Winners and Sinners
The Boogeyman
Is Deflation
BY MICHAEL MARKOWSKI
T
here is one huge potential risk to
the economy and the stock market
that is being overlooked: deflation.
It’s by far the biggest hurdle that the
United States and global economies must
get over. Otherwise, the global economy
will sink into an extended depression.
Though deflation is the most significant risk facing the stock market and the
economy, I can’t recall it ever being discussed by media pundits and analysts.
Deflation is reviled by central
bankers and economists, who consider
it to be the evil twin brother of inflation. Left to his or her druthers, any
sane economist or central banker would
rather deal with the problems caused by
inflation over the problems caused by
deflation on any day.
The 1930s demonstrated that deflation is most dangerous when debt burdens are heavy, as they were in the
1920s and in 2008. The lethal combination of the global credit crisis and
declining hard and financial asset prices
have allowed the seeds of deflation to
be planted in the U.S. and global
economies.
There is ample evidence that Bernanke,
his predecessors, and many of world’s economists have been schooled in what causes
deflation. However, it’s important to understand that there is not currently an economist or central banker that has any handson experience on how to deal with it.
12
EQUITIES / JANUARY 2009
One of the misnomers that everyone
believes is that the result of the government’s intervention and bailouts is
inflation that will soon rear its ugly
head. I disagree. The main reason is
that in a deflationary environment, investors seek out guaranteed debt investments because the value of most
hard and financial assets—including
corporate bonds and a majority of
stocks—are in decline.
Given a deflationary scenario, the security behind the credit of corporations and
individuals is declining in value. Therefore,
the most secure investment during a deflationary period would be U.S. Treasury debt
securities. This is why the demand for U.S.
Treasury bills and notes has driven their
prices to all-time highs and their yields to
all-time lows as of December 2008.
Conservative and knowledgeable investors are putting their monies in U.S.
government debt securities because they
know that they are guaranteed repayment
by the full faith and credit of the government. The U.S. government’s ability to
levy taxes on its citizens enables it to enjoy the top credit rating in the world.
On the other hand, the yield on corporate BAA rated bonds are up from 6.5%
in 2007 to 9.2%, and the spreads between
them and government bonds are the highest since 1932. The fact that investors are
shunning high-rated corporate BAA
bonds with yields above 9% and instead
investing in governments with yields at
under 4% confirms my argument that deflation, not inflation, is the issue.
Should deflation clamp its jaws down
on the U.S. and/or global economy, it
would be difficult for even the top blue
chip corporations to pay their debts in
full. This is because the value of their assets, including inventories and plant and
equipment, would be depreciating along
with lower revenues and profits.
U.S. banks would also have a problem
in paying off their depositors because the
value of their collateralized loans would
be depreciating faster than the repayment
or amortization schedule of principal and
interest payments.
The U.S.’s top-notch credit standing
gives it the ability to borrow at will. It has
been able to do so at increasingly lower interest rates or yields. Ultimately, this country’s credit rating and its ability to borrow
at will for its economic intervention programs and stimulus packages will come
back to haunt it.
Our shrinking taxpayer base due to
bracket creep and the fact that 76 million
U.S. baby boomers will enter retirement
over the next 20 years will eventually result
in a downturn in productivity. Eventually,
the U.S. will have a smaller base of workers that will be strapped with a high tax
burden in order to service the debt that
the U.S. is taking on in its attempt to cheat
deflation pressures. E
To read this article in its entirety,
please visit:
equitiesmagazine.com/jan09
Markowski is the founder
of StockDiagnostics.com,
which publishes current and
historical cash-flow metrics
on over 8,000 companies.