Palisade Research - Thu, Sep 20, 2018

This 'Deflationary' Bull Markets Ending - And Here's What's Coming Next For Investors

image of two businessmen and a businesswoman looking at a clock lit by a flashlight, indicating time is running out

After many years of cheap money and asset bubbles - it looks like the upside is finally over.

That is - the potential upside against the amount of risk taken on - is over.

I often write about investors needing to find asymmetric (low risk - high reward) opportunities. And lately - as I've written about earlier this month - many key indicators are now flashing potentially huge downside ahead.

As I wrote then - it's not like I'm predicting markets to tank tomorrow. Or even next week.

But what I'm getting at is that there's significantly more risk ahead than reward - at least for the general market and equities.

I'm not alone thinking this way. . .

Bank of America & Merrill Lynch (BAML) recently published a white paper with an interesting trading suggestion. . .

First, they show us that the nearly 10-year monster U.S. bull market has been highly deflationary. And in case you forgot, deflation refers to when there's an overall decline in the prices of goods and services.

The 'deflationary assets' group includes U.S. investment grade bonds, government bonds, the S&P 500, 'growth stocks', U.S. high yield credit, and U.S. consumer discretionary equities (aka non-essential goods - such as luxury goods, entertainment, automobiles, etc.) . . .

And the 'inflationary assets' group which includes commodities, developed market stocks (excluding U.S. and Canada), U.S. bank stocks, 'value stocks', cash, and treasury inflation protected securities (aka TIPS) . . .

Since the end of the 2008 crash - the Fed embarked on an 'easy money' and expansionary path via ZIRP (zero interest rate policy) and QE (quantitative easing; aka money printing).

But even after all this - deflationary assets have seriously outperformed inflationary assets. . .

line chart of deflation assets versus inflation assets since 1960

This will cause future economic historians to scratch their heads wondering how this happened.

"Wasn't all this stimulus and easy money supposed to cause inflation?"

BAML chalks it up to what they call the 'Three Ds' - technology disruption, ageing demographics, and excess debt.

Over the last 10 years we have seen companies advance their technology - causing production costs to be lower. And yes, the 'baby boomers' have aged and are entering retirement (if they even can).

But the main reason here - as always - has been excessive debt and underwater assets.

For this, I think BAML would do well to read the economist Richard Koo's theory on 'Balance Sheet Recessions'. . .

As a quick explanation, Koo says that a Balance Sheet Recession is when citizens and companies (the private sector in general) are bogged down by debt after an asset bubble pops. And their primary goal is to save and pay off debt instead of taking on new debt and more spending.

And as people and companies save more, that's money not fueling consumption and investment. This slows down economic growth.

Even with rates at near-zero - slightly negative - people and firms don't want to take out more debt until they pay off old debt (we see this in Japan and the EU).

The massive amount of private savings ends up flooding banks and investing institutions. And since no one's borrowing, these lenders have no where to invest it all. Thus, the only place they can invest all this excess savings is in government debt. And that's why governments can run huge deficits as rates stay so low.

For an example of a deep Balance Sheet Recession - just look at Japan since the 1991 Japanese bubble burst. Another example is the Eurozone post-2010.

Because the housing market burst in the U.S. during 2007 and 2008, many individuals have still been plagued by underwater assets and heavy debt burdens.

But finally - almost 10 years later - things are now starting to recover in the U.S. as private spending, debt, and inflation picks up.

The only problem is that it's a bit too late. . .

So - what's next?

Unfortunately, without the excess liquidity from the Fed - expect excess portfolio returns and growth to come to an end as well.

Making matter worse, since the Fed's tightening so aggressively - via rate hikes and Quantitative Tightening (bond selling) - we're seeing liquidity dry up worldwide. (I've written extensively about the dollar shortage and evaporating liquidity problem - you can read about it here).

And as Central Banks continue tightening and draining the excess liquidity, portfolio and asset price declines won't be far behind. . .

A collapse in global asset prices will undoubtedly kick off a global recession - as it frequently has throughout history.

There's almost always a financial crisis when the Fed tightens after years of easy money. . .

line chart showing major financial events after Fed interest rate tightenings since 1915

Because of this - BAML calls for, what they call, a 'perverse' trading idea.

They call for investors to rotate from the deflationary assets and into the lagging inflationary assets.

My thoughts?

I believe the world's about to get hit with a much harsher Balance Sheet Recession (from years of building up student, auto, credit card, corporate, and mortgage debts). This will make the 2008 'debt disease' look like child's play.

Central Banks will then rush into negative rate territory and more money printing in attempt to reignite borrowing, push asset prices higher, and make debt re-financing easier.

Meanwhile, governments will run massive deficits as they slash taxes and increase government spending to offset the loss of private sector demand.

Put in simple terms - the elites will stop at nothing to try and prevent a deflationary spiral.

So I think inflationary assets should get a boost - especially since they'll stop at nothing to get it. . . publishes interesting contributor articles in addition to its own content. We have not verified any of the above details.

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