CRB Index-Forward Indicator Published April 2010

          Generally speaking, deflation is caused by a decline of currency or credit (money supply) in circulation, or as a result of an increase in the supply of a particular good.  A contraction in the supply of money drives prices for goods downward due to a shortage of available funds in the system.  Inversely, inflation can be created by a short supply of goods, and/or an increase in the money/credit supply (monetary inflation).  The latter is created exclusively by the central bank with the encouragement of the political party in control at the time.

          People rely on the Consumer Price Index for their insight into inflation.  While useful, the index, at anytime, can be, and often is, manipulated to skew the outcome.  The most often method is the stripping of core items.  Because of this, we find this measure to be unreliable.   Furthermore, any consumer can debate the relevance of the metric by simply comparing it to ones own cost of living which has increased much faster than the token 2-3% annual increase the index likes to deliver.  For example, house prices across the nation have doubled in the past ten years which implies a compounded annual return of roughly 7%.  Similarly, gas and food prices have also increased above the 2-3% range.  In most cases, we as consumers can avoid some price inflation by simply choosing not to buy goods, or settle for a cheaper alternative.  However, services such as power are usually set by government, leaving the consumer at the mercy of the price setter.

          While the CPI is indicating a general increase in the level of prices, it is the money supply that ultimately controls the movement in prices.  When the Bank of Canada lowers its lending rates, chartered banks are able to lower the amount of interest they charge on their loans.  As a result, the banks are able to lend more capital based on the debt-servicing equation.  This increase in availability of credit, also known as monetary inflation, raises the price of many goods.  For example, house prices in Canada have reached today’s levels only because of falling interest rates. If interest rates remained flat over the past decade, home prices could only have increased with wages, or 2% annually.  Conversely, the U.S. has experienced monetary deflation as lenders tightened their standards, resulting in less available credit circulating.  As a result, we have witnessed a melt-down in the U.S. real-estate market.
 
          Based on today’s movement in prices,  interest rates should be at least 4%.  However, given monetary deflation is still a strong threat, rates have remained at historical lows.  Today’s low rates have allowed governments around the world to borrow at non-existent interest rates.   What today's low interest rates are telling us is that the financial meltdown, which began almost three years ago, is still intact.     
 
          Japan has had zero interest rates for almost 20 consecutive years.  This policy continues to eliminate savings at a fast clip.  Japanese household savings have declined continuously from 16% of household income in the late 80’s, to 3% today.  At the same time, personal debt loads are climbing to maintain a life style that is not sustainable.  Japan provides ample evidence that low interest rates destroy savings and increase debt.    
 
          Today’s monetary deflation, while mild, is now into it's 33rd month, longer than that of the Dirty 30’s.   Furthermore,  there is very little evidence that it is ending.  People are borrowing and spending as never before, creating a false miniboom.  Considering the average household had a tough time dealing with their debts prior to 2007, how will they cope with today’s load?  Given the bulk of outstanding consumer debt is long-term (mortgage),  any future rate hikes will consume additional discretionary spending needed to fuel a true period of inflation.  Furthermore,  those living in B.C. and Ontario will realize a tax increase on July 1st (HST), resulting in less disposable income.   
 
          Too many people in the investment business are recommending buying all commodities to protect one's wealth.  The facts are there are surpluses of most commodities.  Furthermore, these assets have lost value to inflation over the past 200 years.  Over the past year the CRB Index (based on commodities) is up 22%.  When selling does come, as it always does, the sell-off will be substantial.  We cannot rely on the media’s illusion that China will consume any excesses. They are going to be more of a seller because they have huge stockpiles of most commodities.  Institutional investors will not be buying either.  In fact, I am willing to wager , since they are recommending commodities, they are net sellers, unloading their own positions onto their clients.   This is how the market makers operate.
 
          People have done everything to maintain their spending.  This is why the average sale price of houses in Canada have remained flat to slightly up, even-though there is plenty of housing available (5.8 months supply throughout Canada).  I took my son to Toronto at the end of March and visited the CN Tower.  I was blown away by how many new condo projects that have popped up since my last visit two years ago, not-to-mention those in the midst of construction.  My Grandfather’s Realtor told him there was an estimated 32,000 units being released on the market this spring alone.  It will be interesting whether the units will be absorbed or be turned into rentals, which from simply walking the street, is a saturated market.  “For Rent” signs where visible across the city.  Granted, the majority of the vacant units are in older buildings,  however, desperation is evident when buildings are offering incentives such as a free months rent or a flat-screen T.V. to anyone that signs a 1-year lease.

          House prices in Canada still bare no relation to family income.  After 3 years, American home values are down to around 3 times family income.  In Detroit, one can purchase a bargain at around one time household income.  Canada's average home price is at 5 times income, while Australia at under 6 times.  American prices are at or near the bottom.  Places such as Spain, Northern Ireland, Canada, Hong Kong, New Zealand, and Australia have plenty of room for sizeable price drops.  It should be pointed out that while the average sales price in Canada has rebounded, one is able to buy more house for one’s money.  This is deflation quietly at work.
 
          Once inflationary pressures do surface, central banks will be forced to create higher interest rates.  In a normal economy, rates should be substantially higher today because America is borrowing every cent it can find in order to finance it's $1.6t budget deficit.  Today, we are probably 2-3 years away from a banking prime rate of 4% or higher because deflationary pressure are still present.  Furthermore,  all politicians will complain that rising interest rates will hurt the housing market forcing the Bank of Canada to increase rates slower than needed.  
 
          Over the past 3 years, not one politician anywhere in the world has commented on how zero interest rates have punished savers, those on a fixed income, and all investors.  Part of the reason is few politicians have an understanding of basic economics, and fail to recognize that savers are the backbone of all economies.  It is their investment in shares and bonds that fuel all businesses and jobs, which in return, creates the surplus cash that buys cars and homes.  The investor/saver is the biggest job creator throughout any economy.   It is going to take trillions of dollars of investors savings world-wide to give the economy a solid, long lasting boost.  Yet those savers are getting poorer by the day due to government policies.  These policies will prove to be deflationary.

          We do not know which one will win out in the months ahead, deflation or government printing presses.  We give both an equal chance.  Deflation is usually short-lived, lasting 12-24 months.  However,  Japan has been the exception.  It is presently in its 3rd deflationary depression in the past 20 years. Once deflation gets a grip it is hard to eliminate it because spending slows since prices may be lower tomorrow. Governments will attempt to avoid deflation at all costs.  They tend to  love inflation because it devalues their outstanding debt. 

          Everyone in the investment business, except us, are surprised that the latest numbers from Japan show the deflationary forces are still at work and actually seem to be getting worse. We are the only people who believe the one variable that  is destroying Japan is zero interest rates.  Over the past 20 years,  Japanese household savings rate has deteriorated.  There will be no change in Japan until interest rates move up creating incentive for one to save.  A nation does not prosper by eliminating savings.

          The key to watch is the CRB Index.  Under 181 the world is heading into a period of deflation.  If it climbs over 300, it will warn inflation is coming.  Today it is bouncing between 250-275, a level the world can be comfortable with.  Hopefully it will stay in this range for sometime.  While The Streets are predicting rising inflation, few talk about the present threat of deflation.  History shows that when everyone is on the same wavelength the opposite usually takes place.  We are not out of the deflationary woods yet.