September 2011
Ivan Obolensky

I was asked by several friends to write about what I think is currently happening with the markets, so here are a few thoughts:

The US markets have been in a long-term trading range. The S&P 500 (an index made up of 500 medium-to-large companies) hit a high in 2000-2001 at 1600, fell to around 800 in 2003, went back to 1600 in 2007 and dropped again to 800 in 2009. Lately, it has hit close to 1400 and has come down to the 1100 level oscillating between roughly 1100 and 1200 with huge moves on a daily basis.

I am sure one is aware of the news about Europe, the bad economy, and a myriad of other data. I will concentrate on one thing: the tug-of-war between inflation and deflation, because that is what is happening with the markets.

So what is inflation? One definition is: Too much money chasing too few goods.

If there is a scarcity of goods to buy while there is plenty of money available, prices are bid up as people compete for ownership. An example is the real estate boom in the United States during the early 2000s. Although this was primarily driven by easy credit access and low interest rates, prospective home buying was competitive and home prices inflated rapidly.

This wasn’t the first time this happened. In the ’70s and ’80s inflation became the norm with sharp rises of food and gas as well as the cost of almost every item. Much of this was the result of excessive government spending on social programs, the Vietnam War and the space program. There was an abundance of money.

What happens during inflation?

If there is inflation and prices in general are going up, it is better to own things rather than money. Money will buy less and less going forward so the proper wealth preservation and creation strategy is to buy a lot of things and hold actual money for as short a time as possible.

In this case, it pays to go to the bank and get a loan to leverage your ability to buy more things. Later one can sell them, and one will have a lot more money because of rising prices.

To moderate this strategy (which often happens during a booming economy) central banks raise short-term interest rates to discourage borrowing.

By raising interest rates high enough, it eventually becomes uneconomical to buy more things. Imagine if one could get a return of 20% per year guaranteed by the US government and inflation is 10%. It would make more economic sense to keep the money in an interest-bearing account and stop buying things. This slows and breaks the inflation cycle. This is what was done in the early ’80s and inflation was gotten under control.

This handling had several unintended consequences:

The first was that people in other countries thought that a 20% guaranteed return was pretty good also, so money began to come into the United States from abroad in great quantities. This meant that the dollar rose in relation to the currencies of other countries.

If one was in Great Britain and wanted to invest in the United States to get 20%, one would need dollars so one would sell British pounds and buy dollars to deposit in a US bank. If done in enough quantity, dollars would start to cost more and the pound would be worth less. This is the way currencies work.

Interest rates peaked in the early ’80s but did not come down right way, so money kept pouring in to the United States. The dollar became very strong in relation to other currencies.

With the strength of the dollar, US products in the world market became very expensive. US companies wanted to be paid in dollars so a foreign buyer of US goods had to buy dollars to pay for them. Although inflation may have been halted in the United States, US goods received an inadvertent 50-100% price hike abroad because US exports grew more and more expensive compared with locally made goods while imports into the US became cheaper and cheaper.

This resulted in an economic slowdown in the United States due to declining exports.

It also meant that US companies could buy manufacturing capabilities abroad for 50% less than the cost of paying for them in the United States. It made more economic sense to manufacture abroad. Within ten to twenty years starting in the early ’70s, US manufacturing was cut to ribbons.

It should be noted that the decline was not because the United States became incompetent overnight. This debacle came about from a strong dollar, the result of high interest rates implemented to fight inflation which came about due to earlier excessive government spending in the ’60s.

Another unintended consequence was that lending rates rose. If one could have money in a money market earning 15-20%, then credit cards could also earn 20-30% in interest. After all, if a bank had to pay out at 20%, loaning at 25% was not out of the question. But what if those lending rates were never lowered when interest rates eventually started coming down in the 1990s?

Well, that is why credit card interest rates are so high. They just never came down. Banks made a great deal of money from this rate disparity in the ’80s and ’90s and this excess helped create a housing boom.

It is ironic that the sea of money made through high credit card interest issued by banks helped create an excess of amount of consumer credit, which precipitated a housing crisis that rocked the same banks and the financial world in 2008.

