Dealing with Deflationary Collapse

[bnl]

Have you all read this article predicting deflationary collapse? http://ourfiniteworld.com/2015/08/26/de ... pse-ahead/

I'm sure some of you will disagree or find holes in it, but let's just say for a minute that you think she's spot on with her prediction that deflationary collapse is imminent based on rising debt, rock bottom interest rates, rising oil prices, and stagnant wages. 

Where does the permanent portfolio fit in to this?  I understand that long term bonds are held as a hedge against deflation, but will that even matter if there's a full blown economic collapse?  I have long term US bonds (actually, I have an ETF of bonds), but if there's an economic collapse of the nature she's predicting, then I don't think the long term bonds are any safer than anything else.  The US wouldn't be able to pay the debts, and they'd likely be past the point of even printing money to pay them back.  But maybe I'm wrong?

So if you consider that Gail might be right in the article, what would you do about it?

[MediumTex]

Gail is a long-time writer of doomer porn.

I've been reading her stuff since about 2007.

She tells a great story.  Things never turn out like she argues they will, but she can really get you worked up.  There are quite a few really smart perma-doomers like her in the Peak Oil camp.

[bnl]

Yeah, I've never been one to get suckered into doomer porn, and I usually just skim Gail's articles for some insight.  And maybe this article just hit me at the wrong time, but it's pretty aligned with how I see things going down over the next decade and I think her article just put some more urgency around what I've already been thinking. 

But now I'm still left wondering... Will US T-bonds be a safe investment against inflation? If they aren't, then I really don't know what is.  Maybe machine guns and canned meat?  (I'm kidding...)

[ochotona]

During inflation, you want to have debts, because the real value of the debt goes away with time. During deflation, the opposite; you want to be the person holding other people's debts (you want to be the lender). That's assuming they can pay. US Treasuries should be good.

During 2009-2015, S&P500 was the "TINA" portfolio. Maybe in a deflationary scenario US Treasuries will be the TINA. That and cash. Gold and stocks will be hit hard.

TINA = "There Is No Alternative".

[MediumTex]

During inflation, you want to have debts, because the real value of the debt goes away with time. During deflation, the opposite; you want to be the person holding other people's debts (you want to be the lender). That's assuming they can pay. US Treasuries should be good.

During 2009-2015, S&P500 was the "TINA" portfolio. Maybe in a deflationary scenario US Treasuries will be the TINA. That and cash. Gold and stocks will be hit hard.

TINA = "There Is No Alternative".

Gold might be hit hard, but it might not.

When it became clear at some point in 2008-2009 that deflation was a real risk, gold rose.

Similarly, in the 1930s gold started the decade at $20 an ounce and finished at $35 an ounce.  That was obviously the result of political tinkering with the monetary system, but the takeaway is the same--when faced with serious deflation risks, central banks are likely to do all sorts of crazy things to prevent it, and most of them are oriented around creating expectations of future inflation, which is good for gold.

[mortalpawn]

My take is deflation is a real possibility in the short term.  A variety of forces (collapsing commodity prices, collapsing worldwide production/demand, collapsing oil prices, China, reversing of the dollar carry trade, demise of the petrodollar) are forcing the dollar higher, and suppressing bond prices.  Arguably these same forces are bad omens for the "bubbly" stock market.

If both the bond and stock bubbles collapse together, we're going to see some serious deflation as investors sell anything that's not nailed to the floor to cover their bad bets.  Keep in mind the US big five banks have $225+ Trillion in derivative bets on the table ($520+ trillion globally) - a number the dwarfs the $70 trillion global stock market and even the $100 trillion global bond market, and even the $60 Trillion global GDP.

If there is a fire sale - deflation will be the order of the day and cash will be king.  However, I'm pretty sure (as in 2008) the derivative shortfalls, many of which are leveraged at 60x, will be larger than available assets - so once again we'll have "too big to fail" banks failing.  Even if the Fed somehow prints enough money to "bail out" the banks (and the bill will be much larger this time), the collapse could quickly lead to panic and a loss of confidence in the banking system, stock market, government and dollar. The Fed has no bullets left - all they can do is print.  A "bail in" would be even worse - leading to capital controls and giving account holders a "haircut" as we saw in Cyprus.  Interestingly a 2005 change to US bankruptcy law gives derivative holders priority over account holders if a bank goes bankrupt (insane but true).

What happens in a real banking panic is anybody's guess - but it is most likely to be inflationary and not deflationary as people lose confidence in the banks, bonds, stock market, the dollar as well as the government's ability to pay their bills.  The Fed and government are dominated by Keynesians, so they will print and borrow like mad.

In this case gold could be king (assuming you can hang on to it).  It could get really ugly really fast, however - as those on fixed incomes or the government dole will suffer most.

[barrett]

Nice post, mortalpawn. Just curious how much cash folks are holding if it's more than 25%. 40%? 50% More?

I also tend to think that rates will stay in the 2% to 4% range for a few years as there are few alternatives for long-term debt when looking to Japan, Europe, etc. Buying US treasuries is also a boon to everyone outside the US if the dollar continues to strengthen.

I also wonder sometimes if being invested in anything but cash is really worth the downside risk with such weak returns expected for stocks, bonds and cash for the foreseeable future. Gold might work its magic... but maybe not.

[Lowe]

Mortalpawn's analysis is very interesting.  For the past year I hadn't thought anything could bring gold around again.  But if there is something that could do it, at this point, it would be bank failures.  Not looking forward to that.

[mortalpawn]

Nice post, mortalpawn. Just curious how much cash folks are holding if it's more than 25%. 40%? 50% More?

I'm still a PP believer, so the bulk of my funds are still in PP.  However I did rebalance two months back and slightly underweighted stocks/bonds based on the fact that both were near historic highs, and I've taken most of my VP back to cash and gold/silver.  Also I keep a separate emergency fund in cash to handle day-to-day emergencies.

During the last rebalance, my philosophy was to underweight stocks/bonds by 2-3% in the PP because they had both risen to historic highs.  I'll always be overweight cash because of my emergency fund (which in part is kept to manage seasonal variations in my small business).

So after recent losses, plus factoring in the cash in my VP and emergency fund I'm sitting at about 36% cash, 18% stocks, 20% bonds, and 26% gold.  My actual PP portion is much closer to balanced at 27% cash, 20% stocks, 24% bonds and 27% gold (stocks fell more than bonds so far).

I'm not suggesting the above is an ideal mix for anyone, but I'm just sharing one "real-world" example.  I feel comfortable that I have enough cash on hand to ride out a pretty good drop, and the gold is insurance against a full blown "panic".  The PP investment in bonds/stocks keep some skin in the game in case I'm entirely wrong about everything.