Strategy Series MacroMarkets

US Economy: Structural Deflation? by Kintisheff Research

September 2, 2010 “If I had more time I would write a shorter letter.” - Blaise Pascal

Tsvetan Kintisheff Strategy Series deal with major topics that represent the cornerstones of our
kintisheff@volatiletimes.com macromarkets research framework over significant periods of time. The objective is
+49 (157) 78 90 81 19 to identify leading indicators for major trends in the economy and the markets that
can be applied towards timely and actionable investment recommendations.

We Lean Towards a Structural/Deflation Scenario for the Economy

INFLATION OR DEFLATION?
The debate over inflation vs. deflation continues not only among investors, but also among policymakers – as the Aug
10th FOMC meeting minutes suggest. We believe that adhering to a rigid definition of deflation as a decline in the CPI is
counterproductive. As long as a deflationary spiral is in place, which ultimately threatens a self-reinforcing downward shift in
aggregate demand, a negative CPI reading would be just an after-the-fact registration of this trend.
CYCLICAL OR STRUCTURAL RECESSION?
In our view, the inflation/deflation debate ultimately hangs on the question whether the current recession is mostly
cyclical (albeit deep) or rather a more structural development. If the answer is cyclical, then one may reasonably expect
monetary policy to ultimately correct the course of the economy. In this scenario, the scale of monetary intervention and the
potential difficulties of removing such large stimulus from the system, imply a material threat of inflation. On the other hand,
if the current recession is more structural in nature, monetary intervention will be of little use in averting deflation.
THE CREDIT CRISIS WAS SIMPLY A SURFACE EVENT
To view the recession as cyclical, one must also accept the 2008 credit crisis as the exclusive cause of the economic
downturn. We do not. We believe that structural imbalances had been accumulating in the system prior to the crisis, driven
by easy money, deregulation and trade imbalances. The 2008 episode was just one manifestation of this problem. A separate,
more recent manifestation, was the sovereign debt crisis in Europe. If this view is correct, more manifestations are likely in
the future. We define such manifestations as surface events – they are indicators of major, structural underwater currents.
EPIDEMIC OF OUTLIERS SUGGESTS STRUCTURAL SHIFTS
The symptom of structural shifts in a system is an epidemic of outliers – breakout highs or lows in key indicators. These
outliers suggest that the system model has lost stability and is in danger of exploding. We have multiple such observations for
the US economy (some reflecting reactive policy), including in the areas of employment, credit, and money supply.
BUY: DOLLAR, TREASURYS; SELL: EQUITIES, OIL, GOLD
The structural/deflation scenario for the US economy has significant implications for investment strategy. If easy
monetary policy is increasingly ineffective as a remedy for structural shifts, then low rates no longer will translate into excess
money supply. Thus, the multi-year bear market in the US dollar might be over. Long-term treasurys will benefit from
continued attempts by the Fed to restart the credit system. We see equities, oil, and gold as the losers in a deflationary
scenario.
KEEPING THE ANTENNAS OPEN
We are not a priori “deflationists” or economic bears. We are not the opposite either. We are in uncharted waters from
for the US and global economy, and any prejudiced stance is a luxury we cannot afford. We keep the antennas open for any
developments that might, on a cumulative basis, signal the need for a change in our stance.

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MacroMarkets | Strategy Tsvetan Kintisheff | US Economy: Structural Deflation?

THE DEFLATIONARY SPIRAL MIGHT BE SPINNING ALREADY

Fundamentally, there are two levers that take an economy from available resources (natural, labor, etc.) to a given level of GDP –
productivity and credit. The former arguably dominated the secular growth of the US economy until the turn of the century, mostly due to
technological innovation. Over the past ten years, the credit lever has taken over as the driving engine of economic growth, fueled by easy
money, deregulation, and financial innovation. We now witness two negative side effects of this development. One is debt overhang – we
refer to Richard Koo's discussions of “balance sheet recessions” for more on this subject. Another is withdrawal symptoms – the US
economy has been addicted to credit, which is no longer available. Both of these side effects are highly deflationary in nature.

OUTLIERS because of the increased number of people (incl. discouraged

workers) out of work – a dynamic that the headline unemployment
Excess Supply.
figure fails to capture. The latter can potentially signal a labor force
It is no surprise that capacity utilization is very closely increasingly willing to accept lower pay and more flexible working
correlated with the level of inflation. Naturally, idle capacity destroys arrangements, just as long as it can find work.
pricing power. Notably, such environment discourages private
The percentage of unemployed who cannot find work over an
investment is a negative factor in terms of employment.
extended period of time (15 weeks or more) is now over 60%. This
is a record high for this statistic, which has been tracked since
1948.

