FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
May 12, 2020

IN THIS ISSUE:

1. Inflation or Deflation? Some Believe It Could Be Both

2. How Deflation Can Affect the Economy in Negative Ways

3. Bankruptcies & Liquidations Rising – But a Little Good News

Overview

With government spending clearly out of control and a budget deficit expected to top $4 trillion this year alone, more and more forecasters are warning that inflation is going to soar later this year and next.

On the other hand, with the economy imploding and the unemployment rate exploding at a never before seen pace, other forecasters believe we are heading into a deflationary spiral which will further cripple businesses and consumers.

There are even some who believe we’ll see both – inflation and deflation in the next couple of years. Given all this uncertainty and the seriousness of the prospects, I will address the inflation/deflation debate today. I hope you find it helpful.

Following that discussion, I will revisit the issue of widespread bankruptcies among US small businesses, which is increasingly spreading to medium and large corporations, including some big names. While bankruptcies and permanent closures will continue to increase just ahead (especially when we get the numbers for April), there is some good news on this front that I will share near the end of today’s letter.

Before I get into all that, I’m sure you heard the US unemployment rate soared to 14.7% in April, the largest monthly jump on record and to the highest level since the Great Depression. Over 20 million jobs were lost in April alone, also the largest ever. The only good news was the increase to 14.7% was below the pre-report consensus for a rise to 16%. While the April jobs number was not quite as bad as expected, the May number is expected to be even worse.

Now let’s get on to our main topic, which will cause today’s letter to run a bit longer than usual.

Inflation or Deflation? Some Believe It Could Be Both

With so many historic, unprecedented things occurring these days, its next to impossible to know what will happen going forward. On the one hand, we have the federal government borrowing and spending trillions and trillions of dollars we don’t have trying to resuscitate the worst economy since the Great Depression.

Historically, that’s a recipe for inflation or even hyperinflation.

On the other hand, the economy is collapsing right before our eyes, with GDP plunging and unemployment exploding, with no end in sight. Consumer spending which makes up almost 70% of GDP is in freefall due to the coronavirus crisis.

Historically, that’s a recipe for deflation where prices actually fall.

Today, I want to talk about both inflation and deflation since there is the possibility we could experience one or the other – or both – over the next few years. It could happen.

Obviously, the easier topic to talk about is inflation. We are all familiar with that, we’ve seen it before. There have been inflationary cycles during the 70s, 80s and 90s that most of us have experienced. In inflationary cycles, prices for most goods and services go up, which increases our cost of living.

Prices for goods and services tend to rise modestly every year. The Fed targets 2% as the desired annual inflation rate, for reasons that are far from clear (a discussion for another time). The point is, we’re all familiar with inflation.

The last time US inflation got seriously out of control was back in the late 1970s. In 1979, the Consumer Price Index soared to near 14%, the highest in decades, and many Americans were outraged. At that time, President Ronald Reagan appointed Paul Volcker as Chairman of the Federal Reserve with a mandate to Whip Inflation Now (WIN).

Are you old enough to remember those “WIN” badges? If you are, you are old like me (ha, ha)!

For better or worse, Volcker quickly ratcheted the Fed Funds rate up to 20% (apparently with President Reagan’s approval). This, of course, threw the US economy into a serious recession, but inflation was tamed and interest rates fell sharply soon thereafter. Both interest rates and inflation continued to fall for years afterward and remain muted to this day.

The only question at this point is: Will the massive explosion in federal spending due primarily to the coronavirus crisis result in an inflationary spike later this year or next year? The answer is: We just don’t know yet. But to get to a conclusion, we need to first consider deflation.

How Deflation Can Affect the Economy in Negative Ways

Most Americans don’t know much about deflation because they haven’t experienced it. Yet more and more economists and forecasters are becoming concerned about deflation due to the coronavirus crisis and the lockdown of much of the economy.

Deflation is defined as a decrease in the general price level of goods and services. Deflation occurs when the inflation rate falls below zero. Deflation might sound like a good thing on paper, since lower prices for goods and services would save consumers money.

However, deflation can cause consumers to put off purchases on the expectation that prices will fall further if they wait, thus decreasing demand. That can lead to a toxic cycle in which lower spending prompts businesses to cut jobs and/or wages, further pushing down consumer purchases and prices.

