Market Inflection Point Jude Wanniski August 2, 2001

Every day brings another announcement by a key business figure that we have hit bottom and will soon see the promised rebound. Yesterday it was Merrill Lynch calling the turn, where there is none. Today, Intel’s chairman spun a rosy scenario in a speech in Malaysia, causing markets to jump on the grounds that he must know something. He doesn’t. Only a policy change that results in at least a permanent 15% rise in the dollar/gold price will do the job. If we knew that change would come by November, we would likely hold equities, ready to take small declines in order to catch the upsurge when it occurs. If we knew policymakers might allow deflation to drag out for the next six months or a year, we would manage assets differently, shedding equities along the way and getting into cash or bonds rather than swallowing all the losses. If we had to be in equities we would search for the most defensive and hope for the best. Our focus would be on guessing the timing of the inflection point – the point where it would become apparent to the markets that something was about to change within a reasonably short time frame. This is how we are organizing our analytics these days, knowing there will be policy change, by accident or design, but not seeing it yet on our horizon.

Here’s what we mean: When the last monetary deflations ended in 1982 and 1985, the financial markets reacted a bit differently to each. We think this was because the ‘82 deflation was ended by a surprise decision to monetize Mexico peso debt, which liquified the system, but the 1985 deflation was ended by purposeful planning that began in January and came to fruition in early March, when the decision was announced at the Plaza Hotel in New York to manage the foreign-exchange value of the dollar. In 1982, gold, bonds and equities all took off in the week of August 11. In 1985, equities turned up in January, I think because word leaked out that Treasury was working toward a plan to end what had been called a period of “benign neglect” of the dollar, to weaken it with the cooperation of the Bundesbank and BoJ. Gold began its steady rise in March after the Plaza announcement, to about $330 from its low of $285.

Those kinds of numbers are exactly what we need now, but at the moment there are few signs of either a crisis or of a plan. Argentina would be a likely candidate, given the fact that it is constitutionally tied to the dollar through its ill-conceived currency board. But much of its external debt is held by Spanish banks, and there may be a Euroland bailout in the works for that reason. It would be nice if there were serious planning here for a solution, but on the edge of the August recess all economic policy is on hold, with fingers-crossed hopes that there will be an upswing come September. Most worrisome, though, is Treasury Secretary Paul O’Neill digging in his heels on a “strong dollar” policy, which is where Fed Chairman Alan Greenspan wants him to be, while the Democrats begin the process of boxing him in there. Wednesday’s NYTimes column by Paul Krugman practically ridicules O’Neill for his unwillingness to rescue the economy from the strong dollar, even as the Times editorially warns O’Neill against seeking a cheaper dollar. The net effect is immobility. I’ve drafted an op-ed for the consideration of the Times, pointing out that the problem is not with the forex market, but with the deflationary signal from gold. The difference is important because the dollar deflation could be solved even if all currencies rose against gold in the same proportion.

In my monthly conference call yesterday, I had to acknowledge the failure of my attempts to even get deflation into the national conversation about the economy. However, on the bright side, of all the supply-siders who have been vocal on the issue, only Art Laffer remains insistent that there is no problem and Greenspan is doing just fine. On the darker side, only Jack Kemp is arguing that the Fed has to target gold directly to push its price to $325 or so, and even Kemp has postponed to mid-September plans to argue his case in person inside the administration. The other supply-siders – including Bob Mundell -- are now uniformly saying the Fed has been too tight. But they continue to believe lower interest rates will solve the problem. Larry Kudlow, a sometime supply-sider, on Sunday argued the Fed was deflating the dollar. On Monday, he wrote a stirring defense of O’Neill’s strong-dollar policy.

Because we continue to believe there must be about a 25% correction to the deflation, (i.e. a 25% rise in the gold price) it really is difficult to think of defensive plays in the equity market, at least until we see that potential inflection point on the horizon. Bonds and cash are still the best places to hide, even though we cannot expect major gains in bonds until there is a clearer picture of how a solution might unfold. It does seem logical, as so many of you suggest, that if we are really still gripped by deflation, the long bond yield should be much lower, on the Japan pattern where overnight rates are near zero. We note that the Argentina peso is constitutionally linked to the U.S. dollar, which means it is being crunched by the same deflation, yet it has to pay 20% on fresh loans, which reflects the market’s expectation of a forced peso devaluation. Our bond market also has to be wary of a condition that pushes the Fed into an uncontrolled attempt at economic rescue, where deflation is replaced by inflation, which is what happened after both the 1982 and 1985 inflection points. In 1982, gold eventually topped $500 in Feb. of ‘83 before it fell back. In 1985, it topped $500 again by late 1987. The Fed did not flood the system with liquidity in these proportions, of course. The market simply reflected changed expectations of the government’s position, from deflation to inflation, and the velocity of money already in existence went from negative to positive.

It is worth noting that China has been tied to the deflating dollar, almost exactly, and interest rates on its government bonds have been in a steady decline over the last year, the most recent trades at 4.25% on 10-year bonds. China’s growth rate remains above a 6% annual rate, even including zero growth in its farm sector where deflation has stung. The difference is in the debt structure, as the level of dollar debt within the U.S. economy is easily a hundred times the level inside China. China can swallow this deflation adjustment, even though it has been painful. Nominal equity values cannot avoid the deflation, though, which is how financial analysts in Shanghai are explaining the hoarding of government bonds by primary dealers. There you can make money on bonds while watching equities melt or tread water. Before we expect to see the possibility of that all-important inflection point, we will need to know that the topic of deflation is at least being discussed at the morning staff meetings at the White House. As far as we know, the topic has yet to be raised there. With Alan Greenspan now saying he does not even watch the commodity markets, let alone gold, why should his protege, Larry Lindsey, the President’s closest economic advisor, who assures Bush of an 80% chance of recovery? We are waiting for Lindsey to mention deflation, but are not holding our breath.