Book Review: The Age of Deleveraging

The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and DeflationGiven the strong rebound in the equity markets since March 2009, “most investors believe that 2008 was simply a bad dream from which they’ve now awoken,” starts Gary Shilling in his newly-released tome on deflation, The Age of Deleveraging. “But the optimists don’t seem to realize that the good life and rapid growth that started in the early 1980s was fueled by massive financial leveraging and excessive debt, first in the global financial sector, starting in the 1970s, and later among U.S. consumers. That leverage propelled the dot-come stock bubble in the late 1990s and then the housing bubble.”

Dr. Shilling has had a long and wildly successful career as an economic forecaster. Shilling was one of the few voices of reason that foresaw the busting of the Japanese bubble of the late 1980s, and he also correctly forecasted the bursting of the 1990s Internet bubble and the mid-2000s housing and financial sector bubble. I am delighted to find him on “our” side of the inflation/deflation debate.
It can be a bit lonely here in the deflation camp. Despite the fact that official CPI inflation has been tepid at best for the past three years and that retailers still have practically no pricing power, there is widespread belief that high or even hyper inflation is just around the corner due to the Federal Reserve’s aggressive quantitative easing.

(Note: The CPI inflation rate also tends to have an upward bias according to Shilling. Naturally-skeptical Americans tend to assume that the government statistics under-represent inflation, but Shilling makes a compelling case in Chapter 8 that precisely the opposite is true. The index fails to consider substitution effects, understates the effects of major discounters like Wal-Mart, understates quality improvements, and fails to consider new, popular products that make up a decent size of consumers’ budgets. Though we’ve all been trained to view government statistics as state-sponsored misinformation, I encourage readers to approach Shilling’s view with an open mind.)

Even a superficial understanding of history would tell you that deflation is a far more likely outcome of a bubble and subsequent bust. “Inflationists” seem to see shades of Weimar Germany everywhere they look, but this is a clear case of the representativeness bias at work, as well as its sister heuristic-driven bias, the confirmation bias.

Essentially, the inflationist camp is making the mistake of believing that the pre-WWII Weimar German Republic is an accurate representation of our own conditions today. Why? Because it is example that is often cited in popular economics books and it is thus fresh on their minds. But a better understanding of history would tell you that 1990s Japan is a far better representation than 1920s Germany. Japan, like America, had a massive real estate and consumer spending bubble fueled by easy credit. Weimar Germany’s inflationary spiral was a result of unpayable war reparations. Which would seem a closer parallel to you?

Similarly, the inflationists see confirmation that inflation is “everywhere” when they see prices for fuel and agricultural commodities rising—yet they ignore the fact that food prices have risen primarily due to supply-shock factors (i.e. exceptionally bad harvests in Russia and elsewhere due to extreme weather) and that energy prices are manipulated by both speculators and the OPEC cartel. They simultaneously ignore the fact that retail prices of services and manufactured goods continue to fall, as do housing prices. Furthermore, the bursting of asset bubbles is virtually always followed by a long period of deflation. Gary Shilling understands this.

Shilling believes that as a result, we have a decade or more of continued deleveraging in front of us, and with it a period of lower than expected growth and deflation.

It won’t happen overnight, of course. “The insidious reality is that this deleveraging doesn’t occur in a straight line,” Shilling continues, “but in a series of seemingly isolated events. After each, the feeling is that it’s over…but then follows the next crisis. When the subprime residential mortgage market collapsed in 2007, most thought it was a small, isolated sector. But then it spread to Wall Street with the implosion of two big Bear Stearns subprime-laden hedge funds in June of that year.”

Of course, the crisis was far from over. It was just getting started, in fact. In the year that followed, every major Wall Street investment bank either failed outright or was forced to reorganize. “Then,” Shilling picks up, “the third phase struck as U.S. consumers stopped buying in the fall of 2008 and the fourth, the global recession, coincided.”

The fifth phase was, of course, the European sovereign debt crisis, which—at time of writing—continues to fester. First, it was Greece that sent shockwaves through the capital markets, then Ireland. Based on the action in the equity and debt markets, investors appear to be betting that Spain will be next. Shiller believes that phase six could be a meltdown in U.S. commercial real estate, or perhaps the collapse of the Chinese “house of cards.” Only time will tell. But the key point is that the chain of crises that have marked the past three years still has quite a few links left in it.

