Market Analysis – Monday, January 12, 2015

Overview
This market analysis examines the performance of U.S. financial markets since the 2007-2008 Financial Crisis to provide an outlook for economic conditions from the perspective of an analyst/trader that utilizes fundamental, technical, quantitative, and intermarket analyses. Central bank activity carries on to drive the markets. Meanwhile, the tug-o’-war between deflation and inflation continues for supremacy of the U.S. economy. Altogether, this impacts the prospect for financial markets over the next 18 months.

Trading Ahead of the Fed
20150112 Chart1 20150112 Chart2
The market anticipates Fed monetary actions to get a jump on investing. As the 2007-2008 Financial Crisis develops, a flight-to-safety drives bonds skyward as stocks tumble, sending the bond-to-stock price ratio parabolic. Following Lehman Brother’s bankruptcy filing (Sep 15 2008), the Fed announces QE1, providing a reprieve to the markets. Bonds sell-off (yields rise) immediately, while stock investors digest what occurs; stocks eventually rebound strongly, after a final cleansing of weak holders, in March 2009. Going forward, each time bonds are heavily bid to catapult the bond-to-stock ratio up, the Fed rolls-out yet another unconventional monetary program. Astute investors trade ahead of the Fed, boosting stocks several months before a Fed announcement (Charts 1, 2).

Liquidity, Liquidity, Liquidity
20150112 Chart3
Liquidity continues to drive the markets. Fed intervention keeps a constant bid on bonds as liquidity seeps (flows) into the financial markets, collapsing bond yields, while lifting stocks and bonds. Each time bond yields bounce off the down trendlines reinforces the uptrend in stocks (Chart 3).

Other major central banks contribute to the liquidity influx. To combat the UK’s economic crisis, the Bank of England undertakes four rounds of QE (Mar 2009, Oct 2011, Feb 2012, Jul 2012) and maintains a near zero-interest rate policy. In Japan, suffering a long recession-depression since 1989, the government relies primarily on fiscal stimulus and ZIRP, with miniscule QE efforts. But, with the election of Prime Minister Shinzo Abe in December 2012, and subsequent appointment of Haruhiko Kuroda as governor of the Bank of Japan, the BOJ pledges a money-printing program that is, relative to the size of the US economy, twice the size of the Fed’s QE3. Some of this foreign money flow finds its way into the US financial markets, helping to drive up stocks and bonds.

The Deflation-Inflation Battle
20150112 Chart4 20150112 Chart5 20150112 Chart6
Deflationary and inflationary forces struggle for control of the U.S. economy. Following the 2001 Dot-com Bubble burst, deflationary effects dominate monetary inflationary counter-action. Increasing positive correlation between stocks and bond yields represents a tell-tale sign of deflationary conditions (red shaded region of Chart 4 and first arrow in Chart 5). Then, starting in 2012, the link between stocks and bond yields starts to weaken, turning negative in Q4 2013, hinting that deflation may finally be whipped. But, after bottoming in May 2014, positive correlation comes back with a vengeance as the market shouts deflation (second arrow in Chart 5).

From an economic analysis perspective, the Personal Consumer Expenditure inflation rate (Trimmed Mean version, which excludes high and low data points), the Fed’s preferred measure of inflation, shows 6-month and 12-month annualized inflation stabilizing between 1.25% and 2.00% over the last 3 years (Chart 6). But, with 1-year certificate of deposit rates at around 1.15%, savers continue to suffer drops in spending power, as banks and financial institutions leverage up on near zero financing while assuming riskier bets in a low-yield environment. Next, several scenarios for deflation-inflation are examined.

Three Hypothetical Scenarios for Deflation-Inflation
Scenario 1 (Deflationary Escape): Since December 2013, stocks and bonds appear to have re-coupled, returning to an inflationary / disinflationary relationship (arrows in Chart 4). Under this scenario, the U.S. economy has reached break-away velocity and escapes deflation’s crippling grip. Nevertheless, with U.S. government total debt at $17.8 trillion (as of September 30, 2014), or 101.3% of GDP, an inflation-bias will dominate for years to come. But, even moderate interest rate hikes in 2015 would surely spell the doom for the current stock and bond bull (bubble) market. With banks and financial institutions leveraged up, a rush to the exit would not be unexpected.

Scenario 2 (Return to Deflation): Should economic conditions continue to deteriorate, and/or another major financial institution run into trouble following the official ending of QE in October 2014, new liquidity injections (QE4?) could alter the financial market landscape, yet, once again. In which case, falling bond yields since December 2013, act as an early signal of a flight-to-safety and continued deflation, leading, most probably, to a major sell-off in stocks and clearing of the decks, before new Fed monetary easing re-ignites parts of the financial markets.

Scenario 3 (Keynesian Deflation Paradise): Similar to Scenario 2, except that the Fed announces a new round of QE before any panic selling occurs (perhaps, preempting a major bank failure). Thus, no major sell-off in equities takes place and prices actually jump upwards from today’s lofty level. Of course, this only delays the inevitable correction, which would occur from a greater height, producing a more pernicious psychological effect over all, perhaps, leading to the dreaded deflation spiral. How long politicians continue to kick the can down the road would, likely, be determined by the financial markets willingness to hold government debt.

Economic Outlook
So, what is the most likely outcome for the economy? From an intermarket analysis perspective, returning to Chart 1, the bond-to-stock ratio forms a large right triangle dating back to the start of the 2007-2008 Financial Crisis. As the ratio approaches the apex, a break below support, where the relative strength of stocks overwhelms that of bonds, would suggest a return to normalcy – inflation/ disinflation. However, the more likely bet is for a break above resistance, with bond relative strength dominating, to deflation, and the requisite Fed monetary easing (QE4?).

20150112 Chart7
Equity markets give a strong deflationary signal. An examination of the relative strength of inflation-sensitive stocks (comprised of mining & metals ETF, oil & gas ETF, oil & gas equipment and services ETF, TIPs ETF) and deflation stocks (comprised of financials ETF, utilities ETF, 1/TIPs ETF) reveals that deflationary effects emphatically took control of the economy starting in September 2014 as a major support line was broken (circle in Chart 7). While many economists will wait until lagging economic data become available to cast judgement, the market has spoken: deflation is back.

Epilogue
The underlying causes of deflation never actually went away. Banks and financial institutions still hold huge amounts of non-performing property loans and other credit-related assets and associated derivatives via off-balance sheet vehicles. Accounting and legal gimmicks to hide these do not make them go-away. Furthermore, China, India, and the rest of the developing world possess a plethora of untapped labor that continues to exert downward pressure on prices. As advanced technology and processes roll-out in developing countries (albeit, requiring education and training of the workforce, and additional capital), prices would be suppressed even further. Also, the energy revolution in deep-sea drilling for oil and gas, shale oil, fracking, long distance pipelines, and LNG terminals and tankers raises energy supplies. For the developed world, aging demographics in Japan, Western Europe, and, to a lesser degree, in the U.S., lessens demand over time, depressing prices. To combat ongoing deflationary pressures and high government and corporate debt levels, developed countries would, most probably, continue to try to inflate via money printing and loose monetary policies and increased spending programs. The alternative, of course, would be to restructure the entire financial system, representing enormous losses and layoffs, and even a sharp recession. But, once a bottom is found, investors would return with capital, as they have throughout history, to enable economies to grow once again.

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