deflation or inflation (december 2010)
TRANSCRIPT
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CONFIDENTIAL
DEFLATION ORINFLATION?The most important question facing business owners and investors today
December 2010
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DEFLATION ORINFLATION?
I have yet to see any problem, however complicated, which, when looked at the right
way did not become still more complicated.- Poul Anderson, author
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DEFLATION ORINFLATION?
The disinflationary boom that existed between 1982 and 2007 has ended. This period, widely known as the Great
Moderation, was highly beneficial to asset prices
Strangely, although the increase in the money supply outpaced economic growth over this period (Slide 6), it did not incite
higher consumer prices. This is largely because production capacity growth exceeded consumption (Slide 7)
The result was a relatively steady and prolonged decline in inflation and interest rates (Slide 8), which reduced the cost of
capital for businesses, as well as the discount rate used to value future cash flows for financial assets. A global asset boom
ensued
However, the boom was underpinned by an unsustainable amount of artificially cheap credit. As the credit bubble collapsed,
the authorities around the world, particularly in the US, responded in a disproportionate and unparalleled fashion in attempt
to forestall a debt deflation (Slide 10)
Yet despite the unprecedented monetary and fiscal stimulus, the rate of measured inflation continues to decline
(Slide 11) while the prospect of structurally high unemployment intensifies the current deflationary pressures (Slide 12).Productivity-focused businesses are also driving down wages costs (Slide 13) in order to protect profits
Even as the Fed embarks on successive rounds of Quantitative Easing, broad money supply is rising less than nominal GDP
(Slide 14), while the velocity of money remains depressed
After years of accumulating debt, households are now in a deleveraging mode (Slide 15), an inherently deflationary process
that removes credit from the financial system
As a result, the economy is operating well below its estimated potential, resulting in a negative output gap (Slide 16)
EXECUTIVE SUMMARY
The ultimate outcome of the epic struggle between deflation and inflation is arguably one of the worlds most important questions.Asset prices, business profitability and sovereign creditworthiness will all be affected. If either occur to a significant degree, the socialfabric of society will likely be stretched, challenging existing political systems and currency regimes
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DEFLATION ORINFLATION?
However, despite the current deflationary pressures, the 1970s illustrates how inflation can arrive unexpectedly.
Similar to today, the early part of the 70s also witnessed a negative output gap (Slide 18), low capacity utilization (Slide 19), a
declining velocity of money (Slide 20)
As a result, both inflation (Slide 21) and bond yields (Slide 22) were falling
Although there is no evidence of inflation in reported indices (Slide 25), todays policies could ultimately be highly
inflationary. The US government is running unprecedented budget deficits (Slide 26) while the Feds balance sheet will
soon triple from its pre-crisis size (Slide 27)
Recently, broad money supply has begun to pick up (Slide 28)
And since QE began, commodity prices have also risen significantly (Slide 29), as have other hard currencies relative to the
US dollar (Slide 30)
Today, the deflationary forces of the collapse of the credit bubble have been met with an unprecedented
inflationary response. Unfortunately, the ultimate outcome is unpredictable. Therefore, it is paramount that
investors and business owners to be aware of todays challenges, and where possible, protect themselves
sufficiently
Interest rates tend to move in long cycles. Both inflation and the cost of credit has been falling for nearly 30 years (Slide 33).
As a business owner or investor, are you prepared for a prolonged reversal?
As the inflationary response has grown, the public has been losing confidence in uncollateralized paper money. Gold has
risen to all-time highs (Slide 34). Is it anticipating another Great Inflation?
SUMMARYCONTINUED
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THE GREAT MODERATION
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THE GREAT MODERATION
Ordinarily, excessive money growth would have ignited consumer prices. However, beginning in the mid-90s, capacity grew
faster than consumption, which served to mitigate consumer prices. Other factors contributed to the macroeconomic
tranquility. As a result, the monetary inflation appeared instead in asset prices
Source: Bloomberg, Bienville Capital Management, LLC, Fielder Research & Management
90
100
110
120
130
140
150
160
170
90 93 96 99 02 05 08
Total Capacity vs. Real Personal Consumption Expenditures
Total Capacity Real Personal Consumption Expenditures
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THE GREAT MODERATION
Both inflation and interest rates fell resulting in a lower cost of capital and therefore higher economic profits for businesses.
