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Hoisington Q2 Update...


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I used to believe Hoisington but based upon reading "This Time is Different", I think Hoisington's views lacks historical context.  His views are correct if there is no gov't intervention.  The last time this occurred was in the Great Depression.  Based upon historical precedent since then, debt-induced deflation leads to some type of depreciation event (in the 1930's it was going off the gold standard later it was some type of delinking to a standard of value (Argentina going off the dollar standard) which can lead to inflation goods or inputs are purchased from others who are tied to the standard.  In this case, I think a depreciating event will lead to inflation due to out large trade imbalance.  If the trade imbalance was smaller, the inflationary affect would be muted.

 

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I used to believe Hoisington but based upon reading "This Time is Different", I think Hoisington's views lacks historical context.  His views are correct if there is no gov't intervention.  The last time this occurred was in the Great Depression.  Based upon historical precedent since then, debt-induced deflation leads to some type of depreciation event (in the 1930's it was going off the gold standard later it was some type of delinking to a standard of value (Argentina going off the dollar standard) which can lead to inflation goods or inputs are purchased from others who are tied to the standard.   In this case, I think a depreciating event will lead to inflation due to out large trade imbalance.  If the trade imbalance was smaller, the inflationary affect would be muted.

 

Packer  

 

Agreed.  But don't you think that the big depreciating event can be seen coming at you with increasing probability for some time before it occurs?  If so, the rational expectation in the near to intermediate term would be flattish or deflation.

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I think we can see the steps to a depreciating event coming but the markets will not re-act until a trigger/tipping point is reached.  In the cases of both the gold standard and going off the US dollar standard, the markets did not see it coming until the events occurred.  We are in a similar situation and adding more debt gets us closer to the tipping point.  Unfortunately know one knows where the tipping point is until after it is reached.  The increase in value of treasuries I think is a dangerous momentum bubble and those insurance companies that have alot of treasury exposure may get burned.  It would be interesting to hear Hoisingtons reactions to Niall Ferguson and Reinhart and Rogoff's historical points.

 

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Packer,

 

If you could clarify a little please as I'm not sure where the inflation comes from? The Fed is trying to "create" money to offset the massive reduction of credit. With the massive deleveraging going on currently (Hoisington said $2.4 Trillion), the M3 shrinking, and the velocity of money being next to zero, can the Fed do anything to prevent deflation? Japan has struggled with this for 20 years with nothing but a massive debt to show for it. The US seems to be following this path to ruin. Throw in a collapsing housing market, high unemployment and the Fed would likely welcome inflation. Much of the trade imbalance to due to the fact we purchase about $1 Billion a day in oil.....thanks for the help

 

cheers

Zorro  ???

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I find Hoisington's argument appealing simply because most people do not agree with it. The market rarely does what everyone is expecting. The chance that the US enters a Japanese type deflation are larger than 'the market' thinks. Having said this, I WILL NOT be buying long dated US treasuries; cash will be good enough for me (until Buying Opportunity Of A Lifetime The Sequel comes to a theatre near me! :-) 

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can the Fed do anything to prevent deflation?

 

How about a $5000 (refundable) tax credit for every citizen?

 

This isn't exactly dropping $ out of a helicopter as Ben originally spoke about, but it is essentially the same thing.  Yet it would accomplish the same thing.  Yes, some of this money will end up in banks or paying down debt, and so have no effect.  However, at some point, $ will be spent.  If $5000 is to small, how about a $1,000,000 refundable tax credit for every citizen.  All of a sudden, a huge amount of inflation will occur.  There is some level at which policy can inflate.  These guys are not helpless.

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As long as we're discussing policy options, I'd like to recommend the home improvement tax credit that was in effect in Canada, Feb-2009 thru Jan-2010.  It was tax-neutral in the first approximation, and put money and activity into the hands of lots of ordinary folks, eg laid off from manufacturing jobs, doing roofing and such.

 

Here's the calc:  Suppose $X normal activity in home improvments.  Offer 15 pct tax credit on home improvment spending between $1,000 and $10,000 for the year, ie potential tax expenditure up to $1,500 per household.  Increases activity level to $2X, so tax expenditure is 0.15*2X = 0.3*X.  Taxes take about 30 pct of commercial activity, so the extra $X of activity produces 0.3*X tax revenue which would not have arrived in the absence of the stimulus.  Result: tax neutral, economy stimulated fast, some folks working instead of sitting idle.

 

The present "Canada's economic action plan" has taken longer to ramp up, and is just now beginning to produce significant economic benefit.  Projects were slow going first year and a half, mostly paying for architects, planners, approval process and other initial work. Now it seems like everytime you go near some socially-midsized institution eg a university, there are cranes all over the place. Ontario brought forward 5 years of infrastructure spending plans into 2 years, and that is in mid-stage presently.

