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  Posted on: Thursday, March 3, 2016
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"Stormy Seas" Both in the U.S. and Globally
The Cycle of Deflation 

   
 
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We have warned in the past about the potential for a world-wide deflationary bear market accompanied by a U.S., and possibly, global recession.  We believe this recession and deflationary bear market have begun and expect it will last through most of 2016 and into 2017.

Two weeks ago Barron’s Magazine ran a cover story titled “Stormy Seas”.  The authors were essentially on the other side of this debate, by claiming “Despite Turbulent Markets”, the U.S. economy will avoid a recession and grow at a healthy 3% pace this year.  However, even if Barron’s is correct and the U.S. economy grows at 3%, this would still be the slowest recovery since World War II.

Below are nine reasons that we believe there will be a US and possible global recession in 2016.

  1. The S&P 500 peaked in mid-2015 at 2135 and broke through many areas of support on the way down to the 1800-1812 area.  Though it successfully tested that area in both January and February, we believe that 1800 will prove an important psychological level that will be breached in short/intermediate term.  When this occurs we believe the potential will be there for a rapid and significant move lower.

  2. The spread between the 10 year US Treasury and the 2 year US Treasury (flattening yield curve) is now just 83 basis points; the lowest level since late 2007.  This is a deflationary indicator.

  3. According to Bloomberg, high yield bond issuance was down 72% in February versus 1 year ago. Notable was the complete absence of issuance by energy and materials firms; a possible indication that financing is not available.  This has implications for future default rates. 

  4. The Bloomberg Commodity Index, which is calculated back to 1991 and is broadly representative of the commodity complex, made a new all-time low in January and currently is 68% below its all-time high set in September of 2008.

  5. Gold has been rallying over the past few months as investors are worried about currency debasement and negative interest rates.  Negative real interest rates can occur because interest rates are low relative to some inflation (now) or interest rates are not high enough to compensate for hyper-inflation (a possibility in the future as governments further debase currencies).

  6. ISM manufacturing has been below 50 for five months and is now 49.5.  50 is the break point between expansion and contraction

  7. Downward earnings revisions, according to data compiled by Bloomberg, are happening at double the average pace of the last five years with profits seen dropping the most since the global financial crisis.

  8. The Atlanta Federal Reserve just lowered its forecast of 1st quarter GDP to 1.9% down from 2.1%.  Also significant is that its forecast of real consumer spending growth was lowered from 3.5% to 3.1%

  9. Fear and Loss of Confidence in Central Banks.  The Fed is looking at everything they can before raising rates again---weakness in global markets as well as all financial data.  Other Central Banks are also guessing after the Fed made significant decisions for the past 7 years –i.e., zero interest rate policies as well as increasing the balance sheet from $800 bn to $4.5 tn.  They are now scared to death about the “unintended consequences” of their moves—especially after lowering rates in 2003 causing the housing bubble and the “great recession”.  They are especially nervous knowing that so many countries have taken on so much debt over the past few years without generating enough income to pay the debt down.  We believe that debt restricts economic recovery and will probably cause “Deflation” (see attached “Cycle of Deflation”).  This debt has caused many countries to fall into recessions (e.g. Brazil, Venezuela and a major slowdown in China) and its effect has yet to be fully realized.

 

Lastly and on a separate note, the people running for the Presidency have us very concerned.  On the Democratic side they are talking about income inequality and how they can tax and spend more to alleviate it.  There has been not a mention of the fact that ZIRP has been the policy of our Federal Reserve.  Zero interest rates are their dictum, not the outcome of a free market price determined by the true supply and demand of money.   It did not precede income inequality but has certainly exacerbated it as those with financial assets, real estate and collectibles have benefitted.  On the Republican side the front runners are in a food fight and demeaning themselves, our system and the office they seek.  No one, since Rand Paul dropped out, is talking about $19 tn in debt and potentially $200 tn in unfunded liabilities that are not going away and in fact growing.  We believe this to be the most important economic factor that will influence the quality of our children’s and grandchildren’s lives.  It is so large an influence that it has implications for many things including defense, infrastructure and social spending.  They in turn will factor into our security, quality of life and social order.  And that is about as important as it gets!

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