Inflation vs. Deleveraging
The majority of the developed world is currently dealing with one whopper of a liquidity hangover. Across the world households, businesses, and government got themselves hooked on the drug of cheap and easy debt. When the markets inevitably cut the supply the liquidity drug, the Fed quickly stepped in to keep at least the U.S. junkie functioning with a rapid rise in banking reserves through the “toxic asset” bailout. This bailout created an environment ripe for rampant inflation. From August of 2008 to January of 2010, big-bank cash balances at the Federal Reserve increased at an unprecedented scale from $10 billion to $994 billion. Using the historical money supply multiplier, this could result in an increase in the money supply that is 9-10x the increase in reserves, meaning an increase of almost $10 trillion dollars in the money supply. To put that into perspective, the current supply of U.S. dollars in circulation is estimated to be a bit over $14 trillion. Clearly an additional $10 trillion entering the economy would cause massive inflation… so why aren’t we seeing any indication of that yet?
For the additional bank reserves to make their way into the economy two things need to happen: (1) banks need to want to lend and (2) households and businesses need to want to borrow. The chart below shows an astounding increase in debt as a percentage of GDP from 2000 to 2007. For the United States, the majority of that increase was in the form of residential mortgages.
If we look at the composition of debt, only the UK and Switzerland have higher household debt as a percentage of GDP. While I love to gripe about our out-of-control national debt, household debt is currently an significant problem as well.. The BRIC nations have comparatively insignificant levels of household debt, which gave them a lot more wiggle room during the global meltdown.
Household debt in the United States is exceptionally high and unemployment continues to plague the economy. We’ve got ourselves into quite a pickle. Businesses are hesitant to expand with consumers unlikely to increase purchasing significantly due to their debt load and the unemployment rate. With production well below capacity, the need for businesses to borrow when they do begin to expand is minimal. The unemployment rate obviously impacts households’ ability to pay down their debt is unlikely to improve much as long as businesses hold back on expansion. Add to this that we have yet to see the true impact of the real estate debacle in the commercial sector AND we still have a good ways to go on in the residential foreclosures. All this creates a wet blanket on the potential inflation fire and creates an environment in which banks are unlikely to dip much into their pool of reserves. That being said, I would be very surprised if we don’t experience some type of challenging inflation, but exactly when that occurs is a more difficult question to answer. The global economy is an extremely complex system with nearly infinite variables whose level of impact is endlessly changing. We approach this market with humility and caution, knowing that what is unknown vastly outweigh what is known.
So what are we doing about it? Either way, we expect that with all the debt out there, interest rates will rise so we have significantly shortened the duration of our bond holdings and are underweight in domestic equities. As I mentioned in an earlier post, domestic equities are also currently over-valued. This is an environment in which a good defense is the best offense as we wait for the inevitable opportunities to emerge, holding firm to our principles of valuation and tactical allocation.
