“Deflation World” is coming. For many, if not most, it is going to be a bizarre and disorienting experience.
Most investors will fail to understand what is happening, or to process the consequences of what deflation will mean. And many of the “normal” financial relationships investors have come to expect will seem to run backward, like a movie playing in reverse. It is going to get weird.
Deflation will be a bizarre experience in part because investors today, of all ages, have never lived in Deflation World — our term for a world where overall deflation pressures are persistent.
This is because almost everyone alive today has only known “Inflation World” — the opposite of Deflation World — their entire adult lives.
If you were born in 1930, like Warren Buffett or George Soros, you would have experienced deflation as a child — but it would have ended by the time you were a teenager (and you would be almost 90 now).
In terms of real-world experience, the closest thing to deflation today’s investors know was the dramatic-but-brief price collapse during the “Great Recession” of 2007-2008.
There were no lessons learned from the Great Recession, however, because the window of deflation was too brief. Global central banks rode to the rescue, expanding their balance sheets by trillions in a giant financial experiment that is still ongoing, and the deep psychological takeaway from 2007-2008 was “double down” and “buy the dip.”
The United States has known deflationary periods before, sometimes for decades at a time. In the 19th century, deflation took hold from 1817 to 1860 and 1865 to 1900. The most famous (and brutal) deflationary period took hold in the 1930s.
It is very hard to imagine deflation today because we have more or less had the opposite — the persistent presence of inflation — from 1950 onward.
But deflation has been making its way toward us for a long, long time. It is a natural phenomenon born of truly long-term cycles.
These long-term cycles are based on the natural consequences of debt-and-credit levels waxing, and then waning, in multi-decade trends.
Starting from a low base, debt and credit levels build up for a very long time (multiple decades). Then the debt load becomes too much, and the existing debt has to be worked off. This also takes decades. After the excess debt has been worked off, the cycle starts again.
That is the long-term debt cycle in very condensed form. We are now at the end of a long-term debt cycle that began in the early 1980s, which means debt levels have exploded (and will explode even further in the coming years).
The world’s massive debt overhang, born of nearly 40 years of debt and leverage accumulation in a long-term debt cycle, will be a persistent deflationary force.
The global demographic picture, more bearish now than any point in the past 500 years, in terms of the ratio of retirees and savers to workers and spenders, will also be a persistent deflationary force. (Retirees tend to draw down on their savings, spend little, and rely on pensions, in comparison to the younger generations who continue to work, save, and spend.)
Then, too, U.S. corporate profits have been flat for eight years or more.
- In the first quarter of 2012, U.S. corporate profits after tax amounted to roughly $1.9 trillion (according to data from the St. Louis Federal Reserve).
- In the first quarter of 2019, corporate profits after tax amounted to — $1.9 trillion, the same number.
But hold on, you might ask. If U.S. corporations haven’t made any real money since 2012, how is it that stock prices have been going up? And how is it that earnings have improved? How do you have earnings increases without profits?
Easy — you borrow huge sums from the banks at near-zero interest rates and use the borrowed funds to buy back shares. If you have the same-sized earnings on a smaller pool of shares, your earnings look bigger. Corporate share buybacks, executed en masse, are a way to massage the appearance of higher earnings.
It’s a giant game of financial engineering. A blue-chip company whose business outlook is going sideways, but has major access to credit via near-zero rates, can borrow like crazy, and use low-cost debt leverage to make its earnings look better (via share buybacks that reduce the share count). Investors see earnings per share go up — even if real-world profits are not rising — and they are satisfied.
Then, too, workers haven’t been making any real money either. U.S. labor compensation as a share of GDP is near its lowest level ever — less than one percent above its all-time lows in 2010, a period when corporations were able to cut worker pay dramatically via the justification of Great Recession challenges.
So, corporations aren’t really making money. Workers aren’t really making money, either.
Where is the money going then? It’s going into debt, and ongoing costs of servicing the debt — and especially into corporate debt, as corporations have exploded their balance sheets to finance share buybacks, in order to reduce share counts and make their earnings look better.
All of this — the demographics, the flat-lined corporate profits, the exploding corporate debt levels, the looming end of the long-term debt cycle — was already extremely deflationary in its implications.
And all of that was before the pandemic.
Now, in the midst of the pandemic — which is still very much ongoing, with the true impact on earnings not yet felt — we are seeing the 10-year U.S. Treasury yield less than two-tenths of a percentage point above all-time historic lows.
