Juggling Dynamite

Gary Shilling, president of A. Gary Shilling & Co., talks about the outlook for U.S. Treasury yields, Federal Reserve monetary policy and economic outlook. Here is a direct video link.

The financial world makes the most fees on equity products hence the bias is always to recommend equities. Shilling reminds us of this when he explains that every year the equity herd starts with strong growth forecasts and a bias against bonds…

Gary’s excellent Monthly Insight Letter (subscription only) for June reminds that deflation is actually the norm in peacetime and has reigned in 168 of the past 264 years, versus just 96 years where inflation dominated.  However governments, central banks and financial firms hate the idea of deflation and forecast inflation every year notwithstanding.  Reasons for this systemic bias include:

• deflation reduces nominal tax revenue as corporate revenues, profits and household incomes fall causing taxpayers to drop to lower tax brackets;
• the idea of cutting social security cheques which are indexed to inflation annually (and so should be reduced in deflation) is politically abhorrent, even though real income increases in deflation;
• debt payments in nominal terms remain fixed even while income to service those payments stagnates or declines.  Thus deflation is hard on individuals and governments who are heavily indebted, even while it means increased purchasing power for those who are not in debt;
• given that central bank rates are already at the zero bound, deflation stymies monetary policy since rates cannot be reduced further to prod consumption.  Thus central bank magicians are rendered powerless–their worst nightmare;
• deflation can develop a momentum of its own if consumers forestall purchasing today on the expectation that items will be cheaper in the future.  Although this is only applicable to some discretionary items, since in many items and services, consumers have no ability or interest in holding off present consumption;
• corporations count on inflationary forces to drive sales (corporate earnings, share prices and their executive compensation packages) higher year over year.  Deflation makes meeting these financial targets much more challenging.

In the spring of 2011, global growth began weakening from the cyclical recovery that had begun in early 2009, and stock and commodity markets turned lower once more. All over the world, Central Banks responded with trillions of monetary injections designed to arrest the contraction and encourage belief in a more extended economic recovery. Risk markets stopped falling in response, but it took nearly 2 years of sideways action, and seemingly endless promises and liquidity programs, before stocks were finally able to recover and break higher in the final quarter of 2012.

As shown in this remarkable chart below, levered risk-taking–borrowing to buy on margin (red line)–began turning lower in 2011 (as it had done at prior market peaks in both 2000 and late 2007), but then re-surged with QE inspired speculation into February 2014. Since then, the margin tide has been receding once more. It looks like Central Banks are going to need some bigger, better gimmicks to turn this mean reversion process around, because historically, as margin falls, so do stock prices (S&P in blue).

The Senate hearing into HFT this morning is long overdue and hopefully will reveal how widespread, indefensible and outrageous these practices have become. Carl Levin’s opening comments are off to a good start… You can see a video of testimony here.