Inflation versus Deflation Revisited

It has been a couple of years since I first blogged on the topic of Inflation versus Deflation and I think it is time to revisit the topic.  I may be off in my prediction on this topic or I may have been too early; I am not sure.  We certainly haven’t had deflation, however. 

Treasury prices probably topped in 2012.  The top in bond prices before that was in 1946.  Bond market cycles are really, really long ones!  And we have probably begun to march down the path of a new Treasury bond cycle which will last a long time as well even if the Federal Reserve’s program of Quantitative Easing continues for some time.  I believe we are bound to see some inflation as this new cycle blossoms as well.  In this blog I have indicated (back in March 2011) that I believe that inflation will ultimately win over deflation (we have had low inflation in the CPI – more so in asset prices – since the time of my initial blog on the topic but not the stagflation I envisioned) and I continue to believe that more inflation will be the result if the US continues down its current path.  I no longer believe that the initial effects of Quantitative Easing in the short term (<12 months from now) will lead to significant consumer price inflation, however.

Why?  The rise of the baby boom generation and the concurrent rise in the overall level of credit with that generation have put the US in the position where it is today.  The expansion of the credit markets nicely parallels the rise of the stock market from 1982 until the present.  The US is de-leveraging private sector debt as the baby boom generating ages, slows down consumption and corrects some of its prior excesses – transferring private debt to public sector debt.  The entire process of de-leveraging will take some time to work off and is disinflationary for consumer prices at this time.  With the baby boomlet generation coming into prime consuming years, immigration reform on the horizon, and continued growth in US population, I do not see the US becoming the next Japan so I do not see this as a long term deflationary trend, but simply a medium term disinflationary one.

Quantitative Easing is not having a truly inflationary effect due to the de-leveraging process because the velocity of money has dropped so dramatically.  This drop is unprecedented in US history.  Moreover, commercial banks face regulatory requirements they did not have years ago and simply cannot make the loans that they used to make. Liquidity is available from the Fed, but that is not the real problem. Private capital from the capital markets or earnings to meet capital requirements is simply not available.  Banks must hold capital to backup a fixed percentage of their assets at risk – including their loans – and they cannot expand their balance sheets without this additional capital.  Just the eight biggest US banks have holding company and insured bank subsidiary shortfalls of $63B and $89B respectively.

This capital for banks is simply not available today.  If all the banks in the US are included the capital shortfall is probably well over $1 trillion.  The "money" from the Fed's Quantitative Easing program has to go somewhere.  It doesn't just disappear into thin air.  It can be used as collateral in margin accounts.  The Fed inspired inflation that exists today winds up in asset prices or in goods and services (e.g. rent) closely related to specific asset prices where there is a substitution effect.  The “money” from Quantitative Easing has been going to places like the stock market and back into real estate where deals are being done for cash or relatively little leverage.  It has not yet been able to find its way back into the broader economy in any other significant manner – yet.  Tighter capital requirements will not remain an impediment to lending on banks indefinitely.  Clever bankers will soon figure out ways to get around the current regulations and inflation will take hold when assets once again become monetized more readily.  I believe it is only a matter of time.  The incentives to do so are extremely powerful.  There is too much fee income for the bankers.

Moreover, some inflation will help resolve the problems of how to de-leverage the public sector balance sheet and how to pay the interest on the public debt in the interim when interest rates begin to rise.  But it is a very fine line before inflation expectations get baked into the system or begin to spiral out of control.  As with the effects of Quantitative Easing, there will be winners and losers in the ensuing inflation.  Sadly, I don't believe our leaders are going to lose too much sleep over the consequences. 

Absolute Proof of the Social Media Bubble

In my March 22 blog post of last year entitled "Plus ça change....," I explored the Social Media Bubble that was rapidly building.  Well, that bubble is now in full manic froth.   I feared that this sector of the market would rhyme with the Internet mania of 1999.  It is April of 2012 and my fears have come fully to fruition.  Facebook has not even priced its IPO and the company has purchased Instagram -- basically a popular, virtually pre-revenue photo sharing service with roughly 13 full-time employees -- for $1 billion in cash and stock.  Ouch!

I knew the social media bubble would end badly and that companies would eventually do desperate things as advertising dollars grew tighter and capital dried up.   These events eventually unfold when companies and investors start asking for real ROIs, but I don't think we have quite reached those points in this cycle yet and I thought Facebook had solid discipline and sufficient cash to avoid desperation.  Moreover, I felt Facebook was in a better strategic position than many of the other companies in the space.  For example, I thought Groupon had a business model that was more readily susceptible to competition and less defensible; it did not have the potential for really high gross margins like Facebook and Twitter.  I expected desperation from them.  And even Twitter did not appear to have the stickiness and the time investment and engagement of its users that goes along with the Facebook model.  So I really did not expect Facebook to be the first company to do something silly like this.  I expected Facebook to be one of the last companies to fall prey to this type of deal -- not the first.  (I know one can claim that Zynga's deal for OMGPOP for $200 million was the first over-the-top social media deal, but I don't think it is in the same league.)

