Tuesday, September 5, 2017

Deflation Headed Straight for the US?

Antonia Oprita of The Street reports, August Jobs Miss Plays Into Bear's Worries About U.S. Deflation:
Uh oh. The miss on U.S. employment numbers in August, when the economy created 156,000 jobs versus 180,000 expected, is likely to reopen the debate about the Federal Reserve's monetary tightening stance.

Wage growth also missed expectations slightly, coming in at 2.5% versus 2.6%, while the unemployment rate was 4.4% compared with expectations of 4.3%. Reaction in European assets was muted, with stock markets still in positive territory and the euro virtually flat.

The Federal Reserve has been talking about shrinking its huge balance sheet, but renowned Societe Generale bearish economist Albert Edwards believes the U.S. is heading straight toward deflation.

"There is mounting evidence that underlying U.S. CPI inflation has already slid into outright deflation in exactly the same way that Japan did seven years after its credit bubble burst. Hence, we repeat our call for U.S. 10-year bond yields to ultimately converge with Japan and Germany at around minus 1%," Edwards wrote in recent research.

After Japan's asset bubble burst in 1991-1992, the country experienced the so-called "lost decade" -- a period of economic stagnation that in fact should be re-named the lost two decades, as it extended well beyond the first 10 years.

This stagnation is due to deleveraging by households at a time when the population is aging rapidly, in Edwards' view. "Both factors would also combine to push the West into a similar deflationary bust, despite the best efforts of policymakers (who incidentally would in no way follow the advice they had previously given Japan to liquidate capacity)," he said.

Like many other market observers, Edwards focuses on wage data. He noted that ordinarily, at this point in the U.S. economic cycle, a tight labor market would normally have caused a "notable upturn" in wages and inflation. This would prompt the Fed into a tightening cycle that would usually end in a recession.

Edwards had expected this to happen at the start of the year, and the ensuing recession to tip the U.S. into deflation, but now he said he had been "too optimistic" about that scenario. He noted that over the past six months there were "consistent downside surprises" in the pace of acceleration for wages, which came hand-in-hand with "an unprecedented slump in underlying U.S. CPI inflation into outright deflation."

Core CPI (excluding food, energy and shelter) never fell over a six-month period since the 1960s, according to Edwards, who added: "Deflation did not need another US recession to emerge. It is already here."
In his comment on the employment situation, Warren Mosler also notes this:
[...] it’s the wage data that, for policy makers, may be the greatest disappointment and will provide the doves, who are concerned about the economy’s lack of inflation, serious arguments to delay the beginning of balance-sheet unwinding at this month’s FOMC.
Mosler is missing the bigger picture. If the Fed unwinds or continues to raise rates, it will only exacerbate global deflation which is alive and well, and risk igniting the next major deflationary crisis.

Long before SocGen's Albert Edwards even contemplated deflation coming to America, I was openly worried about this possibility and its widespread implications.

It doesn't matter who called it first, there is now a very real threat that global deflation will hit the US and very few have even thought about what this means for the global economy and risk assets across public and private markets over the near and very long term.

"Leo, we employ an army of PhDs looking into all sorts of risks, doing all sorts of stress tests on our public and private investments. We're ready for the next twenty sigma event."

So you think. Trust me, none of you reading this comment are prepared for a protracted period of debt deflation which could last decades (some more than others). When the deflation hurricane strikes America, it will cause unparalleled destruction and devastation, not just in the US, but across the world.

The entire world is focusing on Kim Jung-un's antics and potential nuclear war with North Korea but that is a sideshow, a distraction from the nuclear deflation bomb which was detonated during the last crisis and is only now headed our way.

"Leo, please, stop with the hyperbole, you're only talking up your book because all your money is now in US long bonds (TLT). You're only pissed because you stopped trading biotech (XBI) and tech (XLK) stocks which pulled back and came back strong in the last few weeks." (click on images):



I stopped trading for a lot of reasons. I don't like the risk-reward setup of trading risk assets, prefer the one on US long bonds, and more importantly, I had to address some serious health issues this summer as my hyperthyroid wiped me out (feeling much better after three weeks of treatment but still not back to normal yet). When you're not feeling well never add needless stress to your life to chase a buck.

Having said this, I called the biotech bottom right before Trump got elected, made a killing since then, and want to protect my gains.

Sure, if I was feeling better this summer, I could have made a lot more, but that's irrelevant. When I trade, I need to be very cognizant of the macro environment and remain very disciplined, focusing on risk-reward going forward.

Nonetheless, I wouldn't be surprised if stocks keep going up, with biotech and tech making new record highs, and I even wrote about the risks of a melt-up and meltdown in my comment on when will the tech bubble burst:
There are two big risks in the market right now:
  1. A major correction or even a meltdown unlike anything we have seen before as literally every risk asset is way overvalued.
  2. A 1999-2000 melt-up where stocks go parabolic led by tech giants and biotech, forcing fund managers to keep buying at higher multiples or risk severe underperformance.
Risk managers often focus on the first risk but neglect the second one which is much more painful because it can last a lot longer than fund managers can stay solvent.