Additionally, lower interest rates increased the prevent value of future returns on assets. It appeared to be Goldilocks
Source: Bloomberg, Bienville Capital Management, LLC,
-2.0
0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
16.0
Jan-80 Jan-83 Jan-86 Jan-89 Jan-92 Jan-95 Jan-98 Jan-01 Jan-04 Jan-07 Jan-10
US 10-Year Treasury Yields vs Inflation (CPI)
10-Year Treasury Yields Inflation (CPI)
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DEFLATIONWILL IT HAPPEN HERE?
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DEFLATION?
By every measure, the fiscal and monetary response today is disproportionate and unprecedented in history, nearly 4 times
the response of the Great Depression where real growth contracted considerably more
Source: Blackstone; Alan S. Blinder; Mark Zandi; The National Bureau of Economic Research; Lombard Street Research;Bienville Capital Management, LLC estimates
Contraction
Cycle Peak Cycle Trough in GDP Length Monetary Fiscal Total
August 1929 March 1933 -27.0% 43 3.4% 4.9% 8.3%
May 1937 June 1938 -3.4% 13 0.0% 2.2% 2.2%
November 1948 October 1949 -1.7% 11 -2.2% 5.5% 3.3%
July 1953 May 1954 -2.7% 10 - -1.4% -1.4%
August 1957 April 1958 -3.2% 8 - 3.2% 3.2%
April 1960 February 1961 -1.0% 10 0.7% 1.0% 1.7%
December 1969 November 1970 -0.2% 11 0.3% 2.4% 2.7%
November 1973 March 1975 -3.1% 16 0.9% 3.1% 4.0%
January 1980 July 1980 -2.2% 6 0.4% 1.1% 1.5%
July 1981 November 1982 -2.6% 16 0.3% 3.5% 3.8%July 1990 March 1991 -1.3% 8 1.0% 1.8% 2.8%
March 2001 November 2001 -0.2% 8 1.3% 5.9% 7.2%
December 2007 June 2009 -4.1% 18 22.1% 11.9% 31.0%
Stimulus as % of GDP
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DEFLATION?
However, as the structure of credit has collapsed, disinflationary pressures have persisted. Inflation has now been in a
downtrend for 30 years and is currently below the level considered to be price stability by the Fed
The PCE price index is a United States-wide indicator of the average increase in prices for all domestic personal consumption. It is indexed to a base of 100 in 2005. Using a variety of data including U.S. Consumer PriceIndex and Producer Price Index prices, it is derived from the largest component of the Gross Domestic Product in the BEA's National Income and Produce Accounts, personal consumption expenditures. The less volatilemeasure is the core PCE price index which excludes the more volatile and seasonal food and energy prices
Source: Bloomberg, Bienville Capital Management, LLC
0.0
2.0
4.0
6.0
8.0
10.0
12.0
60 65 70 75 80 85 90 95 00 05 10
US PCE Core Price Index (YOY)
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DEFLATION?
With significant slack in the labor force, workers dont have pricing power. Rather, employers continue to drive
productivity increases in the hopes of squeezing more out of fewer workers
Source: Bloomberg, Bienville Capital Management, LLC
3.0
4.0
5.0
6.0
7.0
8.0
9.0
10.0
11.0
Nov-98 Nov-00 Nov-02 Nov-04 Nov-06 Nov-08
US Employment Rate
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DEFLATION?
Therefore, labor costs are declining, intensifying deflationary pressures
Source: Bloomberg, Bienville Capital Management, LLC
-6.0
-4.0
-2.0
0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
Dec-79 Dec-82 Dec-85 Dec-88 Dec-91 Dec-94 Dec-97 Dec-00 Dec-03 Dec-06 Dec-09
US Unit Labor Costs Nonfarm Business Sector(YOY % Change)
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DEFLATION?
Despite the efforts of the Federal Reserve, broad money supply has been growing at rates below nominal GDP. The credit
creation process remains highly impaired
Source: Bloomberg, Bienville Capital Management, LLC
0.0
2.0
4.0
6.0
8.0
10.0
12.0
Nov-89 Nov-92 Nov-95 Nov-98 Nov-01 Nov-04 Nov-07
Money Supply M2 Index(YOY % Change)
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DEFLATION?
