Comstock Partners, Inc.February 25, 2010
The Cycle of Deflation
Impediments to Debt Relief
We have been strong believers in the deflation theme since we have been writing these reports beginning in early 2000 (and even before). We are attaching a chart depicting the "Cycle of Deflation" which you should print out and refer to as you read this comment.
As you can see by the chart, the typical deflation starts with savings and investment which produces strong sustainable growth in the economy. However, when "greed" gets added into the equation, things sometimes change into non-sustainable growth. This is what happened in the late 1990's when the dot com bubble mania convinced every man woman and adult child to believe that they were all supposed to be multi millionaires. They became so jealous of their neighbors who boasted about all the money they made in the market, that they also jumped into the market by buying such things as Internet Capital Group, CMGI, Iomega, JDS Uniphase, and many others of the same ilk which are now worthless or declined sharply in the bust.
The unraveling started taking place in 2000 and it looked to us like the American public came to their senses. We expected to have a significant recession where Americans could rebuild their balance sheets as the cycle of deflation took hold. But, instead the Fed lowered interest rates to 1% and kept them there for a year causing the public to again become jealous of their neighbors making thousands and millions of dollars on their homes. And also, believe it or not, the housing bubble brought about another bubble in the stock market. We couldn't believe our eyes!!!
After the housing bubble burst, the stock market also collapsed causing a financial crisis "heard 'round the world". Then, we were sure the markets and economy would fall to levels that would repair balance sheets of the household sector and allow the economy to get back to the tried and true savings and productive investment that built this great country. We still need to repair the household balance sheets that were, and still are, in the worst shape since than the Great Depression. What will it take to get to the debt repayments and debt defaults (see the last stage of The Cycle of Deflation) that has to take place before a sustained recovery can be accomplished?
We understood that the stock market was extremely oversold in March of 2009 and that there had to be a rally. But we found the 70% to 80% rally which occurred to be incredulous. The market is up so far from the lows in March now that they have discounted a V shaped recovery. We have to wonder if the public and financial institutions will ever learn.
We are now in the "competitive devaluation" part of the cycle of deflation and we should be getting close to repairing the balance sheets that are so out of line with history. But, there is a stumbling block to the normal competitive devaluations that typically take place. In the past, a country that incurred too much debt just did what they could to devalue their currency in order to export their way out of the dilemma by exporting their goods and services to their trading partners.
Now, however, it is not so simple. The Chinese have linked their currency to ours, so as we debase our currency, one of our major trading partner's currency is also declining and China becomes the major beneficiary of the debasement of our dollar. Because of this peg (and the Euro tied to 22 countries) the typical method of debasing the currency of debt laden countries (or countries that just want to get even) have swung down in "The Cycle of Deflation" past competitive devaluations to "beggar thy neighbor" policies. We explained many times that "beggar-thy-neighbor" policies essentially go much further than just currency debasement, but actually do whatever a country has to do to protect its jobs and its economy. This means "dumping" goods and services on their trading partners (selling goods and services below cost and subsidized by the government), increasing tariffs, and anything else in its power to help the economy at their trading partners' expense.
A perfect example of this lies in the recent accusations from China that the U.S. has been "dumping" chicken products into the Chinese market. It at first threatened imposing heavy trade duties on U.S. chicken companies, and just recently China did impose the heavy duties. They imposed duties of 64.5% on Sanderson Farms, 80.5% on Pilgrim's Pride, and 43% on Tyson Foods which just happens to be an active investor in China. These types of "beggar-thy-neighbor" policies are an extension of the past policies they have used to support exports. But now they feel that they have to go further since China now accounts for 9% of global exports. Earlier this month China filed a compliant to the World Trade Organization against the European Union tariffs on imports of Chinese shoes. "The dollar peg of the rinminbi has put additional pressure on lower end Asian exporters. This has led to charges of unfair trade from across Asia," said Jamie Mezl, executive vice president of the Asia Society. Even nations in Africa and the Middle East are complaining. "When we look at the reality on the ground we find that there is something akin to a Chinese invasion of the African continent," Libyan Foreign Minister Musa Kusa said in November.
China's exports were helped enormously by repegging their renminbi to the dollar in mid 2008. Their exports got a further boost once the dollar started falling from March of 2009 by about 10%. Now that the dollar has started up they could be close to reversing that decision. Despite all the hoopla of China trying to slow down their growth, the above policies don't support that at all. The Chinese total debt to GDP is very difficult to quantify, but with the enormous stimulus undertaken last year ($550 billion) and government supported bank lending ($1.3 trillion), we know they are not in great shape.
America has retaliated by imposing punitive tariffs (as much as 99%) on Chinese tires and tubular steel (used in oil and gas wells). The Chinese government weighed in by condemning the U.S. tariffs as an "abuse of protectionism".
These examples of Chinese actions illustrate how difficult it is now for debt ridden countries to simply devalue their currency in order to export their way out of the dilemma. And just think about the situation in Europe, where this problem is exacerbated by 22 fold, since they now have 22 countries tied to one currency.
The problem is not confined to America, Asia, and Africa-Look at what is taking place in Greece presently. In the past, a country like Greece that over indulged and got caught with their "hands in the cookie jar," would just debase their currency in order to export their way out of the problem. But, now that their currency is tied to the Euro like 22 other of its trading partners, they don't have the same option as they did in the past to bail themselves out.
In summary, due to the debt related problems many countries worldwide are struggling to help their own economies at the expense of their trading partners. In the past this has been accomplished by debasing their currencies in order to export their goods and services. Because of currency pegs and one currency used by 22 countries (Euro Zone), this means of debt relief is not as easily accomplished. The next stage of the Cycle of Deflation is the much more onerous "beggar-thy-neighbor" policies in order to support the economies of debt burdened countries. This is not good news and could have the same effect for the global economies as Smoot Hawley did (a bill in 1929 that became law in 1930 which raised the tariffs on the U.S's. major trading partners). Therefore, the main problem of reducing the debt of major economies throughout the world is even more complicated and makes us even more convinced that the secular bear market that started in 2000 is still intact.