 

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can the Fed do anything to prevent deflation?

 

How about a $5000 (refundable) tax credit for every citizen?

 

This isn't exactly dropping $ out of a helicopter as Ben originally spoke about, but it is essentially the same thing.  Yet it would accomplish the same thing.  Yes, some of this money will end up in banks or paying down debt, and so have no effect.  However, at some point, $ will be spent.  If $5000 is to small, how about a $1,000,000 refundable tax credit for every citizen.  All of a sudden, a huge amount of inflation will occur.  There is some level at which policy can inflate.  These guys are not helpless.

 

I thought Japan has done that (giving money to citizens) a few times already?

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What will come is a debasement of the currency.  That is why gold and some value investors are bullish on gold.  A primary reason we had deflation with a debt de-levering was we had a dollar tied to something which was a store of value (gold).  Once the link was broken there was inflation.  In reading "This Time is Different", I cound not find an example outside of 1990/2000s Japan in the post WWII era, where deflation ocurred.  Part of it may be the Japanese culture of price-down of suppliers or other factors.  All other debt crises were resolved via debasement which may or may not lead to inflation.  The amount of inflation is dependent upon the ratio of imports to GDP as inflation will be imported from abroad.  I would go with the odds of debasement/inflation for resolution of debt de-levering versus cutting and deflation.  In a democracy the latter is politically unacceptable.  This can happen by either tax cuts or more spending as Watsa has pointed out.   

 

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One of the things Hoisington talks about is increasing government debt starving the private sector -- or at least that's how I understand the low multiplier of stimulus that he mentions.

 

So my question is... doesn't quantitative easing restore money to the private sector, thus offsetting the impact of crowding out?  I mean, the private sector buys govt bonds, and then via the quantitative easing Bernanke thus gets the money back out there again by repurchasing bonds.

 

Regarding the historical examples that Hoisington rely upon... were those periods where quantitative easing was employed on a massive scale?

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- markets will not re-act until a trigger/tipping point is reached -

Could the tipping point be a recognition of 'debt deflation'?

 

- It would be interesting to hear Hoisington's reactions to Niall Ferguson and Reinhart and Rogoff's historical points -

Surely they are aware of the historical points, and have written about them consistently.

 

We have discussed this topic in previous posts about inflation/deflation and the debasement of the currency. My retort to debasement has been compared to what? I assume most in the inflation camp would agree they are comparing debasement to gold only. If this is so, are the inflationistas placing 50% of their portfolio in gold? I suspect not, so the question still remains compared to what.

 

As for inflation/deflation, I ask where is the pricing power for inflation to pop its head out. I still see housing prices decreasing, and more in the US after the tax credits expired. From a US perspective, it would seem very difficult to have inflation with little, to possibly negative, labor pricing power. Who is going to pay more when they do not have a job? Mark me down for a least in the non-inflationista camp.

 

 

Cheers

James

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The deflation/inflation argument requires country risk analysis. Armstrong discusses how capital flight based on confidence drives values. Therefore if there is a waterfall event in the US then the capital will flee US and go somewhere else which will appreciate. I see a worsening environment for capitalism in the US and an improving environment for capitalism in much of the rest of the world whose policies are more sensible.

 

I disagree with Hoisington that US treasuries are a good buy. I bought German 20 year bonds at $1.20 based on my belief that deflation will cause interest rates to drop. I expect German 20 years to approach Japanese levels which will double their value in Euros. The difference is that Germany is unlikely to risk another Weimar inflation so is unlikely to even start down that path whereas Bernanke has made it clear that he will act to prevent deflation even if that means he has to adopt more and more aggressive policies. Richard Koo says sound money is vital for debt deflation or else a loss in confidence might increase interest rates and even a small increase in interest rates could make the debt more difficult to bear causing more fears etc. which could precipitate a collapse. Investors can protect themselves by buying government bonds where capitalism, rule of law and sound money flourish. I am worried about what Germany might spend to protect the Euro. I am confident they will create a country bankruptcy scheme to deal with the risk.

 

 

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I am not sure there is going to be inflation but there will be de-basement of dollars versus other assets who retain their value (good businesses, in-demand commodities).  The holder of fixed-income dollar assets will be de-based.  The inflation if it happens will not be the type in the 1970s push-type we have seen in the 1970s but based upon import prices rising.  As our trade deficit is significant, this is where the inflation will come from.  Think Iceland. 

 

In the 1970s/1980s, we had high unemployment (surplus labor) and high inflation.  The inflation came from oil imports and modest competition that rippled through the supply chain.  I see price competition declining from China as folks are paid higher wages.  So the conditions are their for inflation. 

