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To Inflate or Deflate - That is the question

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Pardon me while I morph this column today from an "Options 101" into an "Economics 101" of sorts. Yes, I know economics is a boring subject to the majority. In fact, economists traditionally only tell us what will happen or when something will happen, but never both at the same time. However, hang with me on this and I promise to keep it interesting - really!

In an ongoing effort to fulfill my promise of serving up prognostications for 2003 or whatever timeframe we care to reference, Fundamentals Guy feels compelled to delve into the currently raging "inflation vs. deflation' debate.

Why care? It's a Big Picture thing. Here's why it's important though. There is a major asset shift taking place worldwide that has wealth flowing out of financial assets and into tangible assets. Concurrently with that, the Fed is literally printing and electronically creating American Dollars, still the favored currency throughout the world, from thin air. Contrast that with worldwide excess production capacity that keeps corporate pricing power of all goods and services under control. Business has no pricing power as long as fierce competition between factories remains a part of the business landscape. Everyone is striving to be the low-cost producer.

Based on the outcome of these two opposing forces - inflation and deflation - we may know, or at least understand the possibilities for our own, individual economic futures.

Let's start with the case for deflation.

Factories in the U.S. are running at approximately 76% of capacity. Doing the math, that leaves 24% of a factory's capacity, on average, available for additional production.

Imagine for a moment that we are the operations V.P. for an S&P 500 company, and we have to make a decision on future capacity needs. We have 24% excess capacity, as we stand right now. We are barely making a profit and are considering ways to save on expenses, thus raising our profit potential. As with most companies, our employees - aggressive or lazy, confident or meek, smart or not - are our largest expense, whether we like it or not. Without discrimination, we are faced with the unpleasant prospect of layoffs, even for the best people. No division or organizational chart is sacred. While that has been an important decision in years past, it is especially true now.

Given that current backdrop, is it prudent to expand production capacity? Congratulations on your intelligently thought out answer! In probably 499 of 500 cases, we have no plans (other than lament or wishful thinking) to expand in the coming year, and we are likely going to lay some people off. Tough decisions, but survival depends on it.

But forget the human aspect of it for the moment. Moving beyond that, we see the very plain implications. The first is that companies to whom we sell goods or provide services are in the same boat and have likely also scaled back any expansion plans. We cannot count on them increasing their business to us this year. Nor can they count on us to ring up their sales. Not that we don't want to give it to them, nor them to us. But all that capacity means we simply won't be investing in MORE capacity. Thus, business investment falls off across the board.

The second implication is that many of those people with whom we work will no longer be required if we tighten our belts in the name of profitability and ultimately survival among those also competitively tightening their belts. Once an employee becomes a "consultant" (euphemism for "unemployed"), he or she no longer has the monthly resources in the name of "disposable income" to participate in that great American pastime of Consumer Spending. That, in itself becomes a vicious circle since a reported 70% of the economy is consumer spending. When your neighbor ceases buying stuff, it affects our ability to remain employed I order to produce it for them. And likewise, them for us.

Let's now couple the prospect of individual unemployment plus lack of pricing power born of excess capacity with a need to service the incredible debt load we have amassed from credit cards, auto loans with $0 down, 0% financing, and a sea of refinanced home loans that frequently involve cash back to the borrower from all that real estate equity built out of thin air. Bottom line: A big loan needs to be paid back from decreasing income from more people who no longer have jobs.

I didn't just make this up. 5% of all consumer credit is in the delinquent or default category - an all time high. Furthermore, 1.8% of all home loans are in foreclosure with an even greater percentage in default or delinquent. Again, an all time high. What makes matters worse is that while prices of goods are now on trend to begin falling and incomes (see airlines for starters) are likewise on trend to begin falling, the debt service required to pay for the assets (real estate in this case, cars or what have you) is not going to change.

Connecting the dots, even if overall debt does not increase, debt service becomes a greater percentage of take-home pay if incomes start shrinking. Those with debt are going to have to apply a greater percentage of their shrinking paycheck to a loan amount that remains constant while the value of the asset also diminishes, as in the case of that $0 down, 0% car. But I'll save my real estate thinking for next week. (Heads up - you thought the stock bubble popping was painful - just wait until real estate foreclosures, with greater household net worth, take over the front page of the local newspaper.)

Now, let's expand our horizon to encompass the whole world, including an emerging consumer goods production behemoth, China. Ever notice that Wal-Mart no longer advertises the "made in America" aspect of its good that we buy? That's because they are mostly made in China now. Same with the goods at Home Depot.

As an aside, and given that each of us effectively "votes" with our Dollars, a few years ago I was personally protesting buying anything made in China and opting to spend a few more dollars to buy made in the USA products. Forgeddaboudit - I can't do that anymore. Nearly everything I buy at "Stuff-Mart" is made in China anymore. Like it or not, I now buy the formerly "Verboten" mostly because there no longer remains easy access to the Chinese alternative. And to think, "stuff" used to say "Made in Japan".

