Thursday, March 12, 2015

Mixed GDP results: Deflation is Winning

You might be wondering  what inflation and GDP (Gross Domestic Product) growth have in common.  The two measures are different, but connections between the two exist.  If GDP is not adjusted for inflation, then inflation becomes part of the GDP growth.  If an economy grows at a real GDP rate of 1% with an inflation rate of 1.5%, then the GDP will grow at a 2.5% rate.  Most economies need a reasonable amount of inflation to maintain a healthy growth level.  A gradual rise in prices helps economic activity.  At the same time, if an economy has a deflation of 1.5% with a growth of 1%, then the economy will shrink by 0.5% in nominal GDP.  Deflation, just like inflation, tends to spiral to higher and higher levels. 

The biggest danger in deflation is that debt takes on a higher value, and capital assets (like your house) take on lower values.  As debt becomes more valuable, and assets are worth less, people tend to get paid less, thus weakening the economy even more.  This is a spiral, and each time the cycle repeats, values become lower and lower. 

An era of deflation makes sense when the current Kondratiev cycle tapered in stagnation while waiting to generate a new cycle.  The Kuznets curves indicate that infrastructure is not growing right now, and that is reflected in the current low oil prices.  The Saudi Arabians need more defensive hardware, so they are forced to sell their oil even in the face of market saturation.  Or the doomsday theorists think the Russians or the Saudis want to shut down the oil shale business.  Oil shale costs a lot to exploit and low oil prices mean the market value of the oil will not exceed the cost of production.  Either way you cut the argument, we are in an era of economic dysfunction.

I'm reading a lot about very modest GDP growth the world over.  Articles never seem to note if they are using real GDP (Amounts adjusted for inflation) or if they are using nominal GDP.  Usually when comparing GDPs, economists will use real GDP. Most nations seem to be posting very mild GDP growths, all under 1%.  Japan seems to have whipped their recession for now with a GDP growth of 1.5% annualized.   India, whose other distinction is being an emerging economy, is posting 7 - 8% growth.  This is actually mild because an emerging economy should post over 10% growth.

The US has mixed economic news.  A Wall Street Journal article points to stronger results in GDP due to increases in health care spending. Another article points to oil companies counting their assets at $95 per barrel, rather than the real oil value of $48 to $58 per barrel today.  In itself, this development could create deflation.  Other sources stated that China is facing the deflation specter, and the same source talked of larger economies like the US, Germany, France, etc. having similar problems.  The fear of deflation is raising its head in large economies that shouldn't be concerned.  

The most potent weapon in the Central Banks arsenal for fighting deflation is decreasing the spot interest rate.  This is the so called over night rate banks pay for transfers between each other.  Central Banks reduce this rate to zero, or close to 0, in the face of negative economic news in the hopes of stimulating the economy into growth.  However when this rate goes to 0%, the Central Banks, in a rational world, can't lower the rate anymore.  Or can they? Several sovereign debt issuers have lowered their interest rate to a negative amount. This means for every $1,000 invested, the return is less, perhaps $990. 

The synthesis of these facts reveal a world economic system that is still reeling in the face of the Great Recession of 2007-2009.  I believe the Great Recession is a symptom of a Kondratiev long cycle coming to an end because the root cause of the Recession was an asset devaluation and crash of the banking system.  The long wave cycle will have to play out prior to prosperity, as seen in the late 90s, returns. 

My short term suggestions are divest energy companies, and balance your portfolio so you have plenty of diversity.  Right now is a hard time to tell which companies and industry sectors will do well in the coming few months. 

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