Gazing into the crystal ball…
There is still a great deal of debate about what Canada’s future monetary landscape will look like. It’s should be a topic of interest for everyone as it absolutely determines which asset classes will outperform in real terms over the next few years. Now I don’t have a crystal ball, but I will once again share my thoughts on what the future may hold with regards to monetary inflation.
I am firmly of the belief that Canada will not see any significant inflationary pressures until the current debt overhang has been dealt with. Any understanding of inflation and deflation is meaningless without first understanding how money is created and subsequently destroyed in our fractional reserve system. I’ve discussed this at length before, so if you’re not familar with this process, I will simply direct you to this video primer.
Essentially it is incredibly difficult for a central bank to create inflationary pressure when consumer credit is contracting and the velocity of money is stable or falling. This is the very dynamic that is at work in the US and is causing the generationally low CPI readings. It is also why Japan has been pushing on a string for nearly two decades and why I believe Canada will follow….along with much of the Western world.
Hugh Hendry, the eccentric and brilliant hedge fund manager recently chimed in on this very issue in his latest manager commentary:
“Evidently there is an all-out war being waged between what we might refer to as the Fed’s fiat money (the ability to increase dollar banking liabilities), and the private sector’s debt-based money (the willingness of the private sector to hold dollar banking assets). The market favours the prospect of fiat printing winning. Perhaps the outcome is a foregone conclusion. However, I continue to argue that the odds seem stacked against this outcome occurring in the short term.
Consider that the US authorities are battling against the $34 trn of gross debt added by the private sector since the start of Greenspan’s tenure as Fed chairman in 1987. This is a formidable obstacle to quantitative easing as it added only $9 trn to income and has therefore left the private sector with misgivings as to its on-going ability to service such a huge quantum of liabilities, never mind add to such exposure.”
Bingo! As I’ve been saying all along, the end game is really not being disputed. The countries all over the Western world will succeed in debasing their currencies relative to commodities…but not yet. The debt overhang has to be dealt with.
What might trigger inflation/hyperinflation?
Given that hyperinflation is just as much a psychological phenomenon as a monetary one, it is incredibly difficult to predict what will cause this. One person who has advanced some interesting scenarios for hyperinflation in the US is Gonzalo Lira. They are well worth the read. However, two points are worth noting. Hyperinflation is exceptionally unlikely, though not impossible, without significant inflation to cause the stampede into hard assets. People are unlikely to flee from cash as they see its purchasing power improving or at least remaining relatively stable. Secondly, remember that a hyperinflationary event in the US far from guarantees a similar event here in Canada. I’ve discussed this before.
Nevertheless, what might re-stoke the inflationary fire? I see two scenarios
1) Consumers run down their credit until they are once again able to step back up the the plate and access the huge sums of idle bank credit sitting on the sidelines. Money supply expands again…..velocity picks back up….bingo! This is the natural process that would occur if the government wasn’t so keen on keeping the consumer spending binge going. In the US, this will likely take at least a couple more years.
2) The Fed and government scheme to get physical currency directly into the hands of the people. While the Fed boss has been nicknamed ‘Helicopter Ben’ for correctly suggesting that deflation can be countered by simply dropping money from helicopters, let’s not assume that this is going to happen.
The Fed could also stimulate massive inflation by kidnapping all the children in the country and holding them hostage until their parents go out and max out their credit cards at Walmart and Gap. Both would cause a sharp jump in the monetary supply and stoke immediate inflation, but both are illegal, well beyond the mandate of the Fed, and extremely unlikely for now. However, if the Fed and the US government scheme to put physical currency or cheques in the hands of the people, look out. All bets are off at that point.
So the bottom line is that significant monetary inflation is highly unlikely here in Canada for some time. Even the US is likely a few years away from significant inflation.
As I’ve noted before, you can have sustained commodity price appreciation in the midst of monetary deflation. This tends to mess with most people’s brain. This seemingly dichotomous situation can occur if the supply of a commodity contracts at a greater rate than the monetary aggregate. If peak oil is indeed as near as the data suggests, and if demand from emerging markets can remain strong in the face of a deflating Western world, oil may well be a prime example of this.
It can also occur if sustained speculative buying convinces many to pile on to the commodity train out of fears of future inflation. In some ways this is the dynamic behind hyperinflation, which is triggered largely by mass psychological and the fear of massive depreciation in purchasing power. I would also argue that this coupled with stimulus buying out of China has led to the outsized gains in the commodity complex of late. CFTC commitment of traders reports continue to support this.
Finally, in globalized commodity markets, it is entirely possible that prices can increase globally while at the same time certain regions experience strong deflationary forces. Thus it is possible that commodities can see a sustained bid out of the emerging markets while the entire Western world slips into deflation. This may well be the nightmare scenario.
So with the uncertainty surrounding commodity prices, it helps to remember that inflation and deflation are monetary phenomena related to the increase and decrease of the monetary supply.
This still confuses people as I constantly hear people say things along the lines of, “how can you have deflation when the price of food keeps going up”. Now you know. It’s in the definition of the term.
So let’s understand this about deflation: Since the money=debt in our fractional reserve banking system, when deflation (a contraction in the money supply….i.e. a contraction in debt demand) hits a country, assets that are heavily reliant on debt to be purchased will be crushed when the underlying debt is denominated in the local currency. Thus, expect real estate to be hit much harder than most people realize when the money supply and velocity of money begin to normalize here in Canada.
How to invest in this strange world…
Remember that if you are saving for a home and plan to purchase it in the next few years, you need to keep your portfolio more conservative. Invest for deflation here. Cash, short-term government and corporate bonds, a bit of longer term exposure, and stable fixed-rate preferreds are top of the list. The returns may not look sexy, but as deflation pulls at the value of homes, your real return is magnified.
If you’re investing for your retirement, it is well worth weighting your portfolio for inflationary pressures in the future, but remember that diversification is still key. Don’t blow your brain out on one asset class. Check out this post on assets and allocations for more info.
Keep your head about you and don’t follow the crowd. Stay diversified and remember your time horizons and portfolio goals. Seek professional advice if you feel overwhelmed. Enjoy the ride!