Deleveraging, which has only just begun in the household sector, is a highly deflationary process as it removes money and
credit from the financial system
Source: Bloomberg, Bienville Capital Management, LLC
$0
$500
$1,000
$1,500
$2,000
$2,500
$3,000
Dec-09 Dec-19 Dec-29 Dec-39 Dec-49 Dec-59 Dec-69 Dec-79 Dec-89 Dec-99
Federal Reserve Consumer Credit Outstanding (in billions)
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DEFLATION?
The output gap, an estimated measure of the US economys growth rate relative to potential, is still negative, implying
more deflationary pressure to come
Source: Bloomberg, Bienville Capital Management, LLC
-8.0
-6.0
-4.0
-2.0
0.0
2.0
4.0
Dec-89 Dec-91 Dec-93 Dec-95 Dec-97 Dec-99 Dec-01 Dec-03 Dec-05 Dec-07 Dec-09
US Output Gap
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THE LESSON OF THE 70S
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THE LESSON OF THE 70S
Similar to today, the output gap between 1970 - 1972 was negative, suggesting inflation was not a threat
Source: Bloomberg, Bienville Capital Management, LLC
-6.0
-4.0
-2.0
0.0
2.0
4.0
6.0
70 71 72 73 74 75 76 77 78 79
US Output Gap(1970-1980)
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THE LESSON OF THE 70S
Utilization rates had also fallen from the previous years levels, implying an abundance of capacity. However, despite the
overall economys excess capacity, bottlenecks were being created in critical sectors
Source: Bloomberg, Bienville Capital Management, LLC
75.0
80.0
85.0
90.0
67 68 69 70 71
US Capacity Utilization(% of Total Capacity)
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THE LESSON OF THE 70S
The velocity of money, a key ingredient to inflation, was also falling
Source: Bloomberg, Bienville Capital Management, LLC
1.50
1.55
1.60
1.65
1.70
1.75
1.80
59 61 63 65 67 69 71
Velocity of Broad Money(M2 Index)
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THE LESSON OF THE 70S
However, despite widely available economic data suggesting disinflation, the Great Inflation was unleashed in 1973
Source: Bloomberg, Bienville Capital Management, LLC
0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
16.0
60 63 66 69 72 75 78
US Consumer Price Index(YOY % Change, 1960 - 1980)
Nixon de-links the end
of Bretton Woods
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THE LESSON OF THE 70S
Similar to economic indicators, interest rates failed to anticipate the ensuing inflation, before subsequently rocketing higher
and peaking at nearly 16%. Higher borrowing rates decreased economic profits, which dis-incentivized business frominvesting in more productive capacity
Source: Bloomberg, Bienville Capital Management, LLC
2.0
4.0
6.0
8.0
10.0
12.0
14.0
16.0
62 64 66 68 70 72 74 76 78 80 82 84
US Government 10-Year Yield
Nixon de-links the endof Bretton Woods
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IS INFLATION BUILDING?
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IS INFLATION BUILDING?
Inflation is a debasement of the currency. It isnt too much money chasing too few goods.
Its simply too much money
WHAT IS INFLATION?
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IS INFLATION BUILDING?
Conveniently, the Fed has shifted its emphasis from the PCE Deflator to Core CPI, which has a significantly larger weight
to Owners Equivalent Rent (OER). The implication is that actual inflation may be understated
Source: Bloomberg, Bienville Capital Management, LLC
-1.0
0.0
1.0
2.0
3.0
4.0
5.0
6.0
7.0
83 86 89 92 95 98 01 04 07
CPI Owners Equivalent Rent (YOY)
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IS INFLATION BUILDING?
Fiscal deficits, which are inherently inflationary, have exploded. Much of the increase is now structural, suggesting
politically difficult changes are required in order to reduce the annual deficit to sustainable levels
Source: Bloomberg, Bienville Capital Management, LLC
-14.0
-12.0
-10.0
-8.0
-6.0
-4.0
-2.0
0.0
2.0
4.0
Dec-68 Dec-73 Dec-78 Dec-83 Dec-88 Dec-93 Dec-98 Dec-03 Dec-08
US Treasury Budget Deficit or Surplus(as a % of GDP)
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IS INFLATION BUILDING?
As a result of QE2, the Feds balance sheet will expand to nearly $3 trillion, or nearly 20% of GDP. The likelihood of
perfectly timing the removal of stimulus is small. However, the potential unintended consequences are large
Source: Bloomberg, Bienville Capital Management, LLC
$-
$500,000
$1,000,000
$1,500,000
$2,000,000
$2,500,000
94 97 00 03 06 09
Federal Reserve Bank Total Assets
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IS INFLATION BUILDING?
