This New ETF Aims to Protect Against Deflation
Do you fear that the U.S. is headed for a deflationary scenario akin to what Japan has been going through?
If so, as the saying goes, “there’s an ETF for that.”
Here’s an excerpt from a Sept. 21 Bloomberg article headlined “Nancy Davis Flips to Deflation in New ETF After $3 Billion Haul”:
Nancy Davis has lured billions to her ETF guarding against inflation. Now she’s looking to repeat that success with a product betting on the other side of the trade.
Her firm, Quadratic Capital Management LLC, is launching the Quadratic Deflation exchange-traded fund (ticker BNDD), it said in a Tuesday statement.
The new product will seek to profit in an economic climate of falling prices, weak growth and negative long-term interest rates. Like its established sibling with the opposing mandate — the Quadratic Interest Rate Volatility and Inflation Hedge ETF (IVOL) — the strategy aims to deliver by trading a mix of Treasuries and options.
“Some investors have expressed concerns that the U.S. will experience an environment similar to Japan given the debt increase and labor market,” Davis, who will manage the new strategy herself, said in the statement. “It’s prudent for investors to have tools available to them so that they are prepared for a wide range of economic outcomes and environments.”
Markets have been fretting over inflation for months on the risk that price pressures could prove less transitory than the Federal Reserve expects. Yet as key measures of reflation ease from multi-year highs, Quadratic is betting investor attention will return to the long-term deflationary forces of the pre-pandemic world.
Of course, no one knows how a particular exchange-traded fund or any other investment will perform.
Yet, Robert Prechter does mention a “safe asset” that “assuredly rises in value during deflation” in his book, Conquer the Crash (2020 edition):
Today, few people give cash a thought. Because interest rates on Treasury bills are “too low,” investors claim that they have “no choice” but to invest in something with “high yield” or “upside potential.” Ironically but obviously necessarily, the last major interest-rate cycle was also perfectly aligned to convince people to do the wrong thing. In the early 1980s, when rates were high, people thought that stocks were not worth buying. Now that rates are low, they think that T-bills are not worth holding. It’s a psychological trap keeping investors from doing the right thing: buying stocks at the bottom (when rates were high) and selling them at the top (when rates are low).
Now let’s dispose of the idea that the return on cash is always “low.” … [The chart below] is one picture of the rising value of cash in the United States, which appreciated 287 percent from March 2000 to October 2002 in terms of how many shares of the NASDAQ index it could buy.
Wouldn’t you like to enjoy this kind of performance, too? You can, if you move into cash before a major deflation. Then when the stock market reaches bottom, you can buy incredibly cheap shares that almost no one else can afford because they lost it all when their stocks collapsed.
Cash is the only asset that assuredly rises in value during deflation.
Also, in Japan, the value of cash appreciated 400% in terms of how many shares of Japanese stocks it could buy from 1990 through 2008.
Two Japanese Prime Minister Candidates Pledge to Whip Deflation
Japan’s decades-long battle with deflation persists, despite past pledges by government officials to defeat it.
Now, two contenders to become Japan’s next prime minister join the list of those who’ve offered stimulus plans.
This Sept. 7 Bloomberg article excerpt provides details:
Two lawmakers battling to become Japan’s next prime minister both pledged to launch stimulus packages over the short term and to defeat deflation over the longer term, as they laid out their platforms Wednesday.
Former Foreign Minister Fumio Kishida said he would inject tens of trillions of yen (hundreds of billions of dollars) to help a Covid-battered economy, as he set out his policies in the race for leadership of the ruling Liberal Democratic Party.
Rival Sanae Takaichi, who is seeking to become the country’s first female prime minister, also said she would swiftly consider an extra budget to aid the economy, though she refrained from putting a figure on the size of the package. The amount would depend on how much was really needed and required careful consideration, she added.
Takaichi, a former economics professor, said she would prioritize the country’s 2% inflation target over achieving a primary budget balance. She said the government’s preoccupation with trying to balance the books had contributed to the failure to reach the target so far…
In his 2020 edition of Conquer the Crash, Robert Prechter provided a historical perspective on Japan’s economy as well as past stimulus efforts by Japanese authorities to defeat deflation:
Japan had one of the strongest economies in the entire world, growing at a 9% rate for 20 years up to 1973, and then a pretty strong rate of about 4.5% through 1994. From there, it’s averaged about 1%.
The reason Japan is in trouble was expressed in a November 1, 2012 headline from MarketWatch: “Japan Is in Worse Than a Deflationary Trap.” But it’s not worse than a deflationary trap. It’s just a deflationary trap. Here’s what the article says: “Policy makers have spectacularly failed. Brutal deflation persists.
Japanese officials tried monetary stimulus, including zero interest rates and quantitative easing.” Does that sound familiar? And here: “Past fiscal stimulus has ballooned the national debt to 200% of GDP.” Does that sound familiar, too? And finally, “The most troubling aspect of Japan’s malaise may be psychological.” That’s the key to the whole thing. When social mood changes psychology from ebullience to conservatism, a trend of expanding credit shifts to a trend of declining credit and therefore inflation into deflation.
Highest-Priced Home in U.S. Goes into Receivership
Defaults and a developing deflation go hand-in-hand.
As Robert Prechter’s 2020 edition of Conquer the Crash states:
Near the end of a major expansion, few creditors expect even the weakest borrowers to default, which is why they lend freely. At the same time, few borrowers expect their fortunes to change, which is why they borrow freely. Deflation involves a substantial amount of involuntary debt liquidation because almost no one expects deflation before it starts.