All About Deflation

Shilling was about ten years early to the deflation party, publishing in 1998 Deflation: Why It’s Coming, Whether It’s Good or Bad, and How It Will Affect Your Investments, Business and Personal Affairs. Still, Shilling’s rationale is solid, and he is rather brave to make predictions that are so far out of the mainstream.

On the federal deficit and its implications, Shilling writes,

“With the prospect of huge federal deficits for the next several years, why won’t significant inflation follow? After all, excessive government spending is the root of inflation. Still, it’s excessive only if the economy is already fully employed, as in wartime. And that’s not the case now, nor is it likely in the slow economic growth years ahead. The continuing $1 trillion deficits result from a sluggish economy, which retards revenues and hypes government spending.”

Ditto, Gary. Dr. Shilling, though not a demographic expert by any stretch, does understand what demographic trends imply. On the Boomers he writes,

“A saving spree in the next decade will also be encouraged by [Baby Boomer] saving. Those 79 million born between 1946 and 1964 haven’t saved much, like most other Americans, and they accounted for about half the total U.S. consumer spending in the 1990s. But they need to save as they look retirement in the teeth… Postwar babies need to save not only to finance retirement but to repay debt. The Fed’s 2007 Survey of Consumer Finance found that 55 percent of households with members aged 55-64 had mortgages on their abodes and 45 percent carried credit card balances.”

Yet while he sees the importance of demographics, he also misunderstands them. Shilling falls into the trap that so many others—Dr. Jeremy Siegel and Fed Chairman Ben Bernanke among them—fall into. There is this persistent belief that the retirement of the Boomers will cause a labor shortage that will lead to severe inflation. As Shilling writes, “When [the Boomers] stop working, the supply of goods and services would fall. In retirement, they might spend less on themselves and on supporting their kids, and they might have lots of greenbacks… Nevertheless, there would not be enough goods and services to go around.”

While this argument might make intuitive sense at first, it is fundamentally flawed. Outside of medical care and select few other industries, spending falls on virtually all other consumer items in retirement. Yes, the elderly still have to eat. But they buy little else that contributes meaningfully to inflation.

This is not purely an academic argument. Japan has been struggling with an aging and even declining population for years now. And Japan would love to have an inflation problem. Instead, deflation persists.

You see, supply is not the problem. In the post-industrial information and high-tech economy, supply takes care of itself. Is it expensive to hire a housekeeper? No problem, buy an iRobot Rhoomba to vacuum the carpet while you’re at work. Is your tax accountant expensive? No problem, fire him and buy TurboTax. In the modern economy, automation and technology can make a good deal of human labor obsolete. We bring in migrant labor to harvest crops because migrant labor is cheap. But if the price of migrant labor got high enough, rest assured that California farmers would use robots to pick strawberries. This is not idle conjecture; their counterparts in Japan already do.

Demand will determine if we have inflation or deflation, not supply.

I don’t want to beat up on Dr. Shilling; most of his arguments are solid, and his book is an excellent analysis. Still, I should point out that we do disagree with the good doctor on these few—but important—points.
After making his case for deleveraging and deflation, Shilling wraps up his book with a list of investments he recommends avoiding or even short-selling given the right opportunity.

12 Investments to Sell or Avoid

1. Big-ticked consumer purchases

This is easy enough to understand. In a period of slow growth and tight credit (and negative demographic trends), sales of autos, boats, utilities and other items usually purchased on credit should suffer, and the companies that sell them should continue to struggle.

2. Credit card and other consumer lenders

It’s also quite easy to see why Shilling considers consumer lending a short. Given the tight credit conditions prevailing and the fact that most lenders have impaired balance sheets, it would be wise to steer clear. That said, new lenders with clean balance sheets and good risk management in place might actually do well.

3. Conventional home builders and suppliers

No shock here. With housing still in rather significant oversupply in many markets, the demand for new construction should be tepid at best, particularly for the “McMansion” segment so popular during the housing bubble.