 

I have not heard Hoisington's argument for why deflation has not occurred anywhere in the world except Japan post WW II.  Japan has some unique characteristics that would lead to deflation that may not happen in other parts of the world like: home-country bias (esp. with savings), a price-down driven manufacturing culture and endurance of  deflation because the welfare state has taken care of the failures.  Other parts of the world that don't have these characteristics will induce inflation at all costs (and this has been born out through the history of debt crises).  I recommend you get "This Time is Different" and see if you question deflationary assumptions.  If there were more historical examples (post WWII), then I would probably be in Hoisington's camp but history doesn't appear to be on his side.

 

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The deflation/inflation argument requires country risk analysis. Armstrong discusses how capital flight based on confidence drives values. Therefore if there is a waterfall event in the US then the capital will flee US and go somewhere else which will appreciate. I see a worsening environment for capitalism in the US and an improving environment for capitalism in much of the rest of the world whose policies are more sensible.

 

I disagree with Hoisington that US treasuries are a good buy. I bought German 20 year bonds at $1.20 based on my belief that deflation will cause interest rates to drop. I expect German 20 years to approach Japanese levels which will double their value in Euros. The difference is that Germany is unlikely to risk another Weimar inflation so is unlikely to even start down that path whereas Bernanke has made it clear that he will act to prevent deflation even if that means he has to adopt more and more aggressive policies. Richard Koo says sound money is vital for debt deflation or else a loss in confidence might increase interest rates and even a small increase in interest rates could make the debt more difficult to bear causing more fears etc. which could precipitate a collapse. Investors can protect themselves by buying government bonds where capitalism, rule of law and sound money flourish. I am worried about what Germany might spend to protect the Euro. I am confident they will create a country bankruptcy scheme to deal with the risk.

 

I was having a debate with my father who also mentioned Germany and the Weimar inflation experience.  To that I said, "Dad, neither you nor I are great historians yet we know about the Weimar experience.  Neither are we German."  He suggested that it's different when it's actually happened to you versus just hearing about it, so I said "Look, who is alive today in Germany that experienced it?  Did the politicians live through it?".  I think it happened so long ago that realistically pretty much everyone in Germany read about it, not experienced it.  He didn't buy it really, so I said... "Well, here in America we had the Great Depression, and yet we still wound up in the present situation we're in now.  So if living through it once didn't change our course, then why are you so confident that Germany will remember it's lesson?"  After all, we might have had the Great Depression here, but nobody in our government remembers it.  And that was a more recent event than Germany's Weimar inflation.  Similar to the Civil War -- we've had one here in the States but nobody really remembers it.

 

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People in small town Georgia still remember Sherman's march even though that happened generations ago.  People in Iceland still remember the outlaws who hid out in a particular cave hundreds of years ago.  Real events that happened in locales are indeed remembered vividly for many generations, unlike the "lessons" of  history books.

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Aberhound - 'discusses how capital flight based on confidence drives values'

That is a fine point and was the case only a few years ago when nearly everyone was bashing the US Government and talking up the Euro and a new middle east currency. Those thoughts now appear to have been ephemeral in nature and flows are now back to where ingenuity and patent laws are fairly protected.

 

Packer16 - 'there will be de-basement of dollars versus other assets who retain their value (good businesses)'

Indeed and given some of the more well run US large cap stocks, this area appears to be the place to put capital for the longer-term irrespective of de-basement or not.  Side note: I thought you were from Montreal, but your tone is US centric now.

 

Another good article on the inflation/deflation debate in Pension & Investments by Jeffery Gundlach.

http://www.pionline.com/apps/pbcs.dll/article?AID=/20100614/REG/100619957&crit=doubleline

 

Cheers

James

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There is a huge difference of perception between the Great Depression in the US and the Weimar inflation in Germany. I grew up in France and have many German friends (I also spoke a decent German 20 years ago): the Germans still think that Hitler's election and rise was a consequence of the Weimar hyper-inflation in the 1920s. There is still a huge trauma in Germany about WWII - not fun to be the heirs of such a fascist regime - and they just don't want that kind of situation to ever happen again. I don't see here in the US the same knowledge/sensibility about the Great Depression. Maybe there is less emphasis on history in the education system here and/or the consequences of the war and depression were less dramatic here. In any case, I think that's the main reason why Europeans, and Germans in particular, are much more worried about inflation than the Americans are.

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Thirty years ago people could make the claim that the US would never again let itself get so upside down in debt because it remembers the lessons of the Great Depression.

 

Where does that leave us today?

 

That's all I'm saying.

 

When there are financial incentives, the "forgetter" kicks in.  Seth Klarman describes the junk bond mania during the 1980's in Margin of Safety.  Change the names of the players and the descriptions of the financial instruments, and there's a play by play scenario of the events  that occurred in the mortgage mania about 20 years later. Failure to learn that lesson isn't a memory problem.  Anyone over 45 on Wall Street during the recent mortgage binging could probably tell all about the earlier junk bond mania and S&L crisis, but why spoil the party and miss all the bonuses?

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