intuitive: Inflation, Deflation or Stagnation

The other day I was exercising my mind, trying not to hurt myself, around the arguments for and against inflation.  There seems to be enough consensus that an inflation trade is less a matter of if and more a matter of when.   I am writing here to offer at least one reason why inflation may not materialize.

Government spending need not lead to inflation as long as the supply of currency does not exceed demand.  In a deflationary period the demand for cash spikes.  As asset values are in decline the safest place to park wealth is in cash and cash equivalents.  This drives nominal yields down, but real yields remain higher than nominal yields as long as the economy is deflating.   As the cost of goods and services is in decline each dollar becomes worth more in real terms.  There is no single country in the world today besides the United States that can provide the volume of liquidity desired.

At some point in the future, however, when the risk taking returns with the prospect of a new growth cycle, conventional wisdom is that the excess liquidity will lead to inflation, and in our case today it could lead to massive inflation or even hyper-inflation.  However, this scenario presupposes that as the cycle reverses we are not working to tighten our currency again.  It also presupposes that we would be looking to remain a debtor nation.

While the balance of debts at the end of this crisis will certainly serve to weaken the dollar, our new administration at least plausibly has the gumption to do what it takes make sure the US pays its debts.  In that scenario we would see a strong plan towards a balanced budget aided in large part to additional tax revenue, likely from the upper class and from the war on energy independence.  As Obama has stated we will see a large deficit for some time, by my guess is he will work to make sure it is gowning smaller and not larger.

As a debtor nation, our debt holders will want the faith that an expanding economy will be able to provide the economic strength required to service and retire our debts.  While raising taxes generally has the opposite effect, the current administration will be walking a tightrope of fiscal and monetary policy.  In addition, with advisors like Paul Volker in the shadows, I don’t think the current easing will be abused as it was by Greenspan.  As soon as we see a recovery underway I would venture to guess that monetary policy will grow quite hawkish rather quickly, further stifling a rapid expansion and ensuring a prolonged muddle through.

Regarding current market levels, valuations, and earning multiples there has been a lot of talk about bear market PE multiples falling into the single digits.  While I have generally felt this was the natural order for where we are headed, the counter intuitive argument from mean reversion in earning multiples lies in comparing inflation and interest rates with past troughs.  As long as interest rates remain low and inflation remains low, earning multiples may see their bottom where they have been, in the low double digits.  What many people who argue that 1970’s earning multiples bottomed in single digits forget is that interest rates and inflation in those days were much higher then than they are today.  From a simple discounted cash flow perspective, using interest rate assumptions as low as they are today provides some serious support for current market levels.  I’d guess the major indexes remain range bound unless or until real earnings come under new pressure.

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