A Deflationary Side Effect Of Central Bank Policy May Threaten U.S. Equities

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Includes: DIA, QID-OLD, QQQ, SPY, SQQQ
by: Vincent Feher

Summary

Deflation may undermine stocks of US companies which rely on pricing power to maintain profitability if global deflation spreads to the US.

Conventional thinking is that excessive monetary liquidity is inflationary, but now the opposite appears to be happening.

Deflation may be occurring because the Fed's short term stimulus created an overproduction of various assets, commodities and goods in already well supplied markets.

Long term oversupply of various assets, commodities and goods may have been created.

The crash in the oil market is an example of this. The deflationary phenomena may spread to sectors other than natural resources.

Currently, deflation is only a theoretical threat to the US economy and equities. Although recently it may have created some volatility in the financial markets, it has not significantly undermined US stocks (except in the natural resource sector). But that may change.

Outside the US, deflation has spread globally affecting Europe, Japan and potentially China.

Deflation may start to undermine stocks of US companies which rely on pricing power to maintain profitability. This could include not only those companies which sell products or services abroad but those which could suffer from a depressed pricing environment domestically. This would result from exposure to broader global deflationary pressures which affect the US economy. If purchasers delay buying decisions because they perceive lower prices will be available later, deflation has the potential to affect a broad variety of industries such as housing, automotive or even technology.

If deflation occurs, it's because central banks, led by the Federal Reserve, unintentionally may be causing and exacerbating the deflation they are trying to stop. They've done this by providing excessive liquidity which is creating a significant oversupply of various assets, goods and commodities. Conventional thinking is that excessive liquidity is inflationary but my view is that, in this case, the opposite is occurring.

Consider the following trends.

Arguably, a global deflationary trend started with the Financial Crisis of 2007-2009. While it only lasted a short time, it revealed that the credit boom in the early 2000s had created an oversupply of various assets and commodities including housing and oil (oil crashed from over $140 a barrel to around $40 between 2008 and 2009). As we know, the Fed and other central banks responded by creating trillions of dollars of monetary liquidity to reflate the assets which had crashed.

However, a significant side effect of that action was to create a short term spike in demand for various assets, goods and commodities due to dramatically reduced interest rates and tremendous liquidity in the financial system. This encouraged producers of those items to increase supply. Had the global supply/demand balance been in equilibrium (i.e., had the world not been awash in excess housing and commodity production) then the effects of this new central bank induced additional production would not have been so significant. But, this new central bank action stimulated even more production of assets, goods and commodities. This added to an already well supplied market for those items. The result was long term oversupply. This leads to deflation.

In addition, central bankers' liquidity measures were only designed to stimulate short term demand. These measures were not intended to continue indefinitely. The Fed and other central bankers have acknowledged the limits of monetary stimulus such as QE. They are gradually pulling back from it. However, the long term supply of assets, goods and commodities, which have been produced in response to that short term demand, continue to be available and have created more long term supply.

What happened to the oil market since the Financial Crisis is a good example of this Fed-induced oversupply. In response to the Fed's monetary stimulus during 2009-2013, investors speculated in commodities, including oil, driving the price up to over $90 for several years. In response, the oil industry invested in new methods of extraction which have led to new long term supplies of oil. But then, the Fed reduced its monetary stimulus. So, the artificial speculative demand for oil diminished. The result was that the oil market crashed. The reason: the short term artificial Fed-induced demand was gone. But, the new long term supplies of oil continued to come on line, depressing prices.

The first warning sign of this coming deflationary phenomena manifested in the gold market and CRB Index in a similar time frame as the deflation in oil. When the Fed's stimulus began in 2009 and 2010, investors poured money into precious metals and commodities, seemingly convinced that hyperinflation would materialize shortly. In 2011, this drove gold to a high of over $1800 and the CRB Index to 580. But neither the collapse of the dollar, nor out-of-control inflation happened. Instead, Gold lost nearly a third of its value and the CRB Index, approximately 25%, while the dollar strengthened dramatically.

These particular examples of Fed-induced short term inflation followed by a period of deflation may seem beneficial to the economy, resulting in low inflation and commodity prices. But what if that deflationary phenomena occurs in other sectors of the economy such as housing, autos or even technology? While this hasn't yet occurred systemically, investors should remain alert to it. If a serious deflationary cycle starts, it will be difficult to stop. The Fed and other central banks may be unable to re-stimulate demand by lowering interest rates again. Simply stimulating production of goods and assets again, into an already oversupplied market, will not solve the problem.

If global deflation spreads to the US, investors should consider selling stocks of companies which are vulnerable to it.

Disclaimer: Further to any disclaimer for the site on which this article is posted, please be aware that the author is not a registered investment adviser (or representative thereof). The content presented in this article is opinion only, and should not be relied upon by the reader in making investment decisions. The reader should base any investment decisions on his own independent research and analysis entirely at his own discretion and/ or seek advice from a professional. No content published in this article constitutes a recommendation that any particular investment or investment strategy is suitable for any specific person.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am currently long the Sqqq and Qid. I trade these positions daily and may buy and sell more of such positions in the next 72 hours.