Deflation? We won't let it happen

Deflation in Japan started in the early 1990s. On March 19, 2001, the Bank of Japan and the Japanese government tried to eliminate deflation in the economy by reducing interest rates (part of their 'quantitative easing' policy).Despite having interest rates down near zero for a long period of time, this strategy did not succeed. In July 2006, the zero-rate policy was ended. In 2008, the Japanese Central Bank still has the lowest interest rates in the developed world and deflation has still not been eliminated.

Systemic reasons for deflation in Japan can be said to include:

• Fallen asset prices. There was a rather large price bubble in both equities and real estate in Japan in the 1980s (peaking in late 1989). When assets decrease in value, the money supply shrinks, which is deflationary.

• Insolvent companies: Banks lent to companies and individuals that invested in real estate. When real estate values dropped, many loans went unpaid. The banks could try to collect on the collateral (land), but due to reduced real estate values, this would not pay off the loan. Banks have delayed the decision to collect on the collateral, hoping asset prices would improve. These delays were allowed by national banking regulators. Some banks make even more loans to these companies that are used to service the debt they already have. This continuing process is known as maintaining an "unrealized loss", and until the assets are completely revalued and/or sold off (and the loss realized), it will continue to be a deflationary force in the economy.

• Insolvent banks: Banks with a large percentage of their loans which are "non-performing" (loans for which payments are not being made), but have not yet written them off. These banks cannot lend more money until they increase their cash reserves to cover the bad loans. Thus the quantity of loans are reduced and less funds are available for economic growth.

• Fear of insolvent banks: Japanese people are afraid that banks will collapse so they prefer to buy gold or (United States or Japanese) Treasury bonds instead of saving their money in a bank account. This likewise means the money is not available for lending and therefore economic growth. This means that the savings rate depresses consumption, but does not appear in the economy in an efficient form to spur new investment. People also save by owning real estate, further slowing growth, since it inflates land prices.

All the reasons listed above are currently existing in the US. We know the disastrous effect of deflation and the Fed will not let it happen. In the recent FOMC meeting, it is clear that Fed becomes more aggressive. As 2008 Nobel Prize winner Paul Krugman suggested, a deliberate hyperinflation may be the best solution, and dollar devaluation is inevitable. What do you invest in when the government starts printing money? A broad range of real assets, Asian stocks, and commodities.

Investment Returns in 2008

The only strategies that made money this year are Short Bias, Volatility Arbitrage, and High Frequency Statistical Arbitrage. Other well known strategies, such as Fundamental Value, Emerging Markets, Commodities, Quantitative Equity, Fixed Income Relative Value, have suffered losses. Many managers are stopped out because of leverage and redemption.

At the end of November, Yahoo! Finance reported the results of some big name investors:

• Warren Buffett (Berkshire Hathaway): -43%
• Ken Hebner (CMG Focus Fund) -56%
• Harry Lange (Fidelity Magellan): -59%
• Bill Miller (Legg Mason Value Trust) -50%
• Ken Griffin (Citadel): -44%
• Carl Icahn (Icahn Enterprises): -81%

Comparing with them, our losses in 401K or house value is not that bad. Who is wrong? The market or us? Why even the savvy investors suffered? The answer is not simple. However, we should understand the bull market in the past decades no longer lasts. Experience, or backtest based on this period is illusionary. One either views the market movements as irrelevant like Warren Buffett, or respects the volatility in the market and admits that we do not understand everything. Be humble and safe. It is not easy to sail in the financial waves.

Welcome

Welcome to Pemberley Post. We are the students of the financial market, learning about the long lasting effect of the current event started in Sep 2008. Most of us are currently working in the financial industry and experienced the direct impact. We will try to catch some of the interesting topics and give a unique opinion. We hope you will enjoy it.