Dealing with ermflation

“Calm down, dear, it’s only a recession.”

– A message on Michael Winner’s T-shirt, sported while in Barbados. (Hat tip to Money Week.)

In ‘Alice Through The Looking Glass’, the White Queen admits that she has sometimes believed as many as six impossible things before breakfast. She would be at home in today’s markets. Last week, pornographers Larry Flynt and Joe Francis lobbied Congress for a $5 billion bailout in line with that sought by the auto sector. “As long as the government is handing out money, we want to be there to take it,” said Francis. You can’t fault his logic. The appeal may have been brazen, opportunistic and self-serving – so perhaps he should really be working on Wall Street.

It turns out that Ronald Reagan had most of the best lines in anticipation of the current economic black comedy. “A recession is when your neighbour loses his job,” he said in 1976; “A depression is when you lose yours. And recovery is when Jimmy Carter loses his.” Refreshingly for a politician, he also suggested that “The ten most dangerous words in the English language are ‘Hi, I’m from the government, and I’m here to help’.” And on the same topic, he described government as “like a baby. An alimentary canal with a big appetite at one end and no responsibility at the other.” Where we stand today, a problem caused primarily by the unconstrained greed of the private sector is now being addressed by the dubious intentions of the public sector. History suggests it will not be handled well. When money is spent, it can only be under one of three conditions. You can spend your money on yourself. You can spend your money on other people. Or you can spend other people’s money on other people. This last version is the very definition of government spending.

Answering just one question correctly should be sufficient to navigate the markets successfully during 2009 and for the foreseeable future: inflation, deflation, or both ? And when ? Unfortunately the future is more than ordinarily unforeseeable (spot how many chief executives use the word ‘visibility’ over the coming months), because none of us has been here before. On the deflationary side, take the largest credit expansion in world history – an expansion that of course has now become a contraction, and the largest debt deflation in world history. On the inflationary side, take the largest fiscal and monetary infusions in world history. Then pay your money and take your choice. Of course, there is a middle way. Since western governments have effectively extinguished cash as a meaningful asset choice, ‘twin primacy’ in investment terms goes to blue chip equities and high quality bonds. Arguably the best way of dealing with ‘ermflation’ – the sheer inability to forecast which particular threat will be the most severe, and over what kind of timeline – is to maintain exposure to both types of asset. Blue chip stocks offer a hedge, of sorts, against eventual inflation, given that they represent a claim on the real economy. Blue chip bonds (and the value is now firmly in the corporate credit market as opposed to government debt, unless deflation kicks in with a vengeance) offer a realistic hedge against deflation. The caveat in both cases is that extreme selectivity will be required. The recession we are entering is going to be peculiarly savage. We already know that the High Street will be awash with blood, and vacant lots, before it is over.

So the onus on investors is to use a particularly robust screening process to identify the probable winners and losers in the Darwinian economic marathon ahead. Measures like the Altman Z Score work for selecting both equities and bonds. Indeed the trick in 2009 will be to treat equities like bonds, as primarily income-generating assets (and something has to replace those deposit accounts at dodgy banks, which is to say all of them). So if the stocks in your portfolio are unlikely to maintain their dividend, or worse still don’t even pay a dividend, you would be well advised to eject them with extreme prejudice. We are long beyond the simple pursuit of capital growth: a deflationary (or ermflationary) depression is an environment that demands a commitment to capital preservation, inasmuch as anything so concrete is achievable in such freakish economic and market conditions. Positive straws in the wind ? High yield seems to have turned something of a corner, but there have been enough false dawns on the way here to be a permasceptic. (And last Wednesday’s troubled German government bond auction sets an ominous precedent for megaborrowers like the UK.) But perhaps the most promising development is that we have entered the last days of the presidency of George W. Bush – a politician who reset the bar when it came to defining ignorance and ineffectuality. Which in turn begs the question of whether any populace deserves the government it gets. Overmuch contemplation on that score is just too horrible to bear.

The third part of the investment triumvirate for 2009, now that Bernie Madoff has effectively destroyed confidence in funds of hedge funds, and given that the unavailability of credit has performed the same function for private equity, is real assets. As we wrote last week, commodities performed well in the 1930s, and history is showing every sign of repeating itself – though whether as tragedy or farce is for the reader to decide.

Originally published at The Price of Everything and reproduced here with the author’s permission.