With that in mind, consider this headline and two subheadlines from a Sept. 8 CNBC article:
Most expensive home in America defaults on $165 million in debt, heads for sale
A Los Angeles megamansion once expected to list for $500 million has gone into receivership after the owner defaulted on more than $165 million in loans and debt, according to court filings.
The 105,000-square-foot Bel Air estate, known as “The One,” was placed into receivership and is expected to be relisted at a lower price.
Let’s now transition from news about a “California megamansion” to Elliott Wave International’s analysis of what is going on with the overall U.S. housing market. Here’s a chart and commentary from the September Elliott Wave Financial Forecast:
Two… indicators suggest that a home price peak may be close. The first arrow on the top graph on this chart shows the July 2006 peak in U.S. Median Home Prices. The arrow on the second graph shows the last major peak in pending sales, which came in July 2005, 12 months ahead of the downturn in median home prices. Now observe the arrows on the right side of the chart. A similar divergence is occurring, as it has been 11 months from the latest peak in pending home sales to a June peak in median home prices. The bottom graph is the U.S. National Association of Homebuilders Market Index. Back in 2005, the index peaked in June, one year ahead of home prices. The index registered its latest peak reading ten months ago, with a record high of 90. In December 2005, when the NAHMI was six months into a 43-month decline to January 2009, pundits argued that “housing is simply taking a much-needed breather.” EWFF showed a chart of the seminal decline in the Homebuilders Index in that issue and stated, “The housing market is in the process of falling into an enormous crater.”
Debt-Plagued Chinese Real Estate Developer Grapples with Default Risk
China Evergrande Group is the country’s second largest property developer and it’s been selling assets to improve solvency.
In a discussion about the debt-burdened real estate developer, the August Elliott Wave Financial Forecast mentioned that the share price of China Evergrande had plunged 84% (as of August 2) from the peak in October 17.
The publication also mentioned the property developer’s bonds and showed this chart:
The chart shows that the price of Evergrande’s 8¾% dollar bonds crashed in July to 39 cents on the dollar.
Nearly a month later (August 31), Bloomberg published an article headlined “Evergrande Flags Default Risk From Cash Crunch; Bonds Fall.” Here’s an excerpt:
China Evergrande Group warned that it risks defaulting on borrowings if its all-out effort to raise cash falls short, rattling bond investors in the world’s most indebted developer.
“The group has risks of defaults on borrowings and cases of litigation outside of its normal course of business,” the Shenzhen-based company said in an earnings statement on Tuesday. “Shareholders and potential investors are advised to exercise caution when dealing in the securities of the group.”
The company said it’s exploring the sale of interests in its listed electric vehicle and property services units, as well as other assets, and seeking to bring in new investors and renew borrowings. Still, sharp discounts to swiftly offload apartments cut into margins, helping push net income down 29% to 10.5 billion yuan ($1.6 billion) in the first half of the year, in line with an earlier profit warning.
… Evergrande’s bonds sank toward fresh lows as investor confidence in its ability to repay debts continued to erode. While borrowing fell, total liabilities that include bills owing to suppliers edged up to 1.97 trillion yuan, near a record high.
A $17 Trillion “Stockpile” of Cash – Here’s What It May Suggest
When people turn financially conservative, they tend to spend less and save more.
That’s part of what may be called a “deflationary mindset.”
As the 2020 edition of Robert Prechter’s Conquer the Crash states:
The psychological aspect of deflation and depression cannot be overstated. When the trend of social mood changes from optimism to pessimism, creditors, debtors, investors, producers and consumers all change their primary orientation from expansion to conservation. As creditors become more conservative, they slow their lending. As debtors and potential debtors become more conservative, they borrow less or not at all. As investors become more conservative, they commit less money to debt investments. As producers become more conservative, they reduce expansion plans. As consumers become more conservative, they save more and spend less.
Is “the trend of social mood” now in the process of shifting from optimistic to pessimistic?
Well, read this excerpt from an August 28 Marketwatch article titled “U.S. households and small businesses have stockpiled a mind-blowing record cash pile of almost $17 trillion”:
U.S. households and small businesses have stockpiled a record cash pile of almost $17 trillion — a mind-boggling estimate that exceeds the $16 trillion in fiscal action undertaken by governments around the world to keep the global economy afloat during the pandemic.
That domestic cash hoard has grown exponentially since February 2020 due to three factors: direct government stimulus payments to individuals, shutdown-induced savings from Americans working from home, and small-business decisions to hold onto grants or loans, according to… a Memphis-based manager at fixed-income dealer FHN Financial, which tracks cash flows.
The magnitude of the cash positions being held is surprising considering the tendency of households and businesses to tap their savings during each of the two or three recessions prior to the pandemic era. After the coronavirus pandemic triggered a deep two-month U.S. recession starting in February 2020, what is different this time around is that savings have soared despite the economy reopening. Two reasons have been offered for this: small businesses look to be focused on rebuilding inventories to brace for pent-up demand, while individuals are opting not to spend money on even the more restricted services and experiences that have now become the norm.
This stockpiling of cash suggests the possibility of a developing deflationary psychology.
Cash will be king during a deflationary depression, so it’s a good idea to start storing some away, if you have not already begun doing so.
Let’s return to Conquer the Crash for an example of how the demand for cash soared in recent history:
When access to credit [in Cyprus] was curtailed in 2013, there was a soaring demand for cash — the one thing nobody had. A March 26, 2013 article in The Financial Times reported, “The most immediate problem confronting businesses was a scarcity of cash.” A businessman in Cyprus said, “The market is operating on a cash basis — everybody wants cash.” That was the immediate result of deflation in Cyprus.