The Most Important Question in Financial Planning Today: The Inflation/Deflation Conundrum- Part I

A Note to Readers on Blogging Schedule:

I wanted to get out a few quick posts for you on some critical issues. That will mean rather frequent posts in the coming weeks. After that my intention is to post once a week on topics generally relating to the broader area of financial planning and a post related to the markets, investing or economics. We'll see how successful I am with that. :) For people who know me "dialing it back a bit" has always been somewhat of a challenge!

In my opinion the most important question faced by the financial planning community in the intermediate term may be the question of whether we face inflation or deflation in the broad economy. Why is that important? Because the portfolio elements that perform well in a deflationary environment (prices falling) are not those that do in an inflationary environment (prices rising). Should you try to account for this? That is a question you should discuss with your advisor. I concede that many advisors and their clients adopt a simple "all weather" portfolio approach. If a conscious choice, that is fine. Other advisors and clients may appreciate a more nuanced approach that incorporates a top down look. The choice is a stark one and may mean a great deal to portfolio performance over the intermediate term (3-5 years), perhaps longer. Let's take a look.

Unless you have been in a cave for the past 24 months, you know that as a response to the current crisis the government has undertaken unprecedented policy steps to stabilize the banking system in the United States. The explicit backing of the various bailouts and program resources provided to the financial system to date is calculated at $13.9 TRILLION. (FDIC, Summer 2009 Supervisory Insights) What this has done is merely offset the massive shrinkage that has taken place in the household sector. To wit, the Fed recently released its 1Q Flow of Funds data. According the Fed, household net worth is now off $14 Trillion from the peak in 2007. This includes real estate and financial assets (stocks, bonds, pension reserves, deposits, etc) net of liabilities (mostly mortgages). This does NOT include public debt obligations. Again, courtesy of the good folks at Calculated Risk and from the Fed:



This ratio was relatively stable for almost 50 years. We then experience a bubble in technology-media-telecom space—which busted—then a bubble in housing which, you guessed it, also BUSTED. Now we are left holding the bag.

This destruction of wealth is not inflationary in the least. It is highly deflationary. In the aggregate the household sector has $14 trillion less dollars for whatever eventual purpose they intended it, savings or consumption. That is real honest-to-goodness balance sheet whackage.

While it is true that all of this wealth would not be immediately convertible for consumption, the fact of the matter is that a significant percent (30% by some estimates) of every dollar of house appreciation was making its way back into the economy via mortgage equity withdrawal. That spigot has been turned off.

And vanishing stock market wealth is also one of the reasons that the savings rate in the U.S. has turned on a dime and is now possibly mean reverting to a new “normal” level. Look at this graph:




Look at those low savings rates during the "house as personal ATM" years. Most are barely above zero. Then as the housing market and stock markets deflated, it stayed low until markets reached crash levels and people woke up to the fact that they were 40% poorer on the whole. It then began to shoot up. Now it sits at about 5% of personal income. We haven't seen that figure for QUITE awhile. Some economists think that will eventually reach 8% or more! If so, even more money will be diverted from personal consumption. People need to mend their balance sheets. Debt is not being destroyed at the same pace as wealth so the ratio of debt to wealth climbs. The consumer's natural reaction is to pay down that debt and SAVE.

On June 17th we learned that the Consumer Price Index for All Urban Consumers increased increased slightly in May before seasonal adjustments, according to the Bureau of Labor Statistics. Since the Fed is obviously trying to reflate the economy that is the good news. The bad news is that over the last 12 months the index has fallen 1.3 percent. This is the largest decline since April 1950, some 59 years ago. That is deflation, pure and simple.

This deflation comes to you with the backdrop of payroll figures that are falling off a cliff. Here is one look at unemployment via Ritholtz'The Big Picture and courtesy of The Chart Store:



The headline unemployment rate is 9.4%. Employers are reacting to uncertain prospects going forward by laying off workers. It appears that rate may be slowing as jobs lost in May were estimated at only 345,000, a number that brought a sigh of relief to the markets. Only 345,000! Whether you believe that estimate or not that is an additional 345,000 workers who will not be bringing home a paycheck. A paycheck to spend. And before we get too giddy about the decline in contraction from six and seven hundred thousand jobs lost monthly, consider that 350,000 was just about as bad as it got during the last recession. So the figure is still awful. Just a little less so.

A crashing market. A deflating housing bubble. Massive layoffs. A revived tendency to save. All these exert huge deflationary pressure on the economy.