The really disturbing question is why did Facebook feel so compelled to pay such a high price for this company?  Instagram is the type of app that Facebook certainly could have reproduced itself in a matter of months with engineering talent it surely could have bought.  Such an app then would have been specifically tailored to the Facebook service in a mobile and desktop environment on both the iPhone and Android platforms.  Facebook's user base is incredibly large and how many Instagram users are not already Facebook users?  I cannot imaging Facebook is picking up too many new eyeballs with this acquisition.  So what if Google bought the company and Google+ got the service.  A bigger competitive threat to Facebook is perhaps an aggregator that enables users to use one interface to interact with all social media services and monitor them all for you as your personal assistant or agent.  To me the Instagram deal really smells like Mark Zuckerberg's ego.  He just got it into his head that he wanted this baby and he was willing to pay whatever price to get it.  Since Mark Zuckerberg effectively controls Facebook through his voting block, he can accomplish whatever goal he sets his mind toward with the company.

The fallout is just like it was back in 1999.  If Instagram can grow that quickly to 30 million users then some other company can figure out a way to grow that quickly as well and there will always be an excuse to pay up for growth until one cannot do so any longer.  That is what happened in 1999. And that is what is happening again now.  And just like in 1999 the numbers will assuredly trickle down as well.  If Instagram is worth $1B for 30 million users, the next company with 5 million users will be worth at least $166 million...and so on.  Eventually, you simply cannot justify the numbers, however.

News Corp. only shelled out $580 million to overpay for MySpace in 2005.  Specific Media bought MySpace for $35 million 6 years later.  I guess Rupert Murdock and his shareholders got their lession in overpayment for a bargain basement price!

Occupy K Street not Wall Street

There is a lot of talk about contrarian thinking and contrarian investing, but there are very few people who actually practice it.  It has long been true in money management that it is better for career management to be invested roughly in the same way as the rest of the crowd even if you lose money than to be out on a limb and be right and make a killing.  This is sad, but true.  Although this is no way to please your clients or to become John Paulson rich, it is certainly the best way to cover your ass and save your job.  It provides the “everyone else was doing it so how could I know” defense.  Indeed, when the financial system is at risk of collapse (e.g. Long Term Capital Management and its aftermath, Lehman Brothers and its aftermath, etc.), a practitioner of this method is unlikely to be one the unlucky few to be made an example of and so will generally be exonerated and not end up in jail or even pay the price of losing his or her job for terrible decision making.  There is also virtually no accountability for poor oversight and bad management these days.  How else can one explain why many of the individual managers at Wall Street firms have generally not suffered at all and losses continue to mount at firms such as UBS that somehow managed to blow through over $2 billion in 2011as its managers remain immune to consequences?  

Thus, it is understandable why there is public anger directed toward managers who work on Wall Street.  But although there are a host of problems with Wall Street and much could be resolved with better (not necessarily more) regulation (i.e. get rid of Sarbanes Oxley and bring back the Uptick Rule and much of The Glass Steagall Act), bankers are not a cause of one of biggest problems that the US faces; they are merely one of many agents acting in their own self-interests.  Bankers are perhaps more high profile recently than many other groups, but we could lump pharmaceutical industry executives, oil and gas industry executives and a host of others into the same categories.  One of the biggest problems we face as a nation is that our government is no longer regularly responsive to its own citizens.  It responds to K Street and not to Main Street.  Instead of occupying Wall Street, I suggest the citizens in Zuccotti Park and elsewhere should occupy K Street.

I think this is unfortunately not very likely to happen, however.  The Occupy Wall Street crew in Zuccotti Park in NYC is not a particularly articulate, organized or terribly intellectual bunch.    And today, the real bang for the corporate investment buck is entirely in lobbying and this is a great tragedy. Where else in this market can one get a 6X return on investment?    There is practically no better return on a corporate investment dollar than on K street and it does not matter whether a Democrat or Republic is in control of the White House or Congress.  This is an incredibly sad state of affairs and if we want to take back our country, it is where we should focus our reform efforts. 

Unfortunately, the Occupy Wall Street battle is probably merely a prelude to an even greater battle that we are only beginning to touch upon in the US.  Many sympathizers with the Occupy Wall Street movement skew young and I believe that there is an undercurrent of the coming demographic war that we are facing in the US.  As the young graduate with overpriced, unsustainable university debts (and are often poorly trained) and face a job market that does not provide them with sufficient economic opportunities to service those debts, they begin to question the transfer of wealth from the working populations to the retirees of this country who receive these unprecedented transfers because they now have net worths far greater than younger households than ever before.  Indeed, households headed by a person 65 or older have a median net worth 47 times greater than households headed by a person under 35, according to a new analysis from the nonpartisan Pew Research Center.  In dollars, that gap amounts to a median net worth of $170,494 for older households, compared to $3,662 for those under 35.

Government policies make this situation possible and it is not sustainable for the long term.  Wall Street certainly has its own problems, but K Street is causing Main Street real angina.  I suggest the protesters Occupy K Street instead.