Deflation also can make it harder to repay mortgages and other debt, which become costlier in inflation-adjusted terms. The economy can get stuck in a rut, similar to the “lost decade” that plagued Japan in the 1990s.

Economists similarly worried about deflation during the Great Recession of 2007-09. But while average annual price increases dipped below 1% in 2010, they never actually went negative. The current recession, however, has featured a more abrupt and dramatic blow to the economy, and it remains to be seen if deflation will unfold just ahead.

“I think the risk of the U.S. falling into a deflationary trap is higher now than at any time during the Great Recession,” said economist Ryan Sweet of Moody’s Analytics recently.

Fortunately, the US is not experiencing deflation now. Sure, oil prices have cratered to historically low levels and gasoline prices are slowly following oil down. But when assessing deflation, economists generally exclude food and energy costs, which are highly volatile.

A measure of prices, excluding food and energy costs, that the Federal Reserve watches closely – known as the core Personal Consumption Expenditures Index (PCE) – rose at an annual rate of 1.7% in March, below the Fed’s 2% target but nothing close to a yearly decline.

Yet the shutdown of much of the nation’s economy to contain the coronavirus – along with more than 30 million related job layoffs – has hammered consumer demand. In response, airlines already have slashed ticket prices and grounded flights. Hotels are largely closed in many cities. In March, apparel prices were down 1.6% annually and new vehicle prices fell 0.4%.

Airlines and hotels are just two examples of industries which have been badly damaged by the economic lockdown. There are many others, as you know. Perhaps a bigger concern is that the sudden drop in consumer spending, amplified by the layoffs, has hammered business revenues, forcing many companies to lower wages at least temporarily.

A myriad of companies have announced executive pay cuts, including Delta, Marriott, Macy’s, Disney, Bed Bath & Beyond, Nordstrom  and others. We hear of more every day. Lower wages can further dampen consumer spending, forcing additional price cuts.

In general, this is how deflation works. Once deflation takes hold, it can be nearly impossible to reverse. The Fed knows this very well, and this explains why the central bank is buying unprecedented amounts (trillions) of Treasuries and other securities.

Finally, I do not wish to imply that all deflation is bad, quite the contrary. There are countless goods and services which cost far less today than when they were originally introduced. Think computers or flat screen TVs, for example. Advances in production, manufacturing and general output serve to lower prices on goods, especially when they reach mass consumption. This kind of deflation can be very good.

Bankruptcies & Liquidations Accelerating – But a Little Good News

As I have repeatedly warned in recent weeks, several million small businesses are at risk for going bankrupt or permanent closure just ahead. We are anxiously awaiting bankruptcy and permanent closure notices for April, which are certain to have increased significantly. And it will not be limited to small and medium-sized businesses.

We are now starting to see some big names fall. Lord & Taylor, the luxury department store chain headquartered in New York just announced it will liquidate its stores as soon as they reopen. Likewise, Neiman Marcus Group, another high-end retail chain filed for bankruptcy last Friday. Retailer J Crew Group also filed for bankruptcy last week. J.C. Penney and numerous other large retailers are said to be seriously considering bankruptcy.

Fortunately, there is some good news on the bankruptcy front. The Small Business Reorganization Act, which was passed late last year and took effect in February, may encourage more companies to seek Chapter 11. This may not sound good, but it may be.

The new law is aimed at allowing owners to retain their ownership rather than lose their companies to their creditors – that is generally what happens in Chapter 11. The law also streamlines the reorganization process so a company is not wiped out by attorneys' fees. Another change under the new law is that a bankruptcy judge can now approve the reorganization over creditors' objections.  

As always, business owners will try to avoid bankruptcy by seeking leniency from landlords, lenders and vendors, etc. But with their companies' financial troubles beyond their control because of the virus outbreak, many will file for Chapter 11, in part because the stigma that bankruptcy has long held will be greatly reduced under the new law.

The bottom line is that the explosion in bankruptcies I and others have predicted is still going to happen in the weeks and months just ahead for companies large and small. But hopefully, most small business owners will not be wiped out and can keep their businesses afloat with the assistance of the numerous federal stimulus programs. Let’s hope so!  

Wishing you strength and good health,

Gary D. Halbert

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