And we continue to see short-term rates scrape along above zero, with the Fed Funds forward curve still forecasting negative rates by Summer 2021.
Again, this is all very deflationary. The bond market is sounding the alarm. And the Federal Reserve cannot “print” us out of this. The deflationary pressures are too vast, and the Fed’s “bazooka” is more like a peashooter in comparison to the scope and scale of this problem.
(Then, too, the Federal Reserve can’t actually “print” money at all — it is highly constrained by the limitations of the Federal Reserve Act and the Banking Act of 1933 — but that is a topic we’ll explore another time.)
Dr. Lacy Hunt, an internationally known economist and money manager considered to be one of the top macroeconomists in the world today, has pointed out that, in the aftermath of major U.S. recessions in the past few decades, the overall level of inflation has tended to drop by 400 basis points (about 4%).
Inflation levels tend to drop after a major recession not because of the recession itself, but because the U.S. government piles on new debt in response to the recession, and rising debt levels are deflationary.
This is because, when a nation’s debt load becomes too much, it is like a great weight on the back of the economy, slowing down growth and causing strain as debt service costs go up.
Then, too, the more debt you already have, the more danger there is of a deflation “tipping point” when additional debt is added. The economists Kenneth Rogoff and Carmen Reinhart completed a famous study across multiple countries and timeframes which argued that, when government debt exceeds 90% of GDP, the presence of additional debt can suffocate economic growth.
The U.S. debt-to-GDP ratio was already at 106% in the fourth quarter of 2019. That is well above the Reinhart-Rogoff 90% warning threshold — and that was, again, prior to the pandemic and real-economy crisis and multi-trillion-dollar emergency debt response.
When you add it all up, as we have already noted, Deflation World was on its way before the pandemic, as a result of issues that had been building for many years, if not decades.
And then the pandemic came along, hyper-accelerating new government debt issuance, while ushering in a real-economy crisis that is going to be a wrecking ball for corporate earnings (even if the stock market refuses to acknowledge that just yet).
We are heading for Deflation World with a very, very high degree of probability — and it is going to feel very strange relative to what we were used to.
Take real estate prices, for example. In Deflation World, general real estate prices could actually decline year-on-year, for a very long period of time.
That means a home buyer in 2020 could try to sell that same property in 2030 and receive less than they paid for it.
The possibility of real estate prices seeing net declines for the next five, 10, or even 20 years is one of those concepts that blows people’s minds, because it is so foreign to what we know in our bones.
But it is also perfectly in line with what we know about real estate prices generally over the very long term, which is that, in a big-picture sense, real estate returns are in line with overall inflation levels.
That in turn means that, if real estate outperforms inflation for decades at a time, there will also be periods when real estate does the reverse — via subpar or even negative returns, especially in the presence of deflation.
In Deflation World, many other relationships in finance could be turned on their head. For example:
- Debt accumulation to fund leveraged buyouts, the bread and butter of private equity, could be a terrible strategy in a deflationary environment. (Private equity will be in big trouble.)
- Price-to-earnings multiples for stocks, and for the stock market as a whole, will spend years in contraction (shrinking) instead of the ongoing expansion we’ve gotten used to.
- Blue-chip companies with heavy debt loads will find the burden of their debt loads increasing, and investors will shun these companies as stock investments, rather than embrace them, as debt-to-equity ratios worsen (via declining multiples and reduced profits).
- Instead of “cash is trash,” the new mantra will be “cash is king,” and not just for crisis periods but on a general basis and over long periods of time — even if that cash is ultimately denominated in something other than U.S. dollars (e.g., Bitcoin via smartphone crypto wallets).
- The “financialization” of the U.S. economy, in which financial engineering seemed to take over everything in a frankly disgusting way, will be thrown into reverse, and “de-financialization” will be the new norm for a long time.
There is lots more to consider — we are only scratching the surface here.
The arrival of Deflation World will not rule out “micro pockets” of inflation or even the possibility of “Inflationary Depression,” meaning, nasty price spikes will likely still occur around shortages of consumer staples due to broken supply chains.
Nor would central banks give up their heroic attempts to fight deflation, even if Deflation World arrives.
The problem the central banks will discover is that all their tools for fighting deflation will be worthless — except for the really, really “nuclear” style options that involve even more extreme measures than we’ve seen. And those options, if tried in earnest, would run the risk of destroying the currency.
This is where we are headed. The evidence is overwhelming and all around us. Get ready, because Deflation World is coming.
