19 Jun Deflation?*

Deflation?

Winter Deflation is coming.

Or is it?

If deflation is coming, will Central Bankers once again be able to Defend the Wall keep it at bay?

Prior to 2019, the longest period of GDP growth in U.S. history was ten years. America will exceed that record this month. Although many economists believe that the growth part of the current economic cycle will end by the middle of next year and be followed by recession, there are good reasons to believe otherwise. The data nevertheless supports the economists. The global economy is slowing.

The U.S. is the engine of global economic growth … and is displaying signs of exhaustion. Recent data show that nonfarm payrolls increased in May by a terribly disappointing 75,000, well below projections. The fact is that 2019 has seen a significant hiring slowdown from 2018, an important barometer of America’s future economic health. America’s unemployment rate nevertheless has dropped to 3.6{29ea29b64b10057f61377b2c087cd5b7537a0cd24da4295a308b0bf589469f35}, its lowest level since December 1969 – with the denominator of “unemployment rate” including only those actively looking for jobs … and a great many Americans apparently were not looking. The labor participation rate in May was only 62.8{29ea29b64b10057f61377b2c087cd5b7537a0cd24da4295a308b0bf589469f35}, its lowest level in more than 40 years. Those Americans who stopped looking for work (for a variety of reasons) provide a pool of as-yet untapped labor. If they re-enter the labor pool, wage inflation will remain subdued … and it may remain subdued even if they don’t. The Bureau of Labor Statistics reported that average hourly earnings increased only 1.3{29ea29b64b10057f61377b2c087cd5b7537a0cd24da4295a308b0bf589469f35} over the last 12 months to May, resulting in a 1{29ea29b64b10057f61377b2c087cd5b7537a0cd24da4295a308b0bf589469f35} increase in real average weekly earnings – clearly not inflationary. In fact, given America’s robust economic growth over the last several years, a 1{29ea29b64b10057f61377b2c087cd5b7537a0cd24da4295a308b0bf589469f35} increase in real average earnings could be seen as a sign of incipient deflation.

Meanwhile, America’s trade deficit is higher than ever, as is the nation’s (and many States’) debt, and the Federal deficit is on track to exceed $1 trillion in 2019, all of which provide fuel for deflation. In March, the Federal Reserve reduced its 2019 GDP growth estimate from 2.9{29ea29b64b10057f61377b2c087cd5b7537a0cd24da4295a308b0bf589469f35} to 2.1{29ea29b64b10057f61377b2c087cd5b7537a0cd24da4295a308b0bf589469f35} (continuing the consistent downward adjustments in the Fed’s growth forecasts over the past ten years) … and that was before recent escalations in the Tariff Wars. In June, Morgan Stanley’s Business Conditions Index, which is intended to highlight turning points in the economy, fell by 32 points to its lowest level since December 2008, its largest one-month decline on record. Inflation (and not only wage inflation) is tame, with forecasters projecting that the Fed will hit its target of 2{29ea29b64b10057f61377b2c087cd5b7537a0cd24da4295a308b0bf589469f35} inflation in 2019.

But this is before taking into account additional American tariffs against China and retaliatory tariffs levied against the U.S. The Fed has estimated that the 2018 tariffs imposed by the U.S. added costs of $419 to a typical American household. The Fed expects that the increase in tariffs announced in May alone, from 10{29ea29b64b10057f61377b2c087cd5b7537a0cd24da4295a308b0bf589469f35} to 25{29ea29b64b10057f61377b2c087cd5b7537a0cd24da4295a308b0bf589469f35} on $200 billion of Chinese goods, will raise that number to $831 per household.

That may sound inflationary, and it may be. Economists have at long last acknowledged that they’re unsure what causes inflation and why there hasn’t been more of it over the last ten years.

Nevertheless, increased tariffs will add to families’ costs and eat into their spending. Those tariff costs will be a further drag on the U.S. economy. They are more likely to be deflationary.

The markets have been acknowledging these economic risks. The yield curve has been unusually flat for a number of months, recently inverting – that is, long-term rates fell below short-term rates. The yield curve is usually upward-sloping with lenders demanding higher rates for longer-term loans as compensation for the duration risk. When long-term rates fall below short-term rates, the rate curve is “inverted” and risk is stood on its head. Because inverted yield curves have presaged a recession every time for the past 50 years, this is worrisome … although inverted yield curves have not always led to a recession. However, this time there are … differences.

Based on recent economic data, U.S. economic growth could be seen as having peaked peaking even without factoring in escalating Tariff Wars, increased automation reducing manufacturing jobs, and declining global growth, the latter especially impacting China, the EU and the UK. Bond market experts therefore expect the secular decline in interest rates to continue, at least in 2019: The Federal Reserve’s, ECB’s, PBOC’s, BOJ’s … next step is expected to be easing rather than tightening, probably by lowering interest rates and reducing or eliminating the rate of balance sheet runoff, or by buying more government bonds. If so, the yields on U.S., EU … debt instruments will decline and the expected returns on other assets, including stocks and real estate, will look good by comparison, thereby supporting (though not enhancing) their current valuations.

Economist Gary Shilling has been forecasting global deflation since … before the global deflationary cycle began. He’s continuing to make that call, relying on five principal ongoing factors: (1) globalization and technological innovation have “decimated” the middle class, resulting in fewer jobs in high-paying utilities, oil and gas fields, delivery services and retail (what he refers to as “the Amazon effect”), thereby reducing wages and wage growth; (2) the global economy is slowing and there is an increasing risk of global recession; (3) the slowing global economy has led to weaker commodity prices (notably crude oil prices) and created a negative feedback loop by reducing jobs and economic activity that, in turn, results in weaker commodity prices and creates a further negative feedback loop; (4) increasing competition and government intervention are impacting pharmaceutical companies and reducing drug prices; and (5) technological innovation/automation is significantly deflating financial services costs. The fact is that “this time is different” insofar as all these factors (and others) have simultaneously coalesced. Making accurate predictions in such a charged economic environment is impossible (though there always are those who will try). The economic cycle hasn’t been repealed, but it certainly has taken a more challenging tack. This creates uncertainty … the unknown unknowns.

An asset class that warrants further focus in a potentially deflationary environment is the stock market Unicorns (high-tech private companies that are being brought to the public markets with a valuation of more than $1 billion). Unicorns are companies with supposed industry-altering applications that their current owners hope will are expected to crush traditional competitors. Two notable Unicorns are Uber and Lyft. As is the case with other Unicorns, both have been burning through enormous amounts of capital … which they expect to continue to do for several more years. They hope expect to become super profitable before their access to capital ends. Running losing businesses is itself deflationary. If the Unicorns don’t realize on their promise, or if confidence in the Unicorn paradigm should fade, that not only would be deflationary, it could also spark a reassessment of valuations throughout the market.

Deflation is coming.

When If it comes, one certainty is that Central Bankers will use the same tools that have worked so well artificially supported the global economy over the past ten years. Those tools include printing almost unlimited amounts of Fiat Currency (another theoretical application of Modern Monetary Theory), reducing interest rates to or below zero, and promising once again to “do whatever it takes” to keep the economy moving on an upward slope. There will come a time when those measures will prove fruitless. What the trigger will be and when that will happen is anyone’s guess. To borrow a theme from Shakespeare in Love, “It’s a mystery.” Suffice it to say, however, that the Central Bankers have a Sisyphean task … with Sisyphus having had the easier job.

Finally (from a good friend)

*┬® Copyright 2019 by William Natbony. All rights reserved.