Deleveraging and Deceleration

The contraction in consumer credit not only continues, but is
actually intensifying. This trend now encompasses mortgages, auto
loans and revolving credit alike. For example, since Q4 of 2008,
outstanding credit card balances have declined by 14%. Over the
same period, limits extended on credit cards have slumped by 27%.
Since the invention of credit cards, there has never been a similar
episode of retrenchment revolving consumer credit.

But there is more to excess supply than just manufacturing

capacity. We are clearly dealing with excess labor supply – both in
the US and globally (we will focus on the global side of the
deflationary spiral in our future reports). The dismal US labor
market statistics are a major driver of the deflationary trend.

Importantly, consumer credit is contracting because both

sides of the deal are unwilling to participate. The US consumer
fears that excess labor supply will only make the labor market more
uncertain in the future. In addition, there is debt overhang.
The result is an inflection point in consumer behavior, and we
are in the midst of an upward shift in the US personal savings
rate. Notably, if consumers also smell deflation, which makes debt
We increasingly tend to discard the headline unemployment burdens more significant, their willingness to borrow will decrease
rate, instead focusing on the employment/population ratio and further.
duration of unemployment. The former is growing in importance

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MacroMarkets | Strategy Tsvetan Kintisheff | US Economy: Structural Deflation?

POLICY RESPONSE
The measures taken by the Fed since mid-2008 may be
viewed as unprecedented and unconventional. But in fact, they
have hardly been unpredictable. The Fed's action plan so far has
followed very closely Ben Bernanke's well-known 2002 speech on
anti-deflationary policies.

Banks in their turn are faced with unprecedented delinquency

rates. The percentage of outstanding US credit card balances that
are delinquent continues to reach new highs, and is currently
standing at 13.7%. The Senior Loan Officer Survey - a reliable
leading indicator of consumer credits in the past – is currently
pointing to increased willingness to lend on the part of US banks.
But we think that this time, the survey may prove a false predictor
of improving credit conditions in the US. “Credit easing” - the massive purchases of an wide range of
risky collateral - is perhaps the most high-profile measure
undertaken so far. Through this tool, the Fed has injected
enormous amounts of liquidity into the banking system, while
simultaneously propping up the prices and the liquidity of the
repurchased assets (mostly MBS) by acting as guaranteed buyer of
last resort.
However, banks have failed to put the Fed's fresh liquidity into
use. Instead, unprecedented amounts of excess reserves have
been accumulated, pushing the M2 multiplier below the 5x mark
for the first time ever. M2 velocity has contracted as well, reverting
all the gains induced by productivity or credit leverage since the late
1980-ies. Thus a ballooning monetary base, the economy's basic
financial resource, has barely been able to have a positive impact
on GDP over the past two years.

In the critical 2002-07 period, the last time willingness to lend

was high, the reading was correlated primarily with increases in
mortgage loans. Auto loans and credit cards lagged considerably.
There was already lack of faith in the creditworthiness of the US
consumer. Willingness to extend mortgage loans was underwritten
mostly by a buoyant MBS market, which appeared to distribute risk
and thus encouraged the lowering of lending standards – a factor
no longer present in the system.
In general, we believe that a tangible increase in mortgages
and other consumer lending is unlikely before the ABS/MBS market
recovers. Considering the high levels of consumer delinquencies,
the ability to repackage risk will be critical requirement before banks
decide to unlock their reserve vaults.

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MacroMarkets | Strategy Tsvetan Kintisheff | US Economy: Structural Deflation?

The next step in Bernanke's action plan, which too was However, we argue that the current situation in the US is not
also outlined in his 2002 speech, is to set targeted ceilings on long- too different. There is growing discord among Fed officials, as
term interest rates. The Fed will back these targets by massive minutes from the Aug 10th FOMC meeting suggest. Members of the
purchases of Treasury bonds. Unlike the asset purchase programs committee too are divided over the issue of whether inflation or
executed so far by the Fed, this next step will represent classic deflation is the more likely outcome.
quantitative easing – an outright injection of cash into the economy. Separately, the US benefited from global coordination of
In other words, this is the Friedman-ist “helicopter” solution. policy responses in the early days of the credit crisis. This
But is this solution adequate? Can the Fed really induce advantage has been lost, as the showdown at the Toronto G-20
growth and defeat deflation by simply creating new money? Ceteris between the US and Germany revealed. In the wake of the
paribus, an increased money supply can increase the general level sovereign debt crisis, Europe has chosen to emphasize fiscal
of prices – there is no doubt about that. But all other things are not austerity over monetary and fiscal stimulus.
equal in the current US economic slowdown. Broader availability of The agenda also differs for the US and the major emerging
money can address cyclical issues, but arguably cannot economies. China, India and Brazil are in the midst of tightening
compensate for structural problems such as debt overhang, excess cycles due to rapid real GDP growth and inflationary pressures
capacity, the apparent lack of new productivity drivers, and global associated with it. Also in tightening mode are two key commodity
trade imbalances. economies – Australia and Canada.
Japan is a case in point of how monetarist tools were Based on the above, we forecast two developments. First,
unsuccessful in thwarting deflation. Ben Bernanke and others have the deflationary spiral in the US is set to intensify. Second, the
argued that inability to act in a timely manner or set sights squarely Fed is unlikely to change course and will resort to long-term
on inflation are responsible for the failure of Japan's monetarist rate targeting. Such forecast has significant implications for
intervention in the early 1990-ies. investment strategy, which we discuss next.

