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Case for Deflation
Asset deflation is already a foregone conclusion in the US as the price of property and stocks have been falling in the past two years. Price deflation only started to manifest itself later with CPI falling from mid 2008 and finally turning negative in 2009. Those who predicted deflation based their case on falling US consumer demand. As we all know, prices are usually determined based on supply and demand. Consumer demand in the boom years was fueled by “spending borrowed money” as consumers took loans against the rising equity in their homes to spend on consumer goods and services. Now that property values have fallen, consumers can no longer borrow and in fact have to use any extra income they have to repay debts, so consumer demand has fallen and is not expected to come back for a long time as explained in this article “Frugality is the new normal, by necessity“. As demand falls, there is excess supply so prices naturally will fall as suppliers have to discount heavily to attract buyers. While it seems good for the consumer to have deflation as things become more affordable, it is actually bad for the economy. As supplier margins get squeezed, they have to cut costs in other areas such as reducing the number of employees. Some suppliers may even go out of business and that would in turn cause problems for their suppliers and creditors. That is why the government has stepped in to try to keep demand up by giving rebates for buying big ticket items through programs like “Cash for clunkers” to encourage people to buy new cars but it seems quite obvious to me that these programs can only temporarily prop up demand and can even cause more problems down the track because it encourages some people to take on more debt when they really cannot afford to.
According to the economists predicting deflation (people like John Mauldin, Gary Shilling and Robert Prechter), deflation will continue until supply matches the “new normal” levels of demand, which could be a lot lower than what it used to be before the recession began. This means a lot of pain ahead as suppliers go bankrupt and unemployment continue to escalate. This pain will be felt globally as many suppliers are not from the US. Many people are expecting demand to go back to pre-recession levels (as they always have in previous recessions) and have jumped in to buy shares of companies at the first signs of an economic recovery. However, if earnings do not go back to pre-recession levels, stocks may be overvalued now and will eventually fall until it hits fair value again (which Gary Shilling sees at an S&P 500 value of 600). Gary Shilling scored 13 out of 13 for his 2008 predictions so I would pay close attention to his predictions for 2009 which he made in January 2009. Robert Prechter who famously predicted the 1987 stock market crash and more recently the March 2009 rally is pretty much in agreement with Gary Shilling, even though he uses quite a different method to do his forecasting. In August 2009, his reiterated his predictions for a “Deflationary depression” even after the stock market has rallied 50% from the March 2009 lows.
While I agree with the arguments put forward for deflationary expectations for the US, there is little information that I can find from Australian economic commentators on how these developments will affect Australia. On the surface, it looks like Australia has remained the “lucky country” and has emerged relatively unscathed from this global financial crisis. Thanks to preemptive action by the government, we have never suffered a single period of negative growth, real estate prices have held up well, unemployment is only up marginally and consumer spending has remained healthy. However, what I see in Australia today reminds me of what I saw in the CNBC documentary “House of Cards“, of what it was like in the US in 2001 after the 9/11 terrorist attack. Interest rates were slashed to historical lows and people were encouraged to borrow to buy property to help promote economic recovery in the US after the dot.com crash. People bought property because they thought it was a safe investment. Home ownership was part of the American dream. As home prices kept going up, many people became anxious and wanted to get into the property market as soon as they can, even if it meant taking on a big loans which they can barely afford. Special Adjustable Rate Mortgages (ARMs) were created to help people afford to buy a house. In 2004, President Bush declared with pride that home ownership was at the highest levels historically and Alan Greenspan was a hailed as a hero for helping to make that happen and for helping the US economy recover from the 2001 recession, even though he actually sowed the seeds for a bigger recession a few years later.
In Australia, interest rates today are at historical lows. We had further government incentives to buy property in the form of the First Home Owners Grant. We have our own versions of ARMs which are currently very cheap. Property is considered a safe investment (especially after last year’s stock market crash). Home ownership is part of the Australian dream so people continue to buy property even though they can barely afford it. Government action has helped us avoid a recession this time but I cannot help but wonder if it is has not sown the seeds for a bigger recession down the track. While government debt is relatively low in Australia, household debt levels are disturbingly high, even higher than the household debt levels in the US (see this chart). From what we have seen in the US housing crisis, their root problem was over leverage. People with high debt are very vulnerable. If interest rates go up or if they lose their jobs, they will not be able to meet their repayments and would be to forced to sell their assets at a loss. Property prices can fall quite quickly when there are distressed sellers so I can see the same property deflation scenario that has already happened in the US and Japan, happening in Australia some time in the future. Of course it is easy to identify a bubble but it is a lot harder to identify the tipping point that would cause the bubble to burst. For now, asset inflation appears intact in Australia but wise property investors will ensure that they are not too highly geared and be ready to sell when it happens.
From the CPI data in the past 4 quarters, Australia is also facing price deflation in line with global trends but there is a buffer between what happens in the US and here, and the buffer is China. China is a major supplier to the US and Australia is a major supplier to China. Although demand from the US is down, China has managed so far to keep demand up through government spending and forced credit expansion. This has somewhat shielded Australia from the demand slowdown in the US because China is still buying from us, although profit margins of resource companies are already being squeezed. I guess our fate will depend on how well China is able to continue to do this. Our stock markets have already priced that it can and we are on our way to a full economic recovery. Personally, I don’t think Asia and Australia fortunes can be so easily decoupled from the US so I am taking Gary Schilling and Robert Prechter’s investment advice to buy some US dollars and to stay mainly in cash and cash equivalents.
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[...] as what we have just discussed here, and other reasons discussed in other blog posts such as “The case for deflation“. I just bought a book called “The Great Depression Ahead” by Harry Dent on the [...]