January 2012 - Richard 'Jerry' Haworth: Dead Sea Fruit

“Something that appears to be beautiful or full of promise but is in reality nothing but illusion and disappointment.”

The global economy is trying to deleverage in order to dis-gorge itself of previous excesses. Governments are fighting it tooth and nail because deflation exposes their preponderance for over-spending. They fight under the guise that it will be bad for us – the ordinary punters. The fact is, in the long term the deflationary cycle, the creative destruction, is good for us “ordinary punters” as a group but a disaster for governments.

Governments pay for their over-spending by either accumulating more debt or retiring said debt with money created out of fresh air (leaving more capacity to borrow!). They respond to the short term interests to “save the economy” only because it suits their interests politically and economically.  Politically because they get more votes by taking the short term option even if it is the worst scenario over the long term, and economically because the value of their accumulated debt is decreased by inflation as they pay back less in real terms.

So like a fight in the playground, deflation has squared up to inflation. Who is tipped to win? Deflation, looks like the meanest, baddest bully around, he already has brought several governments to their knees (Europe?). Governments in turn have used up all their traditional manoeuvres and look, for all money, to have lost. It looks like deflation will win and run the playground at least in the short to medium term.

But governments have a “financial nuclear option”- money printing; and it is upon this weapon they now rely. No government has ever lost a fight against financial deflation using money printing. It is impossible by definition. Governments will win if they have the will to use the “nuclear option” – and it is abundantly clear that they are. 

The assumption they make, which is valid in the short term, is that creating money out of nothing, is in effect a creation of wealth and will flow through to the real economy as increased prosperity. But invariably it doesn’t; people may be slow to the uptake but they are not stupid. This policy will prove to be a “dead sea fruit”, the consequence will be stagflation.

Stagflation is worst of all “flations”, it is inflation in the real economy combined with deflation in the financial economy.  We seek to accumulate wealth but choose to leave it in the financial (paper) economy because it is convenient and fungible. We sell a paper asset when we require goods from the real economy i.e. food. All along we assume that the value of both markets will be in line or with a bit of luck, our Apple shares (paper asset) will have soared in value and when we get to sell them we can buy whatever we please in the real economy. Stagflation at its worst is the opposite. You put $1000 dollars in the bank (paper asset) when it is equivalent of a month’s middle income earner salary. You leave it for 5 years and when you draw it out to buy food, you can buy only 10 cans of baked beans (real asset) because real asset prices have moved up faster!

The worst thing about stagflation is that it is difficult to do anything about it especially when interest rates are kept artificially low. There is no easy place to hide.

Financial inflation confuses everybody. To quote Henry Hazlitt in his 1946 book Economics in One Lesson

“Like every other tax, inflation acts to determine the individual and business policies we are all forced to follow. It discourages prudence and thrift. It encourages squandering, gambling, reckless waste of all kinds. It often makes more profitable sense to speculate rather than produce. It tears apart the whole fabric of stable economic relationships. It’s inexcusable injustices drive men toward desperate remedies. It leads men to demand totalitarian controls, It plants the seeds of fascism and communism. It ends invariably in bitter disillusionment and collapse.”

A Dead Sea fruit indeed!

Fortunately, 36 South can access long dated options which can, by their inherent nature, run faster than the underlying stagflation. A well-chosen portfolio of options has the potential to produce great returns in this environment. We can buy call options on assets which be affected by real economy’s price inflation AND buy put options on assets which will be badly affected by financial deflation.