Deflation Watsa's Latest Bugaboo

[Parsad]

Article from the Financial Post on the deflation hedges, as well as a list of other recent articles by the Post.  Cheers!

 

http://www.nationalpost.com/related/topics/index.html?subject=Prem+Watsa&type=Person

[Packer16]

Its interesting that I read the article Brian Bradstreet referred me to at the annual meeting (the Irving Fisher article on debt deflation) and Irving's suggestion to stop a deflation is what Bernake did and Irving observed Sweden did the great depression (namely reflation).  It appears the Europe is not doing reflation and is probably the prime target for deflation versus the US.  It also interesting to note that the derivatives (US and Euro) were purchased not only because there is possibility of deflation (it existing in Japan also) but also because the price was so cheap 1% of notional value.

 

Packer

[SmallCap]

Packer, your post brought out a couple of thoughts that have been banging around in my head. I can't seem to come to any real conclusion about inflation deflation but in relative terms it seems to me that Europe is much more likely then the US to have Deflation and the US is much more likely then Europe to have inflation. But that is only in relative terms and I still haven't a clue what will happen.

 

 

[Packer16]

From what I can see and have read when you are in these debt deflation cycles (caused by high debt levels), you can have significant increase in money supply with little or no inflation (like Sweden in the great depression and the US today).  What appears to drive overall inflation is wage inflation which is non-existant today in the US.  So I would not expect a large amount of inflation but a falling $ as our real (commodity) debt levels are declining.  All of this dependent upon the Europeans, Japanese and Chinese not following our reflation.  Once they do, it will be a race to the bottom. 

 

Packer

[JohnDoe700M]

Once again: S&P declared that US debt is no longer a safe investment; yet investors are piling into US debt, not out of it, driving the 10-year interest rate below 2.4%. This amounts to a massive market rejection of S&P’s concerns.

 

The “signature” of debt concerns should be stock and bond prices both falling; what we actually see is those prices moving in opposite directions. And that’s normally the signature of concerns about a weak economy and deflation risk (see Japan, decline of).

 

http://krugman.blogs.nytimes.com/2011/08/08/aaauuuggghhh-market-commentary-edition/

[petec]

Packer, I've been thinking the same about wage inflation.  If wages are not rising with inflation I don;t see how inflation becomes hyperinflation.  But if they are rising with inflation...

 

What I don't understand is what will trigger wage inflation.  Do we need a recovery?  Or just a long enough period of 2-3-4% inflation? 

 

(Historical note: in the Weimar Republic, banknotes were printed every morning and trucked to factories to be given to workers who got half an hour off to go and buy something before their money became worthless.  Not that I think we're going back to that!)

 

On another note, hyperinflation protection is also very cheap to buy.  I wonder why the Fairfax team haven't built barbell protection.

[link01]

[

On another note, hyperinflation protection is also very cheap to buy.  I wonder why the Fairfax team haven't built barbell protection.

 

what hyperinflation instruments are you referring to? other broad based asset indicators associated with inflation have been recently getting cheaper but dont yet look cheap from a multi year historical perspective

 

and if fairfax were to buy some hyperinflation protection now as you suggest he'd really be buying a  straddle rather than some form of barbell protection

 

i think he's probably still firmly in the deflation camp at the moment, tho he trimmed his long term us treasury holdings, likely because the prices had discounnted all but the most draconian deflation outcomes

 

http://www.zerohedge.com/news/china-and-end-commodity-super-cycle

 

http://www.zerohedge.com/news/chinese-buyers-defaulting-commodity-shipments-prices-plunge

 

 

[petec]

I'm referring to this:

 

http://www.artemiscm.com/wp-content/uploads/2012/04/Artemis-Capital-Q12012_Volatility-at-Worlds-End1.pdf

 