. . .Which leads to the next part of the deflation argument, competitive devaluations. Competitive devaluations are where, like in a beauty contest, each currency takes a crack at making itself more attractive to the pageant's remaining judges - in this case, the U.S. consumer. Europe, especially Germany, is headed for recession, and Japan has been in it so long (actual deflation) they may have forgotten the word, "prosperity". All are trying to compete for the business by selling their factory goods the cheapest. How do you make it cheaper? Have your local Central Bank (your counties version of the Fed) lower the value of the currency by printing more of it!

Japan is doing just that. The Yen currently trades at roughly 120 to the American Dollar. But Japanese central bankers (Japanese Ministry and the Bank of Japan) have made no secret of printing up (or electronically generating) enough currency so that the American Dollar will buy roughly 150 Yen at the end of 2003. Spoken or not, the reason for doing so is so that the consuming world will buy Japanese goods as opposed to other country's because it is inexpensive for the buyer to do so.

And don't forget China, as mentioned above. They are the lowest cost goods producer in the world. While China's GDP has grown roughly 8% annually since opening its doors to a bastardized, but functional form or capitalism, its Achilles heel remains unemployment, which is running at about 10%. To keep these people employed, China would rather produce lower and lower priced goods than idle the factories and risk higher unemployment. This also has the added beneficial consequence of making its products continually more affordable to the rest of the world.

And fortunately for us here in the U.S., the Chinese Yuan is fixed at slightly more than eight per U.S. Dollar. China has steadfastly refused to change that arbitrary ratio for selfish reasons in that it keeps U.S consumers interested in buying inexpensive goods. Judgment day for the U.S. will be when Chinese unemployment falls to a figure they find acceptable. Whatever that number is in the single-digit range will give China the confidence that its own people can take up the slack where the U.S. consumer leaves off, as the Yuan rises against the Dollar. That's the point at which the U.S. Dollar will begin to shrink in value to the Yuan. It is our Achilles heel.

China is a sleeping giant, but now awakening - a powerhouse waiting to happen. They will figure prominently and dominatingly in the world economic picture over the next 20 years. We ignore their emerging presence at our own peril.

In fact, just for the fun of it and to capitalize on what for me and my family will likely be a lifelong trend, Fundamentals Guy is contemplating an introductory Mandarin Chinese class at the local junior college sometime this year!

Let's not leave out India either. India ranks highly as a low- cost producer in the high tech world by offering skilled software engineers on par with our own and inexpensive call-center labor, both at a fraction of the price of those in the U.S. In fact, the call center or customer support department you call for help with your widget may likely already be located in India. Through the abundance and cheapness of fiber optics (not to mention pretty decent English skills), it is becoming common practice to locate these departments where labor is a fraction of the cost of that on U.S. shores. Again, cost of goods and wage expense falling equals exported deflation.

Criminy, here we are approaching deadline again, not to mention I've used up my "word quota" for the day (Only so much can go on a page, you know?), and I haven't even touched on inflation yet! OK, I promise to get to the case for inflation next week instead of real estate. Then I'll wrap up the prognostication series with real estate followed by may case for gold and possibly some other hard assets or commodities.

But for this evening, let's get back to deflation so we can deliver this pretty package and tie it up with a nice bow. In short, producing countries are going to compete to get their excess capacity into production even if it means a devaluation of their own currency - generally considered devastating practice to any economy. All of this means that the cost of goods, services, wages, and the corporate generation of profits is likely to come down. We got our first taste of this today as the core CPI figures registered a meager 0.1% for the month of December. Were it not for the 11% increase in energy costs, or the steadily rising cost (bubble) in housing, education, and healthcare, the core cost of goods including cars and all purchases from "Stuff- Mart" during 2002 would have been negative. Much as I like to see cheaper goods, it's a double- edged sword that will ultimately slice disposable income and thus our ability to repay a strapping debt burden.

Deflation is a grave danger to the U.S. economy only because Americans savings rates are less than 2% of income. We simply have nothing but income - increasingly tenuous income - and little savings with which to meet our personal obligations.

The good news, if we can call it that, is that the Federal Reserve is making currency - both electronic and printed - so available that it desperately hopes it can stave off deflation by inflating the money supply. The Fed theme is to "Inflate or die". The Fed cannot risk the perils to the economy that deflation would bring and will stop at nothing, not even a drastically weakened Dollar or a real estate bubble to keep the U.S. economy afloat. Monetary inflation brings its own set of perils, which will have negative economic affects too. But, as noted, I'll have to get to that next time.

Hmmm. . .Scylla and Charybdis; Devil and the Deep Blue Sea. Both are examples of extremely hazardous alternatives. Pick one! Neither spells an appreciating equity market. But there is a way to profit from this situation, and by the time this series is over, you'll know my thinking on the subject. Big hint: I'm no gold bug. . .disliked the stuff for 20 years. But gold is in a secular bull market as depicted on the charts and moving averages not unlike stocks in the early 1990's.

Until next time, make a great weekend for yourselves!

Buzz



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