Deflation vs. Inflation In Relation To Debt & Deleveraging

he article focuses on inflation and deflation in regards to unsustainably high levels of debt and economic health.

When Deflation Dominates & What it means for Stock Prices

Needless to say, when a recession hits and deflation is the dominating force in the economy, earnings, corporate profit margins, and stock prices collapse. In past recessions, earnings collapsed 33% on average, measured using trailing twelve months EPS on the SPX. In 2001 and 2008 EPS collapsed by 57% and 51% respectively, measured peak to trough, and are caused by a decline in top line growth without a proportionately equal decrease in expenses thereby causing margins to contract. Furthermore, it is relevant to note that profit margins tend to mean revert over time.

Today corporate profit margins on the SPX are about 9%. During the 1990, 2001, and 2008 recessions, margins dropped to 5.9%, 4.2%, and 4.9% respectively. The multiple of earnings that the SPX typically trades at is approximately 15. Using 2012 current analyst estimates of $100 for the SPX (I have seen anywhere from $90 to $115), the market is trading at about 11.5x 2012 earnings. However, analysts are notoriously awful at predicting recessions and don’t recognize them until they are front and center in the middle of one (I would imagine this is because the “Chinese Walls” in investment banks are an illusion and that analysts are under pressure to pump the market and stocks to help the bankers. The market is still below 1999 levels, yet over the last 12 years analysts only rated approximately 10% of all outstanding stocks as sell or an equivalent rating.).

EPS on the S&P 500 was $84.8 for 2010 and is estimated to finish 2011 at $96. If we assume analysts are not being overly optimistic with $96 in EPS and we shave 33% off of that number to represent the typical recessionary contraction, EPS falls to $64.32 for 2012. Even if the market traded at a 15x multiple here (multiples often contract to as low as 10x in a recession) the fair value for the SPX would be 964.8 or about 16% lower than its current price. As I noted previously, the drops in both 2001 and 2008 where far greater than 33% in terms of earnings. The 964.8 value does not even factor in the risk of another banking crises or breakup of the EU or euro as we know it.

When Inflation Dominates & What it means for Stock Prices

There are 3 basic ways a country can deal with its debt issues. The first involves spending cuts, austerity, and a depression as people spend less (put less into the economy) and save more. They use their excess earnings to pay down debt instead of purchase discretionary items. Since the U.S. economy is 70% consumer spending, spending less leads to deflation and a severe recession or depression. The second way is to default and refuse to pay it back. This can lead to wars with other countries and throw the country into a depression. A lot of developed nation debt is held by domestic bondholders through pension funds, brokerage accounts, mutual funds, etc. Old people in particular hold government debt as they mistakenly view it to be risk free; it is anything but. Countries default on their debt all the time, which brings us to number 3. The final way a country can solve its debt problem is to default through inflation.

A default via inflation is the most likely scenario for the United States, but not as clear cut in Europe. While Europe has already begun austerity and is deeply concerned with inflation, as seen by the ECB’s refusal to lower interest rates, the United States is preparing to inflate out of its debt just like the United Kingdom is doing as we speak. The UK has a tremendous debt problem on their hands and spending problem. The riots in London reflect the start of a huge burden the younger generation is being asked to carry. The UK announced “surprisingly” on October 5th that they would increase their bond buying program (printing money to inflate out of debt) by several hundred billion pounds. The United States is in the process of prepping for this as seen by Operation Twist.

Before I explain Operation Twist, I will briefly explain how inflation is a default as a lot of people have trouble understanding this (which is why politicians historically often choose to inflate out of debt instead of an outright default). In an outright default if I owe you $100 I basically give you the finger and only pay you $50. In this example, I have defaulted 50% on my debt and you lost 50% of your money. Default via inflation goes like this. When you lent me that $100 initially you were able to buy 2 Ferraris. When the debt comes due, I will still give you $100 as promised plus some interest or coupon over time. However, the $100 that I give you will be worth 50% less and buy half as much as it did when you first lent it to me. By increasing the supply of money, I made each individual dollar worth less (inflation) and paid you back in nominal not real terms. Now you can only buy half of what you could when you gave me the money; you can buy 1 Ferrari. That is a 50% default on my debt and a 50% decreasing in purchasing power or wealth on your end.

Operation Twist involves the selling of short maturing Treasuries by the Fed and exchanging them for longer maturity (6-30 years) Treasuries. This does almost nothing to boost the economy as they claim. What it does do, is lock in debt at a low interest rate for a long period of time so that when the Fed looks to increase the inflation rate to say 6%, and yields on Treasuries start to rise as investors demand to be compensated for inflation, they won’t have to roll debt they are paying 2% on into debt that they have to pay 6% or 8% on. Locking in lower rates allows U.S. debt as a percent of GDP and revenue (tax income) to decrease making it easier to pay off the debt via inflation. Just like a bank pays depositors one rate and then charges borrowers a higher rate making the difference (spread) between the two, the government will pay lenders (depositors) 2% (what the 10 yr is currently at, using 2% as an estimate for total weighted average coupon rate for all debt outstanding) and erode their wealth (purchasing power) by 6% annually via inflation. This has happened many times throughout history. The 3 decades following World War II saw Treasuries return -50% in real terms.

The danger here is that inflation widens the gap between the rich and the poor. Printing money boosts housing prices and stock prices because both earnings for stocks and prices for real estate are in nominal dollars. They are not adjusted for inflation. Since only people with money (the rich) can own real estate and stocks, they get richer (the more they have the better off they are). The poor on the other hand can see wages (income) stagnate while their costs increase. We have already seen this over the past few years thanks to QE1 and QE2 (printing money).

When we devalue the dollar by increasing the money supply it pushes up the price of commodities (think the price of oil specifically). Inflation is why you will never see oil traded at $20 per barrel ever again. If the cost of transporting goods goes up and heating costs go up, costs increase for people and yet they don’t make any more money than they did a few years prior. This squeezes discretionary (spending on cool/fun stuff) and causes even more citizens to rely on food stamps (44 million and counting) and welfare programs like unemployment just to get by. To offset this, the government must print even more money and raise taxes to try and keep unemployment low by taking from the rich and giving to the poor. Historically tax rates are at an all time low so expect them to go higher. The devaluation of the dollar against other currencies helps create jobs as our exports become cheap to other countries (this is why you hear people whine about the Chinese Yuan being overvalued). The problem right now is every country wants to devalue their currency because every developed country as a ton of debt to unload. This phenomenon has been dubbed “the race to the bottom”.

Inflation, especially hyperinflation, can destroy an economy. It’s a force that often cannot be controlled once unleashed. It destroyed Germany post World War I, it hurt us in the 1970s and 1980s until Paul Volcker came in and raised rates dramatically to combat it (as Brazil did recently to fight their problem). It killed Zimbabwe a few years ago and it has claimed many other countries in the past. Inflation eventually makes money worthless if left unchecked and societies switch to bartering goods and services instead of using a medium of exchange (money) for goods and services thus creating huge inefficiencies in the market and widespread poverty.

Europe’s problems and the the problems in the United States do not have an easy fix. We are most likely in for another lost decade and pain one way or another. Someone has to pay for the overspending and overborrowing of the past.