The markets are flopping around aimlessly. Investors are confused. The media is having more and more trouble trying to whip up enthusiasm or maintaining credibility: the latest doozy to float through the market was the Hindenburg Omen (a technical formation which predicts equity crashes 25% of the time).

What is going on? Why are the markets so directionless? Are we staring into the abyss of deflation plus the second part of a double dip recession or will we have to dust off the 1970’s era Misery Index to describe the upcoming years of stagflation? With warning signs of both inflation and deflation in the economy, there is little wonder that professional and individual investors alike are confused by the signals.

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The financial markets are definitely not showing much direction overall but the relatively calm surface is hiding turbulent and conflicting currents not far beneath the surface. The Fund King System remains in a “risk off” stance with recommendations across our main portfolios all tending towards US government bonds (TLH & TLT), cash, gold and silver. None of the readings on these individual asset classes are particularly compelling…but they are positive. So, as we wait to see just how awful US 3Q GDP numbers might be, the System is not recommending any risky positions. What currencies do you want to be in? It looks like the US Dollar and Japanese Yen are the best for now. The Euro has staged a bit of a comeback on the completion of EU wide bank “stress tests” but is still weak. A bet on the Euro is certainly a bet on the health of the European Banking system which remains overly dependent on potentially fickle wholesale financing (as opposed to deposits). The Australian Dollar is also a bit weak largely due to a potential economic slowdown in Mainland China (a huge consumer of Australian minerals).

The currents underneath the surface derive from the powerful forces that are struggling to define the next phase of global economic development.

Option 1: Deflation

Long Term US Government Paper is attracting money from those who see the current lack of consumer demand growth as an intermediate trend and a signal that we will enter a period of sustained deflation. When the Global Financial Crisis started in 2008, analysts who suggested that the US or European economies might experience some of the deflation and stagnation that Japan has endured since 1990 were summarily dismissed. However, that dismissal now seems to have been premature. Even in the early 90’s, investors had a hard time believing that Japan would not shake off the slump in short order. The country that had given us the economic miracle, just in time inventory, quality circles and firms that could buy up Rockefeller Center and Pebble Beach would surely continue their inexorable rise as the leader of the dawning “Pacific Century” (now redubbed the “Asian Century”). Deflationary fears are also driven by the evidence that massive government stimulus combined with very accommodating monetary policies has not delivered as advertised. If the Fed is “pushing on a string”, then perhaps it has run low on viable options. With Middle Class America taking serious hits on income (high unemployment) and wealth (underwater mortgages), the deflation camp is betting on continued sluggish consumer demand. The main risk to a deflation geared portfolio is a change in consumer demand. Signs of a positive change in consumer demand will send investors scrambling out of Treasuries (and the US dollar) and back into riskier assets (High Yield, Equities and eventually Commodities).

Option 2: Inflation

On the other side of the debate are those who see governments (particularly in the US but also in Europe and Asia) increasing their weight in their respective economies. Governments are beholden to voters and usually choose paths that lead to the least amount of pain in the short term. That suggests a risk of currency debasement and sustained inflation. Debtors prefer to pay back money far in the future after inflation has worn away the value of future dollars. Since the big debtors include most of the G7 Governments and their Mortgage Paying Electorate, there is no doubt about which way political will is positioned. The fear of currency debasement is at the core of the Gold Trade. So, while both Gold and Treasuries have been moving up together over the past few years, their performance should diverge sharply once it becomes clear whether we are heading into deflation or inflation.

Option 3: Healthy Global Growth

And what about the middle road between these two outcomes…decent growth with inflation at 2-4%? That outcome is the only one on which very little is being wagered because it seems the least likely. This recession is different from what most of us are used to because it is due to a financial crisis, not the usual manufacturing inventory overstock. The NBER, the official arbiter of recession timing, has yet to declare an end to the recession which started at the end of 2007. Perhaps their caution, which was criticized toward the end of 2009, was justified after all.

What should investors do?

For now, one would be wise to follow the advice first given by Oliver Cromwell:

“Put your trust in God; but mind to keep your powder dry.”