No doubt, 2008 was very painful, I remember it like yesterday when the Dow was falling 400, 500 or 700 points a day. It was beyond scary and I don't want to minimize the psychological effects of a severe meltdown.

But what about the risks of stocks continuing to grind higher? I'm not going to lie to you, that risk is in the back of my head too at the time of writing this comment, and it's something I lived back in 1999-2000 when you'd wake up and see tech stocks up 10, 20 or 30 percent a day every single day!

It was relentless, like a giant steamroller eviscerating short sellers and leaving many value managers scratching their head asking whether there is a new paradigm in markets.

The problem with these melt-up rallies is they're led by huge liquidity. That's what happened back in 1999-2000 and it took several rate hikes before that tech bubble burst.

But now we have even more liquidity in the system as central banks around the world slashed rates to near zero and engaged in unprecedented quantitative easing.

In other words, it could take a lot of time for this liquidity party to dry up so don't be surprised if stocks continue making record gains, frustrating fund managers who don't want to indiscriminately buy at these high valuations.
Still, the focus right now shouldn't be on when the tech bubble will burst, it should be on when deflation hits America.

Ray Dalio is warning of the dangerous divide but unlike him who doesn't see "any important economic risks on the horizon", I see a major risk, global deflation coming to America, clobbering risk assets across public and private markets for a very, very long time.

I know I sound like a broken record, but asset allocators and policymakers need to focus on the seven structural factors that lead me to believe we are headed for a prolonged period of debt deflation:
  1. The global jobs crisis: High structural unemployment, especially youth unemployment, and less and less good paying jobs with benefits.
  2. Demographic time bomb: A rapidly aging population means a lot more older people with little savings spending less.
  3. The global pension crisis: As more and more people retire in poverty, they will spend less to stimulate economic activity. Moreover, the shift out of defined-benefit plans to defined-contribution plans is exacerbating pension poverty and is deflationary. Read more about this in my comments on the $400 trillion pension time bomb and the pension storm cometh. Any way you slice it, the global pension crisis is deflationary and bond friendly.
  4. Excessive private and public debt: Rising government and consumer debt levels are constraining public finances and consumer spending.
  5. Rising inequality: Hedge fund gurus cannot appreciate this because they live in an alternate universe, but widespread and rising inequality is deflationary as it constrains aggregate demand. The pension crisis will exacerbate inequality and keep a lid on inflationary pressures for a very long time.
  6. Globalization: Capital is free to move around the world in search of better opportunties but labor isn't. Offshoring manufacturing and service sector jobs to countries with lower wages increases corporate profits but exacerbates inequality.
  7. Technological shifts: Think about Amazon, Uber, Priceline, AI, robotics, and other technological shifts that lower prices and destroy more jobs than they create.
These are the seven structural factors I keep referring to when I warn investors to temper their growth forecasts and to prepare for global deflation.

More importantly, when deflation strikes America, it will have devastating effects on risk assets across public and private markets and it will decimate private and public pensions, especially those that are already chronically underfunded.

[Remember, pensions are all about managing assets and liabilities. Deflation strikes both, especially liabilities which will soar to unprecedented levels when the pension storm cometh and rates decline to new secular lows.]

There are a lot of people reading this comment who will roll their eyes and dismiss this as total nonsense. These are the same people who believe in the Maestro and others warning of a bond bubble ready to burst. They simply don't understand there is no baffling mystery of inflation deflation, the latter is clearly gaining on the former.

These people are in for a very rude awakening, one that will decimate the bulk of DB and DC pensions across the world and decimate the retirement accounts of millions of people as they get ready to retire and succumb to pension poverty.

It pains me to see the Fed and other central banks ignoring the risks of global deflation. It equally pains me to see policymakers unable to address things on the fiscal front. More worrisome, it pains me to see pensions taking on dumb risks across public and private markets at a time when they desperately need to hunker down and really think carefully of their long-term strategy to make sure they have enough assets to meet the needs of their beneficiaries.

Below, James Cheo, investment strategist, Bank of Singapore, says risk events combined with a historically weak trading month in September mean overweight cash is the way to go.

Why overweight cash? Cash is trash. More importantly, this isn't going to be a buy the big dip like in 2008, it will be a protracted bear market unlike anything we've ever seen before, drawn out over many, many years.

You should all be overweight US long bonds (TLT) before deflation strikes America and probably well after. You don't have to be a nut like me and put all your money in US long bonds, but if you are a retail investor and are not at least 50, 60 or even 70% in US long bonds (TLT) right now, you are going to get slaughtered over the next year. I'm dead serious about this.

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