4. Antiques, art, and other tangibles

Shilling’s belief is that, as traditional inflation hedges, high-end collectibles will do poorly in a period of deflation, and we would agree with this. Interestingly, the biggest buyers today of fine art, antiques, wine, etc. are largely the nouveau riche of China, India, and other emerging markets. When China’s bubble bursts—and it most certainly will, it’s just a matter of time—this segment should get hit especially hard.

5. Banks and similar financial institutions

There are a lot fewer banks to invest in these days after the failures of 2008-2009, and those that remain find themselves burdened with impaired balance sheets and a harsh regulatory regime that frowns on risk taking. This doesn’t bode well for bank profits going forward.

6. Junk securities

Shilling’s contention here is that weaker, risky companies are not a good place to be invested during a weak economy. I would largely agree, but might be inclined to keep an open mind—eventually. Given the carnage of the past couple years, there might be some bargains in this sphere in companies that got downgraded to junk status but might actually be relatively healthy. Assembling a portfolio of such securities would probably do quite well. Still, this sector will get absolutely hammered should interest rates continue to climb as HS Dent forecasts. The higher cost of borrowing would force many companies to go under, and the value of even the healthier bonds will sink as interest rates rise. Best to be patient here.

7. Flailing companies

The rationale here is the same as #6 above. In a weak economy, it’s risky to hold marginal securities.

8. Low- and old-tech capital equipment producers

Essentially, slack capacity means little or no ability to raise prices. It also means little or no economic incentive to hire new workers. Capacity utilization has recovered from the pits of 2008 and 2009, but even after its sharp rebound it remains near the lows of prior recessions. The bottom line here is that we don’t need new industrial capacity; we have too much as it is!

9. Commercial real estate

This one is really a no brainer. We saw what happened in the residential real estate sector, and by some measures commercial real estate got even more overvalued during the boom. Furthermore, a sluggish economy and the pending retirement of the Boomers means that demand for office and other commercial real estate should be weaker going forward. Add in the potential for higher rates, and you have a recipe for absolute disaster.

10. Commodities

I’ll be honest; I hate commodities as an asset class and view them as completely unsuitable for retail “buy-and-hold” investors. Commodities are best used by aggressive short-term traders who understand the risks that are being taken and who know how to avoid the ravages of contango. The ETFs that purport to “invest” in commodities would appear, for the most part, to be designed with the express intent of allowing nimble traders to rob naïve passive investors blind.

Though his critique is less scathing, Shilling would largely agree, and adds that slack demand from the West should create downward pressure on prices. If you are a trader, knock yourself out in commodities. If you’re good, you can make a lot of money. Just don’t make the mistake of considering them an investment.

11. Developing country stocks and bonds

It might surprise a lot of readers to see Shilling include emerging market stocks and bonds on his “sell” list. His view is that the emerging market economic model largely consists of producing goods as cheaply as possible and then sending them all to the West. That’s not a particularly good model when the West is deleveraging and spending less. When China bubble burst, the fallout will be huge for South American and Southeast Asian emerging markets who have come to depend on China for growth. Once we see a good crash in this sector, we might be inclined to invest, particularly in the countries with less export and commodity exposure and in the companies and industries geared towards local consumers.

12. Japan

I’ve written tens of thousands of words worth of material over the years about Japan, virtually all of it negative. I’ll spare you a repeat, but suffice it to say that bad demographics and nosebleed levels of debt make Japan, in Shilling’s words, “a slow train wreck.” (Personally, I like John Mauldin’s description of Japan as a “bug in search of a windshield“)

It’s not nice to end an article on a negative note, so let’s wrap this up with Dr. Shilling’s 10 recommended investments to buy.
10 Investments to Buy

1. Treasuries and other high-quality bonds

Given the low level of current yields, this asset class is a little less than inspiring. Still, it is better to get a guaranteed 3.3%—with the possibility of capital gains in real terms due to deflation—than to put your capital at risk in something from the “sell” list above.

2. Income-producing securities

The rationale here is pretty straightforward. In an environment of stagnant or falling prices, income received becomes increasingly more valuable with each payment. But furthermore, cash payouts send a very important message to investors about the safety and quality of a stock or other security. If you’re going to invest in the market, make sure you’re getting paid to do so.

