Gazing into the Crystal Ball

Now that everyone is talking of an economic recovery, here is a thought experiment on how the future might look like.  Let us look at some indications:-
1. Ballooning of central bank balance sheets;
2. Price fixers have decided that cash is cheap (Read, Central Banks are keeping the interest rates low);
3. Governments have found themselves overstretched on their budget - be it municipalities or the PIGS (no, I am not calling the Europeans swines - look it up)of Europe.

There are two paths that seem likely out of this situation.  One seems to be what everyone is fearing - inflation.  And it seems to be the easiest way out of the situation.  Looking at the lack of political will and the bickering, it seems to be the likely course of action to most people around.  The interpretations seem to be muddied by further assuming that tail is wagging the dog and mixing correlations.

Let us diverge a bit;
Think of Gold-Oil ratio - Oil is fast consumed, people can't wait to dig enough out to finish it.  Gold mining adds about 1% to the overall gold stock each year and it is a metal that is hard to be destroyed.  Most Gold demand is from the craze for the glitter and an automatic response to go back to the good ol' days.  Jewelery demand is lower compared to the investment demand.  (Even people who buy jewelery in India think of it as an investment, more so these days).  Part of it is the belief that the central banks will have to return to gold and the other part is that gold is a hedge against inflation.  Now, in investments, unexamined beliefs are a road to disaster.  Believing that the central banks world over are going to gold backed currencies is to believe that people will stop using automobiles and start to use horse buggies or bullock carts, just because they pollute.  The more likely course of action is that everyone will learn to live with fiat currencies just like we learned to live with higher emissions.  And expect an outcry against pollution, every time there is a smog.  (Note to Gold Bugs, Romans also used salt (the word salary comes from it)as currency, should I start buying up Salt as well?)

Coming back to Oil, it is scarce in supply and expected to get scarce by most accounts.  Varying accounts put the peak oil production in different years of the first half of the last decade.  The solutions to this are complicated - yes, there is wind, solar etc etc.  Think of various uses of petroleum products; it is in food, water, air (conditioned or polluted, that is) and all the infrastructure that we have now is built on it as the primary source of energy - think of the engineering problems of running an airplane on coal or for that matter, a car using hydrogen.  When the change away from oil happens, it is going to be disruptive - systemically and financially.  Being someone who doesn't like to bet, I would neither try to invest on that thesis; nor do I have the necessary expertise to do so.  I would keep my eyes open though.


Getting back to our thought experiment, and path number one, which is inflation.  Inflation is essentially an invisible robbery of the saver, the creditor and the pensioner.  When you have so much of future obligations, without matching income in sight; it is a tempting situation to inflate, especially if you are the debtor and have pension obligations. But once you go down that path, it is difficult to regain the credibility for another generation or more.  Think Germany in the 20s. 

What will happen if inflation rears its head - the central banks have to raise interest rates, impact will be a lot of unwinding of the carry trade (short/borrow dollar, long/buy you name it).  Asset classes other than dollar will get a mark down.  And, because of the higher opportunity costs they will stay marked down for sometime, until the expectations change.

Independence of Central Banks also are called into question these days.  This time around, will there be enough political will/backing to go through this pain since it implies lower asset values?  The proportion of voters depending on asset values is higher than before since current yields are paltry everywhere. 

Second path is deflation of balance sheets, the central banks somehow get a backbone to stand up to their political masters, get the prudence to deflate and keep deflating their oversized balance sheets.  It will mean money will be sucked out of the system.  Less credit, means longer term projects with returns much later in their life cycle will be the first to get knocked out.  Think infrastructure projects which have a long gestation period or projects which are end-loaded - where the majority of cash flows is at later stages.

Let us assume, that demand doesn't pick up in Euro land and Uncle Sam's households and it starts to look like low level of aggregate demand for a longer duration, it will also imply the creation of a long-term bubble elsewhere in the world where demand has picked up.  Essentially, automatic savings like 401ks and pensions will flow like water from higher-priced (low-yielding) assets to lower-priced assets and this will distort riskiness of those assets again.  It will imply deja vu all over again.  Think of other secondary impacts, foreign ownership of assets in regions where savings levels are high.  It will start to look like colonialism in a new form.

Personally, I prefer the second path to the first, since deflation means lower prices and better value for the money.  Inflation is an all right situation as long as you keep reinvesting in yourself and keep updating your skill sets.  It is an ugly scenario for a saver or a pensioner, especially given the trend in economic measurement under estimating inflation.  Either way, stocks as an asset class are going to suffer.  Does that mean I am going to not invest?  Hell no!! Just that I will be very cautious until I see clear trend.  Until then watch out for the PE re-rating in your stock returns.