Deflation and Debt

Prem Watsa has the reputation of being Canada's Warren Buffett. Unlike Buffett, however, he has made pretty significant macro call on deflation:

Despite the fact that central banks from all around the world are explicitly trying to create inflation, Prem believes that the forces of de-leveraging are too strong for the money printers to counteract. (Read anything written by Van Hoisington if you want more detail on the deflation trade). As such, Fairfax has entered into large, long-term, CPI-linked derivatives that benefit from deflation. In addition, given that de-leveraging and deflation would likely have a strongly negative effect on the value of financial assets such as stocks, Fairfax has hedged 100% of its equity portfolio.

This is an incredibly pessimistic view of the Fed's monetary powers. He cites Japan's multi-decade deflation as an example of what he envisions for the future:

In Japan, after the bubble crashed, it took 5 years to actually see deflation
- They then saw cumulative deflation for the next 17 years
- It takes time for people to understand that they actually have to de-lever
and that there is no other option
- Prem's view is that there is a possibility of deflation in the US
- Since 2008 we have had a ton of stimulus and Fed monetary
actions
- In spite of that the economy is weak and there is no
inflation in sight

I'm not sure if he's right. Although the Federal Reserve may not be able to control long term real variables such as growth and unemployment (as they are currently attempting to do so with QE3), I do believe that they have absolute power to manipulate nominal variables. Put another way, Bernanke can't force you to spend your dollar, but he does have control over how many dollars are out there and thus the relative value of your dollar.

The idea that too much debt leads to deflation is creatively called debt deflation. The process is simple: the higher your debt, the more likely you are to use your money to pay it off (rather than spend or save your money). You may even begin to sell off your assets to pay off this debt if your income is insufficient (a process known as deleveraging). Systematic selling leads to a decline in prices, as simple supply and demand analysis would have it (more sellers than buyers means lower prices). However, as prices go lower, you receive less for your asset sales, making it harder to pay off your debt, precipitating even more asset sales.

This is analogous to the paradox of thrift you learn in Econ 101 (where if everyone simultaneously tries to save more money, the aggregate level of savings will decline): if everyone tries to pay down debt, the aggregate debt level actually increases. This is why economics is split into micro and macro universes, individual behavior looks very different when aggregated.

Are we seeing this feedback loop between deleveraging and deflation right now in the US?

Inflation is currently running around 2%, right around the Fed's target. What about deleveraging? McKinsey Global Institute (the research arm of the management consultancy) had an excellent report last year which showed that the US private sector is ahead of all other developed countries in its progress of paying down debt. In fact, there are some signs of releveraging (taking on more debt, or the opposite of deleveraging) in the US, which is a sign of increased confidence, as corporations have started issuing debt to take advantage of record low interest rates. Home prices are starting to increase, which makes households richer, and more confident about taking on debt (such as mortgages, which is money borrowed against the value of your home).

The Fed has effectively broken the link between deleveraging and deflation. If anything, we may have to worry about over-inflation (I hesitate to say hyper-inflation), as massive amount of reserves enter the system (but that's a topic for another blog post).

On a different note, once value guys (like Prem Watsa) start making macro calls, maybe that's when macro guys should start making bottom-up security recommendations. In that spirit, here are list of stocks I like.

Consumer Discretionary (2 securities) TARGET CORP OMNICOM GROUP Consumer Staples (3 securities) GENERAL MILLS IN KIMBERLY-CLARK WAL-MART STORES Energy (2 securities) EXXON MOBIL CORP CHEVRON CORP Financials (1 security) PARTNERRE LTD Health Care (1 security) ABBOTT LABS Industrials (4 securities) RAYTHEON CO NORTHROP GRUMMAN CINTAS CORP L-3 COMM HLDGS AMDOCS LTD DST SYSTEMS INC Materials (3 securities) SONOCO PRODUCTS SILGAN HOLDINGS BALL CORP

Disclaimer: this is not to be taken as any form of investment recommendation.

--
Andy Zhang