"Today most investors purchase tail risk insurance on the premise that long-term deflation is the primary risk. With the complete opposite idea in mind I asked several dealers to quote me a price for an over-the-counter 10-year out-of-the-money European call option on the SPX with a strike rate of 10k (spot is at 1,400 so 700% OTM). The price of the call option ranged from a low of "are you insane" to a high of 20 cents. The median price was about 10 cents. What many fail to realize is that a far-OTM call option will exhibit powerful double convexity during an inflationary shock. The premium will be heavily influenced by both rising volatility and interest rates and these two variables are self-reinforcing in hyperinflation. The key point is that during the rare inflationary event large payoffs would accrue for sufficiently long-dated OTM calls even if the SPX is nowhere near the strike. The convex payoff is astronomical in consideration of the small upfront premium demanded."

 

[link01]

volatlility at the end of the world by artemis capital is a very thought provoking article, & i seen it before.

 

but is a otm call option on spx really a cheap bet on hyperinflation? how was the performance of the braod indices like spx during the 70's, a period of high tho not exactly hyper infaltion?

[Rabbitisrich]

From Monetary Regimes and Inflation, you want to get into gold and fine suits.

[petec]

I think equity indices tend to give negative real returns but strongly positive nominal ones in hyperinflationary periods.  So yes, an OTM call on the SPX would be a way to protect yourself against hyperinflation.  The author also discusses volatility derivatives as a way to do this but the discussion went rather over my head!

[Packer16]

I just don't see how hyper inflation in wages is going to happen.  What has happened and probably will continue is an increase in the nominal prices of commodity inputs.  Since wages are probably the majority of the price in items we buy (if you include transportation and selling costs) and in most sectors we have a labor surplus, the commodity price increases get reduced by the lower cost of labor component.  Also the main factors which have historically led to labor shortages (and thus higher real wages) of war, famine and following an less productive economic system (communism) have been largely eliminated, I think we are in for a longer period of increases in commodity prices (due in part to looser monetary policy) but not consumer prices with shrinking labor costs being the major reason.  This BTW I think is why margins will not revert to the mean as the cause of the reversion has been higher labor costs.  The only way AT margins will decline is of the gov't increases taxes. 

 

Packer

[TwoCitiesCapital]

I think equity indices tend to give negative real returns but strongly positive nominal ones in hyperinflationary periods.  So yes, an OTM call on the SPX would be a way to protect yourself against hyperinflation.  The author also discusses volatility derivatives as a way to do this but the discussion went rather over my head!

 

I have a hard time believing that any financial assets (paper assets) do well in a hyper-inflationary environment. I guess it all depends on the rate of the hyper-inflation. The simplified scenario looks like this:

 

1) You buy an ownership in the business through purchase of stock.

2) The earnings of the business should grow with inflation, but will likely lag a little bit given lower earnings/prices at the beginning of each period.

3) The price of the stock might rise to reflect these gains in earnings

 

However, if we're talking real hyper-inflation like Weimar Republic, then I don't think it works like this. Think about it; it takes a few days for trades to settle and cash to be withdrawn from your account. If there is a danger of that cash losing a significant portion of value of that 3 day period, then that will have to be discounted into the prices. Secondly, in a hyper inflationary environment, investors will be drawn to real assets as a hedge. Third, there are huge risks to companies for holding cash for liquidity/safety/flexibility because it's losing value so fast. This means they have to either continue holding a depreciating asset or accept the risks involved investing it in other less liquid assets. This increases the risk to businesses and exposes you to the risks involved with whatever investments they are making.

 

Stocks may appreciate some, but I do not see how it will keep up with inflation. I think that there could be massive real losses resulting from P/E contraction due to the loss of attractiveness in stocks for the aforementioned reasons.

 

Just my two cents...

[petec]

Zach,

 

my read on the Volatility article is that in the Weimar Republic stocks appreciated hugely, but did not keep up with inflation.  This makes sense to me, and it would result in a huge win in real terms for holders of way out of the money index calls, but not for stock investors.

 

Pette