By Chris Nelder | 22 June 2009
A fierce debate now rages among economists, investors, pundits and the puppetmasters of fiscal policy: What’s next, inflation or deflation? Has the most massive money-printing spree in history successfully stimulated the global economy and put it back on an upward course with rising inflation? Or are we still in a global downturn, temporarily masked by the stimulus, with prices, wages and employment still falling?
| The comforting gain in the major stock market indexes since the March, 2009 lows has given renewed confidence to the "green shoots" trumpeters who still dominate the airwaves and the press. |
But grayer and wiser heads in the investing community— like Dave Rosenberg, John Mauldin, Nouriel Roubini, Gary Shilling, Peter Schiff, and Dave Cohen— have a more bearish view. The financial sector must now 'deleverage', they argue, which means liquidating assets, repaying debt, saving instead of borrowing, and contracting in general. In their view, the process will take years, not months, and what we have seen since March '09 is a classic bear market rally.
As my colleague Steve Christ pointed out recently, U.S. household net worth has fallen by well over $1 trillion, and household wealth is down around 20% from its 2007 peak. Commercial real estate is contracting painfully, with prices plunging and vacancies and defaults soaring. Meanwhile, consumer credit defaults are still rising, even as the end of the home buyers' tax incentive has snuffed out the resurgence in home-buying.
Liquidity in the credit markets remains a problem as well. Banks simply aren’t lending out the Fed’s forced injection of fantasy capital. Indeed, they have been entirely intent on paying it back as quickly as the Fed will let them, on the heels of secondary stock offerings and other measures they have taken to raise capital and reduce exposure. (For a personal anecdote, I called Discover card some time ago to take advantage of a recent 1.8% promotional offer on balance transfers they had sent me, and was told that they aren’t accepting any more balance transfers right now, from anybody, period.)
On the whole, I think the case for continuing deflation and contraction is well made. [[But see Puncturing Deflation Myths: normxxx]]
Commodity Inflation
At the same time, food and energy prices have been rising rapidly. Oil has rocketed from the low $40s to the low $70s in just four months, a roughly 71% gain. Soybeans rose about 50% over the same period, with most other grains gaining similarly. Normally, this would suggest inflationary fears, and indeed it has apparently drawn hedge fund money off the sidelines, out of bonds, and back into energy and commodities. (Energy analyst Dave Cohen did a great study of speculation in the current commodity cycle in "Bad Signs, New Bubbles.")
I don’t want to make too much of the commodity resurgence, however. The market continues to price oil inversely to the dollar, and the dollar’s fall in 2009 was echoed almost perfectly by oil prices, until this year, when the price of oil in January tended to drop again with the rise in the value of the dollar:
See http://stockcharts.com/h-sc/ui?s=$XOI:$USD
The dollar’s decline can be viewed as the proper result of printing trillions of dollars out of thin air, without new assets to back it— the inflationary thesis. [[But, of course, since almost "everyone is doing it", the dollar is likely to be stable to rising for 2010.: normxxx]]
Indeflation
On the whole 2009 looked a great deal like 2008 across the energy and commodities sector, with the same sort of inflation. But there is an important difference: The economy and the consumer grew sick, very sick in 2009. Gasoline at $3 was a nuisance in 2008, but in 2009 it really hurt. Perhaps we should be zooming out on this picture, and considering the 'affordability' of oil. Consider this 60-year chart from the blog of "Mr. Excessive," which tells quite a different story:
The 'affordability' of oil, as measured by the S&P500, peaked in 1999, and has been in decline ever since. Oil prices began rising sharply at that time, as the early effects of peak oil began to be seen. Global conventional oil production has been flat since 2005, despite a tripling of prices. [[But the discovery and supplies of natural gas has exploded— largely thanks to new techniques and knowledge.: normxxx]]
So is it to be inflation or deflation?
My pal Gregor Macdonald argued this question elegantly on his blog in April, 2009 and in a later conversation asserted, I think rightly, that it’s not an either-or question. In fact, we’re seeing inflation (of prices) and deflation (of assets) simultaneously. Investor guru Doug Fabian has termed this "indeflation" and Izabella Kaminska of FT Alphaville has called it "compartflation."
