I find it best to think of the monetary environment as a great tug of war. On one side is inflation which threatens to blow price asset bubbles, raise worker wages as well as prices and set in place an expectation of further inflation. Unchecked, this leads to hyperinflaton, destruction of the currency and eventually economic collapse. Think Weimar Germany of the 1920 or more recently Argentina. Pulling against inflation is deflation, a dropping of prices due to either excess supply or deficient demand. This leads to industry shutdowns, unemployment, lower wages and also loss of corporate profits. Think the Great Depression.
While many people tend to concentrate on warning of one or the other, I like the tug of war analogy. There are plenty of inflationary as well as deflationary forces in the world. The key is whether or not they are balancing each other or whether one is getting the upper hand. Usually there is a back and forth as one side begins to gain ground and the other gives it followed by a reversal as the losing side pulls back. The great fear of the bears on either side is that one side will win, dragging the losers through the mud and causing an economic collapse.
The great deflationary force today (perhaps a better term is disinflationary force) is globalization. This introduces more and more workers into the world economy and keeps wages down, prices down and corporate profits up. Against this is the greater demand for commodities as the world develops and the high profits spawning price asset bubbles. The US trade deficit and growing national debt seems to require a dollar decline which would lead to inflating prices for the US consumer. For the most part, these forces act to cancel each other out. Despite the fact that each team is pulling harder than before, things haven't moved much. The last two decades have seen low and stable inflation.
There are the gold bugs who think that paper money is the root of all evil and that the promoters of this great evil are the Federal Reserve and other central banks who aim at positive inflation. Their prediction is always hyperinflation where gold will soar in dollar value and the gold bugs themselves will become imensely rich. So far these gold bugs have had miserable returns as they missed the great bull market in stocks from 1982 to 2000 even considering the rather impressive gain in gold of the past few years.
On the other hand are the deflationists. Gary Shilling comes to mind as their chief proponent. At least with Gary Shilling we find someone who has made some excellent returns with his predictions. Gary made the excellent decision to buy zero coupon 30 years treasuries at their yield peak in 1980 and keep buying them (even on margin) through all of the great bond 25 year bull market. His return has been over 20% anualized since bond yields have fallen due to the change from the high inflation 70s to the low inflation 80s and 90s. Shilling still predicts that the disinflationary forces of globalization will dominate and cause outright deflation. He predicts a popping of the housing bubble and a decline of US house prices by as much as 30%.
Who is right? I tend to side with Shilling who makes some excellent arguments. However I also wonder if there is something else at work which makes the inflation/deflation distinction, the wrong way to look at things. Certainly I see the housing bubble deflating. This is clearly deflationary and will lead to a US recession. But what of the rest of the world. I think they are unlikely to decouple and will follow the US into a world recession. But what of the dollar? It does seem that the trade deficit cannot get much larger and that foreign holders will eventually dump dollars driving up interest rates. So can one be a dollar bear and still a deflationist? Shilling is not a dollar bear as far I understand. How can he deny the dollar weakness? Can't the Fed simply inflate the currency and reflate asset prices if they choose. This seems to be what PIMCO bond guru, Bill Gross predicts. Of course this can cause inflation just as the Fed bailed out the NASDAQ crash in 2000. But then again, if a world recession hits, no country will want too strong a currency. So perhaps the Fed can ease significantly without the world dumping dollars. Perhaps investors will pull out sharply from foreign investments to buy safer US assets which will prop up the dollar. I think this is Shillings idea. The US dollar is a safe haven. Asian currencies are not. So how does this all work out? I find this quite perplexing. I see great danger in financial markets but am unsure of how to avoid it.
My solution so far is to buy some safe, large multinational US stocks like JNJ, KO, MO concentrating on the less economically-dependent areas like health care and consumer staples. I figure that these seem rather hedged against either senario and are
reasonably priced. About 60% of my money is still collecting 5% in the money market due to indecision and fear of these threatening global imbalances.