3. Food and other consumer staples

In this case, Shilling is talking about processed foods that you would buy at the grocery store, not commodities. His rationale is solid. You want to own, at the right prices, companies that supply basic needs that will be met regardless of the condition of the economy. Even during the Great Depression, folks had to eat. We should mention though that in a major bear market, all stocks fall. These are best bought after a substantial correction.

4. Small luxuries

This is an area that I see a lot of promise in, and I’m glad to see Shilling agree. Even after two decades, Japan remains a virtual sponge for luxury goods, soaking up an obscene amount of the world’s luxury output. Once you get used to projecting a certain image, it’s hard to trade down. Furthermore, there is an element of escapism. Wasting a little money on frivolities can help you get through the hard times.  (See prior posts on luxury goods.)

5. The U.S. dollar

I’ve made the case for the dollar for the past several years. Shilling’s view on the dollar is essentially the same as my own: the dollar is the worst currency in the world…except for all the others. And during times of crisis, investors will continue to flock to the dollar as a safe haven. This is ever more true now that the euro is facing an existential crisis due to the sovereign debt fiasco.

There is another point as well. There is concern that the Fed’s profligacy is bad for the dollar, and in a vacuum it is. But the massive private-sector deleveraging that is underway is destroying dollars faster than the Fed can “print” them and faster than most other currencies. So, regardless of attempts to debase the dollar, it is likely to rise against other currencies.

6. Investment advisers and financial planners

This will no doubt be good news to many of our readers in the business. The rationale is pretty straight forward. A decade of dismal returns will lead many to seek professional help, while the Boomers will be rolling their 401k plans into IRAs that will need an investment manager or financial planner. It’s a cutthroat business, but a rising demographic tide should lift all boats.

Investors should use their heads here, however. As in the cases above, this sector is best bought after a correction. But more specifically to this sector, watch out for broader exposure to the financial sector. You don’t want to buy investment management firms that are likely to blow up along with the banks.

7. Factory-built housing and rental apartments

Shilling’s argument here is mostly that existing homeowners will be trading down for the foreseeable future. While I agree, we would also add that the Echo Boomer generation is leaving the confines of the university and will need an enormous amount of apartments in the years ahead. It’s tricky to invest in this sector, as the only way for most investors to get exposure to apartments is through REITs, which would currently appear a bit overpriced. But the trends supporting the sector are solid. For the best prices in this sector, it makes sense to wait until 2013, when much of the damage to the broader real estate markets will have been done.

8. Health care

This is probably the biggest no brainer on the list. Even in a world dominated by deflation, I see substantial inflation in the health sector. As the Baby Boomers age, they will put unprecedented pressure on the health industry. Health insurance companies, though, are probably best avoided. There is simply too much political risk in that sub-sector, and a weaker economy may lead some policy holders to stop paying their premiums.

9. Productivity enhancers

Companies and consumers will be looking for ways to cut costs, and companies that allow them to do this should do well. An interesting case that Shilling should have mentioned but didn’t is the Japanese robotics industry. Facing labor shortages due to a declining population, Japan has created robots that resemble something from a science fiction movie. Expect the same in the United States and Europe.

10. North American energy

Shilling’s rationale here is more political than anything else. Given the geopolitical risks and that virtually all major energy exporters have…shall we say, “complex” relationships with the United States, domestic production makes strategic sense. This is, however, driven by politics. The Green Energy movement all but evaporated during the meltdown years. When the economy is in a tailspin, energy efficiency is the last thing on most people’s minds. Our usual advice to wait for a crash might not be relevant here, as a crash in energy prices will actually create less incentive to invest in domestic energy sources. It might be best to pass on this recommendation.

Concluding Remarks

In The Age of Deleveraging, Dr. Shilling has published a very good and very convincing body of work. A world economy dominated by deleveraging is a very different animal than a world economy dominated by an accumulation of debts. As investors, you have to position your portfolios accordingly and—I want to be firm on this point—you have to adopt a tactical approach to investing. Take advantage of rallies when you see them, but be prepared to take profits. In a period of deleveraging, you win by not losing.

Charles Lewis Sizemore, CFA

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