There is no reason to embark on risky or illiquid trades now. Avoiding a nasty drop is just as important as participating in market rallies to the overall health of your portfolio. At best, you will rack up a big commission bill, at worst, you could get stuck in a position that looks wrong footed in the autumn. Despite all the promises from internet penny stock newsletters, this is not the right time to go chasing after “the next big thing” with any more than a few percentage points of your portfolio.

The big question in finance is whether we are heading for deflation or inflation.

In order to become a better investor, one must occasionally push aside all the heat and noise of today’s financial markets and plot out alternate courses for the future. But before we push it away, let’s look at what the bond market is telling us. Today’s bond markets are definitely pricing in deflation which appears to be a safe bet if you look at the GDP numbers in the US.

Price source: http://www.bea.gov/national/xls/gdpchg.xls

Actual GDP growth in current dollars turned negative for the first time since 1949. Why is that important to the bond market? Because bond investors are paid in current dollars. The great fear of a bond buyer is that inflation will eat up returns and principal. US Treasury yields are below 3% (see Bloomberg chart) and almost any inflation above 2% would be detrimental to bondholders financial health. These investors are not writing editorials in the New York Times, they are risking real money.

Why are bond investors so confident now?

Because there is lots of money but no chasing. Milton Friedman and Anna Schwartz proposed that “Inflation is always and everywhere a monetary phenomenon.” In simple terms, inflation is caused by too much money chasing too few goods and services. The problem with Friedman’s dictum is that it has been mis-sold by Fed and Treasury officials of late. They sold the country on the idea that since inflation is a monetary phenomenon, one need only double the Fed Balance sheet (print money) and the threat of deflation will disappear with a few months lag.

So now there is too much money but still no inflation. Inflation is not kicking in because retail sales are telling us that there is certainly no chasing of goods or services going on in the United States. Consumption makes up almost 70% of GDP so one needn’t look too far for the answer. What about the Government stepping in? With all due respect to Nobel Prize economists like Paul Krugman, the Federal Government is good for a bit more than 20% of GDP and most of that is transfer payments (taking money from one group and giving it to another). However stimulus programs are packaged, the government will not get dollars to chase goods and services on its own.

The Road from Deflation to Inflation

So that is a wrap. The smart money in the bond market has figured out that all the noise coming out of Washington will not trump the bruised and battered consumer whose credit lines have been euthanized over the last two years.

But the road to inflation is not totally blocked. The money is still there. With corporates building cash piles, real estate mired in the foreclosure work out dumps, and some version of the Volker Rule likely to constrain the amount of money banks can punt in the markets, there are not many profitable places for a bank to turn. Once bank lobbyists have figured out how to gut the financial reform legislation, mailboxes should start filling up with credit card applications once again.

And once the credit taps are opened, we will see the excess money start to chase goods and services. Will the Fed step in to raise interest rates and preserve “sound money”? Perhaps when inflation gets into the high single digits but by then it will be too late. Current GDP will be growing at 10% or better, government coffers will be filling up as taxpayers are pushed into higher brackets and the Debt to GDP ratio will stabilize and then start to fall.

Who wins?

No one really. Bond investors are hit first and pay the most but inflation is a stealth tax on everybody and it tends to be a very regressive tax. The political will for cutting spending or raising taxes is almost non-existent so developed economy governments will fall back on inflation to get the job done quietly. Does that amount to a default? If one reads “This Time Is Different”, one might feel that way.

What should investors do?

Nothing today. With the weight of money on the deflation side of the trade, there are no points awarded for being early. This is a trade to watch out for and the indicators are retail sales and M2/M3. Once these turn, there are a number of funds and ETFs that can give you inverse exposure to bonds. But be careful about the tracking errors that can build with time. With inverse and leveraged products, it is easy to be right on the idea and get it wrong on the execution.

A simple way to hedge against inflation is to borrow as much as you can service at today’s low “deflation inspired” rates. A 30 year mortgage below 5% (check rates here) may not sound too sexy today but if inflation rises to 3-5% and hard assets start to appreciate, it could be a cocktail party bragging point for years to come.