Deflation Cometh?

They say the sea turns so dark that
You know it's time, you see the sign
They say the point demons guard is
An ocean grave for all the brave
--Kansas

Read several 'newsletter' type missives this weekend from John Mauldin, Richard Russell, and David Rosenberg. A common theme thruout: prepare for deflation.

The rhetorical question over the past few years has involved the macro sequence. Will we see deflation before Big Inflation. Or will the printing-presses-gone-wild precede a deflationary bust?

This is not just an academic question. Effectively managing wealth through extreme inflationary conditions (e.g., cash is trash) requires radically different actions than those required to cope with extreme deflation (e.g., cash is king). People seeking to preserve, much less increase, wealth during either extreme will be further ahead if they tilt their investments in the correct direction.

This blog has dedicated many posts to this subject. For a long time, I have favored the 'deflation first' camp. The 2008 credit crisis was largely a deflationary event, thus lending some validation to this view.

Moreover, deflation has lingered in the background despite massive monetary and fiscal stimulus over the past few years. Prices in many categories have not budged much. And people are saving more and hoarding cash despite negative real rates.

The corresponding thesis is that we've been on an artificially induced borrowing orgy for decades. At some point the system can't/won't take on any more leverage, and market forces commence cleansing the system of projects that should never have been taken on and will never see the light of day.

The newsletter trio above thinks that we may be at or near the deflationary point of no return.

Oddly, I'm no longer so sure. The gargantuan interventions that we've seen from policymakers suggest that no intervention will be considered too extreme if conditions get dire enough. Paraphrasing Jim Rogers, policymakers are likely to keep printing money until they run out of trees.

What Jim should have added is that, in the digital age, the supply of electronic trees is infinite.

Further, policymakers have observed that markets respond, at least in the near term, to interventionary actions if bold enough. It is also an election year, and this administration surely sees the correlation between stock prices and the polls.

I am thus inclined at this point to put significant weight behind a scenario that has policymakers trying to move heaven and earth this summer in response to the EU situation and to weakening global economies. Perhaps this is what gold was sniffing out after last Fri's weak job print.

Regardless of the scenario favored, it is foolish to bet exclusively on one scenario. From where I sit, the system could surely break toward either extreme. Currently, I'm assigning probabilities as follows:

Big Inflation   60%
'normal'  10%
deflation   30%

Note that the middle-of-the-road scenario, one that by definition should typically get the largest weighting, is not very likely from where I sit. This is how binary the system has become.

I've been positioning accordingly--meaning that I've been moving some assets out of the deflation bucket (e.g., cash) and into the Big Inflation bucket (e.g., stocks and commodities). Nothing too radical, but enough to rebalance my positions to more accurately express my views.

Like the fluidity of our predicament, my views are constantly evolving as reality unfolds in uncharted waters.

position in SPX, gold, commodities