Inflation is not yet on the corner

As I have argued, Ray Dalio also believes that inflation is not just around the corner…yet. In my view, consumer price inflation is cyclical and therefore not embedded, but deflation is secular. That makes a big difference when considering policy responses.  But I have been arguing since October that some austerity is inevitable, if for purely political reasons. So, the present worldwide deleveraging in the public sector will lead to a deflationary outcome.

However, with governments printing money, inflation, now propping up asset prices, will eventually come to consumer prices. First the deflation, then the inflation, I say. Ray Dalio agrees. But, he also has some choice things to say about the situation in Europe.

From this week’s Barron’s:

Barron’s: We last spoke in February 2009, exactly a month before the bottom in the U.S. stock market. A lot of money has been printed.

Dalio: Governments always print money. Last year was very similar to March of 1933, although we hadn’t contracted for nearly as long, and the Federal Reserve was much quicker on the trigger. They didn’t let the economy get so bad; they moved a lot faster and in large quantities. The whole world did — all the major central banks and all the major governments did what was done in March 1933. Classically, there is big monetary stimulation and big fiscal stimulation, and we had that globally in a  magnitude that we had never had before…. It caused the stock market to retrace about 60% of its decline, and it caused the U.S. economy to retrace 40% of its decline. But it did not produce new financial assets. There has been very little new lending. The stimulus produced very little in the way of economic activity.

[Barron’s:] A year ago you thought it wouldn’t be until late 2010 that we would get the best opportunity to buy stocks.

The government response was quicker and larger than I thought it would be. But the boundaries of the old highs and the boundaries of the lows in the stock market and in the economy will be with us for a long time. If there were to be a decline in economic activity below the prior low, it would be intolerable, and central banks would print money again. The risk to that right now is that public sentiment has turned more negative about perceived bailouts. There is a lot of criticism about saving financial institutions and running a big budget deficit, but if the government didn’t do those things we would be in a terrible situation. It will be impossible to stimulate that way in the future because politically it is untenable. That’s a risk because, between now and 2012, the economy will probably go down again, and it will be important for monetary policy and fiscal policy to be able to be stimulative, and for the Federal Reserve to be able to purchase assets again.

[Barron’s:] Are you suggesting we will experience something of the magnitude of 2008-09?

No, that won’t be allowed to happen again, although, inevitably, there is another recession out there. It will probably come sooner than most recessions do. Usually, there is about five years between recessions, but for various reasons related to the size of the debt, the next recession is going to come sooner. We are in the equivalent now of a quantitative easing-induced cyclical recovery. But it is a fragile recovery, and credit growth is not picking up very much, and it goes back to the fact we still have too much debt. We have not reduced our debt burdens in any way significantly. What we’ve done is to largely roll them to the vicinity of 2012 to 2014. Corporate balance sheets are much, much better because they extended the maturities of their debt and slashed expenditures by laying off workers. I would be shocked if we saw new lows in the economy, but you can’t go to new highs anytime soon, either…. The average American’s net worth is less, and incomes are less and so the amounts they can leverage will be less — so for a long time spending rates will be less than they were at the peaks.

[Barron’s:] How do you view current developments in Europe?

Europeans are faced with the same three choices we were facing in dealing with debt — print money, redistribute money, or restructure. The European situation is a  particularly risky one for a number of reasons. One, the size of the debt dwarfs that of any other debt crisis. It dwarfs the Latin American crisis. It dwarfs the Asian Contagion. These are enormous, enormous amounts. A lot of attention is paid to the sovereign debt, but there are also big private-sector debts. It doesn’t make much difference whether it is government or private, there is way too much indebtedness in these countries….

It’s a very frightening situation because there is a  risk here that the Europeans will not move decisively or quickly enough. There is a pulling back of capital at a time when the need for capital is greater. There is rollover risk. Spain, for instance, has to roll over 40% of its external debt, which is about $700 billion to roll over, and because it is running a current-account deficit, it actually has to borrow more than that, which is almost another $80 billion. Just the government has to roll over about 20%, or about $125 billion. Spain will have to borrow more than it has ever borrowed before in the next year at the same time as people’s inclination to lend to Spain is reduced. The government debt of all the peripheral countries in the euro zone that has to be rolled over in the next three years is the equivalent of $1.9 trillion, and that doesn’t include the private-sector debt.

Edward here.  So what does this mean for investing.  Dalio explains.

[Barron’s:] How are your portfolios positioned?

Our portfolio is mostly skewed to Treasury bonds, gold and emerging-market currencies, especially Asian currencies. We also hold commodity assets that are limited in supply and that high-growth emerging countries need. I want to minimize my exposure to the major developed countries’ currencies — the U.S. dollar, the euro, the British pound and the yen — because those countries have a lot of debt, and they are going to need to print more and more money and will have more sluggish growth rates. I prefer the yen to the others. However, none of these can get too far out of line with the others, and when there is downward pressure on one, there is pressure on all. Just as the notion that the G-7 countries represent the major world powers is obsolete, it is also an obsolete notion that their currencies are the major reserves of wealth.

The depreciation of the major currencies and the printing of money will not cause a significant general level of inflation anytime soon.

[Barron’s:] Explain why the printing of money won’t cause inflation.

The printing of money will offset the deflation that is coming from the weak demand for goods and services due to weak credit growth. For example, in March of 1933 the U.S. printed a whole lot of money, and that had the effect of converting deflation into modest inflation, but not a high rate of inflation…. My point is, in developed countries there is too much of most things at the moment, and that’s creating a  deflationary environment. There is too much manufacturing capacity. There is too much labor. There is too much housing stock. As Europe’s economy weakens and its debt crisis worsens, the printing of money does not mean that it will produce an accelerating inflation because simultaneously there is also less being purchased, and the surpluses are already causing deflationary pressures. That is why, contrary to almost everybody’s belief, I believe the bonds in countries that can print money will be good investments.

[Barron’s:] Thanks, Ray.

But, in countries that cannot print money, you have a problem.  The Eurozone is different from the US or the UK as long as it remains intact; unless the ECB starts printing a lot more money ie starting massive unsterilized credit easing via purchases of Greek sovereign debt, the Euro acts as a de-facto gold standard for member countries. Think of the Euro as gold and the Euro countries as having implicitly retained their national currencies with a fixed rate to gold.

Deflationary forces are, therefore, that much greater as we are now realizing. It will either be default for the weakest or socialization of losses and risk contagion within the Eurozone. For everyone loading up on German Bunds, that is something to consider – ie the socialization of losses from weaker debtors to stronger debtors within the Eurozone.