Instead of just looking at the dollar and inflation, we should consider that, as former International Petroleum Exchange head Chris Cook argued on The Oil Drum, energy is the only real currency. Our fiat money is but a distorted representation of it, and that energy is declining in real terms as oil and coal all become progressively harder to extract and/or of lower energy content.
Are We At An Inflection Point?
We now appear to be bumping our heads against an invisible ceiling, where the decline in real energy meets our pain tolerance for higher prices. When gasoline hit $4 in 2008, it produced real 'demand destruction' because people simply couldn’t afford it with their evaporating dollars. Likewise, the spike in natural gas and coal prices ultimately translated into such high prices for basic building materials like cement and steel that demand was curtailed.
| It now seems possible that we have reached an inflection point in economic history, where the price at which energy is high enough to sustain new production is the same price at which things become 'too expensive', leaving us no option but to downsize. |
Academics including Charles Hall, Cutler Cleveland, and Howard Odum have explored the relationship between primary energy and economic growth exhaustively. Hall and his graduate student David Murphy graphically depict where we are now as follows:
Source: Murphy, D. and C. A. S. Hall (in press). "Year in Review— EROI or Energy Return On (Energy) Invested." Ecological Economics
Until we understand this key point, we are going to continue to go through wrenching cycles such as we experienced in 2008. Spiking energy and commodity prices lead to destruction of the economy, which then gathers itself at a lower overall level until prices spike again, and back around the wheel we go. Even as energy use declines, the ceiling will get lower and lower, and it will take more and more money to buy the same things.
No amount of tinkering with monetary policy can change that. Unlike money, BTUs can’t be printed out of thin air. Unfortunately, neither the Fed nor Congress seems to have learned this lesson. The Fed still thinks that tweaking interest rates, buying bonds, forcing banks to keep the fantasy money, changing the "rules of the game" and the like can somehow ease us into a manageable 'recovery' [[i.e., to those old 2007 highs.: normxxx]].
Suffice to say that I still have very low expectations that our national leadership will offer any tangible, effective methods to reduce our consumption of petroleum significantly. I certainly do not see them coming to grips with the near-certainty that by 2012, the world’s oil supply will go into terminal and relentless decline. [[Which simply means that we will pay more for scarcer and more expensively obtained oil until we reach a new (and rising) equilibria— and until the more expensive sources (shale oil, tar sands, very deep sea oil) can be tapped in abundance (and our new abundance of natural gas can be fitted into the energy picture.): normxxx]]
On the international scene, finance ministers for the Group of Eight (G8) expressed 'concern' over the influx of capital into the commodity sector after their meeting last weekend. In a communiqué issued in 2009, the group stated,
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| Ministers have asked the International Monetary Fund (IMF) and the International Energy Agency (IEA) to suggest new ways to monitor and regulate the oil markets, in an effort to limit speculation and dampen future volatility. |
If done very carefully [[and apolitically? : normxxx]], such an effort could moderate the boom-bust cycles ahead, and give the world a crucial measure of slack in which we can sustain the long term investment horizon needed to transition to a 'renewable' energy infrastructure. If done hastily or badly [[or largely to satisfy political constituents: normxxx]], it could starve the energy markets of capital, or cause other unintended and probably worse effects.
I think that as it is now constituted, the market is inadequately equipped to face this inflection point of 'indeflation', and history is no longer a useful guide. We’re entering uncharted territory with the risk of peak oil still priced at approximately zero.
So what does all this mean for investors?
First, long-term investing in a 'diversified portfolio of stocks' is probably not going to be a good strategy for a long time to come (if ever); it’s time to play defense and look for low-risk yield. Second, it means that investing in oil and commodities will continue to be the name of the game for many years, but investors must watch the signs I have identified here carefully to know when it’s time to dive in and when it's time to jump out, as we churn through these cycles under a dropping ceiling. And third, it means that we all need to learn to live at a lower level, eliminate debt, build savings, and buckle up for a long and bumpy ride.
Until next time,
Chris
ߧ
Normxxx
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