Money supply has begun to rise
Source: Bloomberg, Bienville Capital Management, LLC
$8,400
$8,500
$8,600
$8,700
$8,800
$8,900
Sep-09 Dec-09 Mar-10 Jun-10 Sep-10
M2 Money Supply Index
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IS INFLATION BUILDING?
Since Quantitative Easing began, food and energy prices are up nearly 50% while the CPI is reporting a only 2.9%
cumulative increase
Source: Bloomberg, Bienville Capital Management, LLC
100
120
140
160
180
Mar-09 May-09 Aug-09 Nov-09 Feb-10 May-10 Aug-10
Crude Oil & CRB Food Index(Rebased to 100)
Crude Oil CRB Food Index
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CONCLUDINGTHOUGHTS
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CONCLUDINGTHOUGHTS
Everyone has a game plan until they get hit in the mouth
- Mike Tyson
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CONCLUDINGTHOUGHTS
Interest rates have been declining for nearly 30 years. In response to each crisis, the Fed has used them as a tool to entice
borrowers to incur more debt and invest in more capacity. As an investor or business operator, it is imperative to askyourself, Are you prepared for the inverse of this chart?
Source: Bloomberg, Bienville Capital Management, LLC
0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
16.0
80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10
US Government 10-Year Yield
Penn Square Bank Failure
Continental Illinois Failure
87 Crash
S&L Crisis / Gulf War I
Mexican Peso Crisis
Russia Default / LTCM Failure
Dot.com Bust
9-11Subprime Credit Crisis
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CONCLUDINGTHOUGHTS
Today, gold is at all-time highs while interest rates are at generational lows. Both cannot be correct. Is gold anticipating
another great inflation? Or is it reflecting declining confidence in uncollateralized currencies?
Source: Bloomberg, Bienville Capital Management, LLC
0
200
400
600
800
1,000
1,200
1,400
1,600
01 02 03 04 05 06 07 08 09 10
Gold (in USD)
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CONCLUDINGTHOUGHTS
Given the magnitude of the current global imbalances and the enormity of the fiscal and monetary response, price
stability over the medium-to-long term is arguably the least likely outcome
Recently, deflationary pressures have had the upper hand. However, prices in critical assets and sectors are rising, and in
contrast to previous deflationary periods, today central banks have the ability and willingness to print money
Correctly positioning an investment portfolio or business for the inevitable outcome of either continued deflation or
significantly higher inflation is of critical importance, yet doing so too aggressively could prove disastrous should the other
unfold
Unfortunately, at this time, it remains impossible to accurately identify which side we will fall. Although higher
inflation seems more likely, flexibility remains key
As the analysis of the 1970s demonstrated, a significant inflation can occur with little-to-no warning signs. Estimated
outputs gaps were of no help. Anticipating it would have required a fundamental understanding of the likely ultimate
outcome of the policies implemented at the time
Ironically, the outcome of Quantitative Easing could have the inverse of its intended effectthat is, increasing the things we
need (i.e. commodities) which reduces real incomes and economic growth, while having only a negligible impact on the
things we already own (i.e. residential real estate)
We are at a critical juncture in economic history. Do you believe policymakers have the political will, as well as the
necessary foresight to successfully navigate todays challenging environment?
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FIRM AND CONTACT INFORMATION
Bienville Capital Management, LLC is an SEC-registered, independent investment advisory firm offering sophisticated and customized
investment solutions to high-net-worth and institutional investors.
The members of the Bienville team have broad and complementary expertise in the investment business, including over 100 years of
collective experience in private wealth management, institutional investment management, trading, investment banking and private
equity. We have established a performance-driven culture focused on delivering exceptional advice and service to a select number of
investors. We communicate candidly and frequently with our clients in order to articulate our views.
Our clients include individual and institutional investors, high-net-worth families with complex needs, entrepreneurs and professionals
with at least $1 million of investable assets. Bienville Capital Management has offices in New York, NY and Mobile, AL.
New York Bienville Capital Management, LLC
32 Avenue of the Americas, Ste 2100
New York, NY 10013
Phone: 212.226.7348
Alabama Bienville Capital Management, LLC
64 North Royal Street
Mobile, AL 36602
Phone: 251.445.8139
Email Cullen Thompson
Donald Stoltz
www.bienvillecapital.com
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DISCLAIMER
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