So what about deflation? Deflation is in many ways the opposite but with a twist. With deflation there is not a great deal of money; in fact there is too little. Rather than prices rising, they fall. The twist is that it is much harder to deal with deflation from a central bank perspective. In fact, no central bank has successfully dealt with it to date. That is why central banks would much prefer an inflationary environment.

In the mid-80s the US dollar was high in relation to other currencies. In 1985, the United States announced to the G5 members (the Group of five leading economies that has expanded to 20 and now includes heads of state) that the United States was planning to reduce the value of the dollar in relation to other currencies by approximately 40%. This was because US goods abroad were very expensive and imports were rising. American business had been feeling the squeeze for some time and there was mounting political pressure.

What would you do if you knew your overseas investments were going to take a 40% haircut? And what if it amounted to millions and millions of dollars invested? One would start to liquidate and repatriate the money, which is exactly what Japan did. Japan had during this time turned into an economic powerhouse. Much of this was due to the previously mentioned currency changes as the result of US inflation handling, and much was due to a complete redo of Japanese manufacturing as it ramped up exports particularly to supply US demand. Much of this accumulated wealth found its way back to the United States in the form of investments until the 1985 announcement. The stock market crash of 1987 may have been a consequence of this repatriation. At any rate, those funds came home to Japan and went into the Japanese stock market instead, which soared and peaked at the end of 1989.

But Japan had a problem. The price of a cup of coffee now cost 100 dollars if you were from the United States and all the real estate of only the city of Tokyo was worth more in dollar-terms than the entire United States. This gigantic price disparity was fueled not only by repatriated dollars from the United States but by individuals and companies borrowing and re-borrowing as prices rose, resulting in a bubble. Asset prices soared. Then the market peaked and fell. Loans were called and some were found to be bad loans. Asset prices began to sink.

One way to create deflation is to make money disappear, as in a large default or market crash. Banks have to have collateral and assets in order to make loans. If a large portion turns out to be worthless, the bank is forced to raise capital to bring its capital levels up to what they should be. Because lending slows down, there is often an economic slowdown as well.

Central banks, including Japan, have a policy of lowering interest rates in order to make money easily available for businesses to spend, so as to stimulate the economy. The Japanese began to lower interest rates but the economy remained anemic and prices continued to slowly drop year after year.

In the ’90s or early 2000s I remember the announcement of a Japanese stimulus package. It was going to put several billion dollars (several trillion yen) cash into the hands of the consumer to stimulate the economy. Observers waited for some reaction. There was none.

Where did all this money go?

It seems it went into the freezers of thousands of Japanese homes. How come? If prices are going down at the rate of 10% a year and you don’t trust your bank, one solution is to store the cash in a freezer until you need it. In effect, that money is earning 10% because its buying power is increasing. That same money is worth more and more without even earning interest.

An unintended consequence of low interest rates was eventual negative interest rates. This came about because the banks were so mistrusted that it was worth paying the Japanese government 1010 dollars (or so much yen) to receive back a guaranteed 1000 dollars in six months.

Another unintended consequence was that retirees have little opportunity for interest income to live on and, in a country with an aging population, this has created a great deal of hardship which continues to this day.

Japan has been the only country in very recent times that has experienced long-term deflation. Growth has been virtually nonexistent for the past 20 years.

If much of the above sounds like the real estate bubble in the United States in the early 2000s and the bank blow-up of 2008, it’s because it’s true. What has happened and is happening in Japan may be a precursor to what will happen in the United States.

So what is happening in the markets today is the seesawing back and forth of market perceptions as to whether we will have inflation or deflation. Everything that is happening is the result of the uncertainty as to which camp is correct.

When the US Federal Reserve puts billions into the economy, there is the prevailing belief that inflation is around the corner. Stocks and commodity prices rise.

When there is risk of a large default or the fact that housing prices are slipping and foreclosures are rising, and banks have to raise capital to cover bad loans, then the prevailing view is that deflation is winning and commodities and stocks sell off.

As talk of bailouts increase, the inflation camp has the upper hand and stocks and commodities rise.

So where does this leave the markets? They are still in a tug-of-war with neither side fully in control. In my opinion the inflation scenario is not cut in stone, and deflation is a bit more likely.

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© 2011 Ivan Obolensky. All rights reserved. No part of this publication can be reproduced without the written permission from the author.