Preparing for Deflation: The Risk Few Are Discussing

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By Joshua Enomoto, Founder of and Contributor

As an active member of the alternative investment community, it is my duty and calling to warn of the impending danger of inflation and its evil step-sister, hyperinflation. After decades of deficit spending and the building of normalcy bias, inflationary pressures seem inevitable. Inundated with images of the Federal Reserve and other banking conglomerates printing their way to solvency, hedging against this most devious of monetary sins is counted as a basic necessity.

Inflation, at its core, is remarkably easy to address from a personal perspective: since more money is chasing after fewer goods, mere ownership of desirable assets can lead to arbitrage opportunities. Such assets typically include gold bullion due to their immediate liquidity, but can also include entities like real estate, stock certificates, and even businesses. Essentially, as long as an investor concentrates on transacting his or her currencies towards tangible assets or ownership of productive entities, inflation can be controlled, and perhaps profitably as well. Indeed, the default mindset of the American consumer (ie. the accumulation of “stuff”) may be enough to offset much of inflationary pain, even amongst the least financially savvy.

The real question, then, is how to handle deflation? After all, there are very few YouTube videos warning of the dangers of hyper-deflation and the rising valuation of the U.S. dollar:

Based on the latest technical snap-shot of the dollar index, there can be no question that the greenback has ridden a wave of bullish sentiment since the beginning of this month, with the 50 day moving average 2.2% above the 200 DMA. And while many in the precious metal community have a tendency of dismissing the index as a “basket filled with other worthless fiat currencies,” such sentiment distracts from real-time changes that are occurring in the FOREX market, which will inevitably have consequences across all asset classes.

The implication of the above chart becomes more complicated when we consider the future trend of deflation: will it be a short-term cycle (hopefully) or a long-term secular pattern? Of course, very few of us would welcome deflation, but not wanting it does not necessarily equate to avoiding it altogether. As it is a very real possibility, we should at least prepare strategically for such a scenario.

A short-term deflationary cycle is often attacked through the FOREX market, trading currency pairs and speculating on their directional momentum. Notorious for its volatility, it’s not unusual for average investors to stay out of this sector altogether and instead, “ride it out.” This latter strategy has been uniquely successful, as the U.S. equities market has lifted itself to record heights even without the benefit of “street” inflation, thus providing an uncommonly common solution to a difficult problem.

What happens though, if deflation is the motif for the long-term? Is holding the dollar and selling assets the way to go, a direct reversal of the strategy employed against inflation? Secular deflation is admittedly one of the greatest fears of almost any investor. Whereas price hikes and its preceding threats dictate that the mere purchase of gold would lead to financial protection (or at least its pretense), the “unbuying” of bullion is hardly an elucidation during price declines based on fiscal volatility. First, commodities typically fluctuate in greater nominal percentage terms than single-unit currencies, thus implying that the sale of bullion in the face of deflationary forces have likely led to a capital loss. The currency unit would then have to appreciate in value to overcome the principle loss, as well as any premiums or taxes, for the sale to have made financial sense. Second, the lone attraction of bullion ownership in an inflationary cycle is capital gains profits, which helps to offset cash-flow opportunity costs had the money been invested towards productive assets instead. But in a deflationary downturn, the ownership of bullion is a pure liability: capital gains are negative, opportunity cost is positive, and interest/dividend payments are nil.

The risks are further amplified in illiquid assets, such as real estate. Obviously, from a principle standpoint, the value of property would likely be in decline. But even from a cash-flow perspective (real estate as an investment), the expected returns can quickly turn negative as secular deflation is usually accompanied by high unemployment. As less currency and human capital is flowing through the economy, rents would have to be reduced. Should the rental have been purchased in a cycle prior to the deflation, that property could easily turn into a liability.

Obviously, deflation presents an opportunity in that those who have led a “savings” mentality can take advantage of lower prices, both in terms of common stock as well as key commodities. Theoretically, the cost of day-to-day living would be cheaper and therefore would provide some relief in a depressed economy. But the tricky part of deflation is that it is indeed a cycle, a financial journey of desperation that must be endured, not enjoyed. While many mainstream contrarians hawk statements like “the best gains are made during the worst crises,” the reality is that no downtrend ever signals a “BUY ME NOW” sign. In fact, buying when others are selling is a tactic that is rarely learned, if at all. Even those that have an innate gift for moving against the grain may become disillusioned with years, perhaps decades of volatility.

The inherent danger within the U.S. economy is that carry-trade volatility in the currency markets can dramatically swing 10-year Treasury Note yields to higher levels, constricting nominally what little financial activity is occurring already. In fact, currency trades, often leveraging to the power of 200:1, can spike the valuation of the greenback regardless of any money printing, threatened or otherwise. A very delicate balance is in stage during these tumultuous times, and no scenario, no matter how ludicrous it may appear at face value, should be derisively dismissed.

Precious metal investors should absolutely tread with the utmost caution: the threat of deflation, along with the incredible leverage of carry-trade volatility, implies that the current spot-price of gold and silver bullion cannot be confirmed as “cheap.” At the most elementary assessment, if the directional momentum of physical bullion is long-term deflationary, a so-called “buying opportunity” may in fact front-load a 20-year opportunity cost. If other macro fundamentals turn negative, gold would have to be stored as a foreign investment and some of the negative aspects of capital liabilities discussed earlier would still apply.

In deflation, there are no easy answers: those that are hawking such are outright liars. With that said, should our country take that turn for the worst, some practical solutions are: stay cash-rich, limit exposure to monetary assets (gold), transfer some exposure to inelastic assets (palladium), and move funds to foreign markets.
I will be writing more about deflation and potential ways to protect yourself in future articles: if I am wrong about a deflationary forecast, you will likely be more cash-heavy than you prefer. However, if I am right, you stand to be mentally and financially prepared for a scenario an alarming few have ever considered the possibility of.

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