CONCLUSION: INVESTMENT STRATEGY

A deflationary outlook, combined with predictable responses by the Fed, yields a range of investment opportunities. We see as clear
winners are the US dollar and Treasurys. We see equities and commodities as the main losers, with oil and gold particularly vulnerable due
to substantial bubbles in these two markets over the past couple of years.

Buy Dollars
In a deflationary environment, the Fed is likely to inject dollars into the
economy. It might seem intuitive that one should avoid going long the dollar.
However, unwillingness to lend and borrow implies that the new liquidity is in fact
“dead money” with constantly declining velocity. Thus, working dollars will be
increasingly hard to find. As a result, the value of the dollar will increase. This is
basically the Japanese Yen experience brought home to the US.
To gauge the propensity of the US dollar to appreciate in tight money
markets, one need only look back to the recent credit crisis episode. Note also on
the chart to the right the room that the dollar has lost during the credit driven
expansion in the US between 2000-2008. We believe that in a deflationary
scenario, all of this lost value can be recaptured.

Buy Treasurys
As the short-term interest rate lever is exhausted, we think that the Fed will
try to control intermediate-term interest rates. This will happen through massive
open-market purchases of treasurys, likely in coordination with the Treasury
Department, allowing the US government to increase spending, perhaps on major
infrastructure projects, and thus stimulate the economy. On the other hand,
treasurys will be a logical refuge for cash in a deflating economy. Thus, they are
the likely recipient of private investment outflows from other asset classes.
To summarize, in a normal cyclical recession, treasury yields converge and
the yield curve normalizes as the fed begins to tighten and short-term rates rise. In
a structural recession, we expect the curve to flatten out in a different manner –

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MacroMarkets | Strategy Tsvetan Kintisheff | US Economy: Structural Deflation?

short-term rates will remain at or near the zero bound, and longer-term rates will
contract. From this point of view, there is plenty of room for 10-year and 30-year
treasury bond prices to appreciate.

Sell Equities
Equities will be the first to pay the price for imploding liquidity in the US
economy. A high risk premium asset class, equities require ample liquidity and
trading volume to sustain their current multiples. It can be argued that much of the
Dow rise to 14,000 in mid-2007 was simply reflecting hidden inflation and dollar
depreciation. We expect exactly the opposite trends to be in place over the
foreseeable future.
Separately, in a deleveraging economy, it is not surprising that equity trading
volumes in the US have already been declining for several months. We note that
even though equity volumes have declined 50% from their peak at the hight of the
credit crisis, there is still a long way to go before volumes fall back to the levels
prior to the credit bubble. As this trend continues, equity multiples are bound to to
contract.

Sell Oil
Oil staged a record bull market in 2007-08 and has been in
correction/retrenchment mode ever since. Our deflationary scenario for the US
economy is very bad news for the “black gold”. The US is, of course, the main
direct consumer of of oil. However, via international trade, the US also influences
demand for oil and its derivative products in many large emerging economies.
Separately, we note that to a large extent, the 2007-08 bull market in oil was
due to financial engineering and growing liquidity flows into oil trading pits. For
example, since oil demand is driven by global economic growth, which in turn is
still largely driven by US growth, crude prices should track short-term treasury
yields. This correlation broke down in 2007-08, without an apparent shift in oil
market fundamentals. Now that the US economy is deleveraging, and dollars are
becoming precious and scarce, we expect the liquidity premium in oil to disappear.

Sell Gold
Gold is, of course, an inverted fiat dollar index. As long as we believe that the
US dollar will appreciate, we will also recommend selling gold. But there are
additional reasons why we would shy away from gold, even if our deflationary
scenario does not materialize. While a complete discussion will be reserved for a
future report, it is safe to mention here that sings of a liquidity bubble in the gold
market, not unlike the NASDAQ, housing, and oil fevers from the past decade, are
omnipresent. For example, when one sees gold on TV late night commercials and
gold vending machines in German hotel lobbies, this is probably a time to bail.

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MacroMarkets | Strategy Tsvetan Kintisheff | US Economy: Structural Deflation?

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