Thursday 4th December 2008

Every day yet more bad news comes out...massive job losses (Credit Suisse cutting 11% of their entire workforce), panic interest rate cuts by central banks, new safety-nets needed for those who are in financial difficulties, company profits turned to unimaginably high losses, bail-outs of private companies by governments, and falling oil prices (bad news because it is politically destabilising).

Let's look at the compass and see where we are headed.....

Governments are trying to halt the decline in business by reducing taxes (mainly for the bottom tier as they spend it fastest) and by making money available to the banking system so that it can lend to consumers and revive the housing market (so people can continue to borrow against their houses for income) . The idea is that if the consumer has more money then he will spend more. The problem is that they are trying to fight a natural cycle. It's like trying to turn the tide. Canute wasn't able to and neither will governments.

I think that we can safely dismiss the idea that present policies are going to do anything for the downturn -- they might help to prevent a collapse of the banking system and it could be that's the main objective, in which case fine; a collapse of the banking system would leave us so deeply in poo we might not recover for decades. Yes, decades.

Accepting that business is going to contract for at least the next twelve months (and that is very optimistic) can we see any more clearly now what is going to happen?

There will be massive new demands on the public purse as unemployment rises and private pensions fail to provide for their pensioners. Tax revenues will fall with reduced earnings and spending, and reduced corporate profits. Added to the billions of pounds spent supporting the banks and other companies, the deficit will become unmanageable. The US and UK will issue more money (dollars and pounds). The Euro will probably follow but more reluctantly. Inflation at this time appears to have fallen to nearly zero and there are fears that we will slip into a long period of deflation, like Japan.

That is possible but I believe that they are looking at the wrong signals. The 'deflation' (i.e. falling prices) that we are seeing today are due mostly to stock clearance and price wars. This will not continue. Normally, most of the stock is cleared out by the end of January -- what doesn't sell before Christmas is sold in the sales. This year, it looks as though it will take longer to sell. Maybe March or April during which time shops will close down and goods will be sold at fire-sale prices, adding to the apparent 'deflation'. If the central banks continue to respond by printing more money in an attempt to fight non-existent deflation then when the glut of product dries up, and new product has to be ordered from the factories, the prices will be much, much higher. This could happen very quickly. In this situation we would have an economy drowning in money with low stocks of products to spend it on. The classic recipe for inflation. Only this time, the numbers will be so massive that the inflation will be a monster.

When you are making investment decisions I strongly caution you not to assume that we will be entering a period of deflation. It could happen, but it's far more likely that we will see hyper-inflation early in the New Year.