Tony and Rob Boeckh provide their insights into an unstable future in The Great Reflation Experiment: Implications for Investors. Excerpts below.

Link: The Boeckh Investment Letter

Prior to government bailouts and stimulus, the panic, crash, and precipitous economic decline of 2008/9 were clearly on track to be much worse than the post-1929 experience. The pervasiveness of leverage – from banks to consumers to supposedly blue-chip companies – and the illusion of stability in the system, were fostered through the 25 years that this credit bubble has grown, basically uninterrupted. The speed and magnitude of the bailouts and stimulus – the end of which we won’t see for a long time – aborted the meltdown. However, the story is far from over.

The Great Reflation experiment ultimately has two components. The first is a rise in federal government deficits, debt, and contingent liabilities. The second is an expansion of the Federal Reserve’s balance sheet. Both are unprecedented since World War II. U.S. federal government debt is likely to reach close to 100% of GDP over the next 8 to10 years according to the Congressional Budget Office (CBO) and supported by our own calculations (Chart 3). Anemic growth, falling tax revenue, increased government spending, and bailouts of indigent states, households, businesses, and an aging population will all undermine public finances to a degree never before seen in peacetime. According to CBO data, government debt could reach 300% of GDP by 2050 as contingent liabilities are converted into actual government expenditures. This massive peacetime deterioration in public finances will have grave consequences for living standards and asset markets, particularly in the longer run.

In the short run, huge deficits and growth in government debt are necessary. They will continue to play a crucial role in deleveraging the private sector and in helping to fill the black hole in the economy that has been caused by the sharp increase in household savings. Further out, government deficits will put upward pressure on interest rates. However much of the economy, particularly housing and commercial real estate, is far too weak to absorb an interest rate shock. Therefore, the Federal Reserve will have to monetize much of the rise in government debt, making it extremely difficult to unwind the explosion in the Fed’s balance sheet and consequent rise in bank reserves – the fuel that could be used to ignite another money and credit explosion.

The bottom line is that the Fed is in a very difficult position. Its room to maneuver is either small or non-existent and the markets understand this. That is why there is a sharp divergence between those worried about price inflation and those fearing a lengthy depression.

Implications for Investors

Investors are also in an extraordinarily difficult predicament. From the peak in 2007, household wealth declined by about $14 trillion, over 20% to the first quarter of 2009. Tens of millions of people had come to rely on rising house and stock prices to give them a standard of living which could not be attained out of regular income alone. They stopped saving and borrowed aggressively and imprudently against their assets and future income, some to live better, some to speculate, and many to do both. That game is over.

Pensions have been devastated and people’s appetite for risk has declined dramatically. The return on safe liquid assets ranges from 0.60% to 1.20% depending on term and withdrawal penalties. Reasonable quality bonds with a five-year maturity provide about 4%. Bonds with longer maturities have higher yields but are vulnerable to price erosion if inflationary expectations heat up. As for equities, people now understand that blue chip stocks carry huge risk. GE, once considered the ultimate “bullet proof” stock, dropped 83% in the panic, and Citigroup lost 98%. Revelations of massive fraud schemes have further damaged trust and confidence in markets.

Against this backdrop, we offer a few thoughts. First, an increase in price inflation as reflected in the CPI is a long way off. The degree of excess capacity in the world is probably the greatest since the 1930s, although excess capacity does get scrapped during recessions. Western economies will remain depressed for years and China will also be important in keeping inflation down. Its capital investment is larger than the U.S. in absolute terms. It is currently 40% of GDP and growing at 30% per annum. Profit margins in China will probably get squeezed, which, together with the huge amount of underemployed labor means that the Chinese will keep driving their export machine at full throttle, continuing to flood the world with high-quality, inexpensive goods. Therefore, investors who need income are probably safe holding reasonably high- quality bonds in the five-year maturity range. A bond ladder is a very useful tool for most people. Holdings are staggered over say, a five-year time frame and maturing bonds are invested back into five-year bonds, keeping the portfolio structure in the zero-to-five year range. In this way, some protection against a future rise in price inflation and falling bond prices can be achieved.

Second, massive monetary stimulus is good for asset prices in the near term (e.g. stocks, bonds, houses, commodities) in a world of very weak price inflation and a soft economy. That is true as long as the economy does not fall apart again, which is very unlikely given all the stimulus present and more to come if needed. Therefore, investors who can afford a little risk should own some assets that will ultimately be beneficiaries of the wall of new money being created and thrown at the economy.

There is a major risk to our relative near-term optimism, and that is the U.S. dollar. Foreign central banks hold $2.64 trillion, overwhelmingly the largest component of world reserves. The U.S. role as the main reserve currency country is compromised by its persistent inflationary policies and current account deficits, a subject high on the agenda at the recent G-8 meeting in Italy and referred to frequently by China, Russia, Brazil and others. Foreign central banks fear a large drop in the dollar, which would cause them potentially huge losses on their reserve holdings. They don’t want more dollars, and yet they don’t want to lose competitive advantage by seeing their currencies go up against the dollar. To preserve their competitive position, they have to buy more when the dollar is under pressure. On the other hand, since the 1930s, the U.S. has never subjugated domestic concerns to external discipline. Officials may talk of a strong dollar policy, but their actions always speak differently. Their attitude towards foreign central banks is, “we didn’t ask you to buy the dollars”. The U.S. has typically seen such buying as currency manipulation to gain an unfair trade advantage.

The most likely outcome is a nervous dollar stalemate or, as Lawrence Summers once described it, “a balance of financial terror.” The most important central banks will continue to hold their nose and buy dollars to keep it from falling too sharply. However, this is a fragile, unstable situation and the dollar must fall over time.