Recent events such as the downed Malaysian airplane over Ukraine and Israel's invasion of the Gaza Strip remind us of how quickly world events can hurt global economic conditions, and how fragile the world economy remains after the 2008 financial crisis. Given this state, and the easy money policy of the worlds’ central banks, the threat of deflation trumps the threat of inflation now.
On the day of the crash, the Dow Jones Industrial Average dropped almost 1% in its biggest one-day point decline since May 15. U.S. oil futures closed $1.99, or 2%, higher at $103.19 a barrel. That was the largest one-day dollar and percentage gain since June 12, when Islamists launched an uprising in Iraq. Also, investors piled into perceived safe havens such as U.S. Treasuries and gold, pushing their prices sharply higher.
We don't know the exact impact to the U.S. economy of a protracted period of higher global oil prices if war between Russia and the Ukraine were to break out, or the battle between Hamas and Israel were to spread into a wider war within the Middle East. But we do know that such events, if deep and prolonged, could easily tip the U.S. back into recession.
And given our fragile recovery and these scenarios, the Federal Reserve's accommodative stance is likely to remain for some time.
Of course, war is just one of many major concerns that could reverse the economic gains that have been made in the last few years. As we reported recently, The Bank of International Settlements, the institution in Basel, Switzerland that is the central bank for central banks, said that stimulus programs address the immediate problem at the cost of creating a bigger financial crisis down the road. And in the report, the BIS noted that, "the fallout from the financial cycle can be devastating."
What would a financial bust look like in a post-2008 financial bust world? Well, we got a taste ! in early July, when worries over the financial health of a major Portuguese lender, Banco Espirito Santo, spooked global markets, causing shares to plunge in southern Europe and sending U.S. stocks down.
What happened? As the Wall Street Journal reported, "a shock in a small country spread across the continent, pulling down every major stock index in Europe, trickled over into Wall Street and sent investors scurrying for the perceived safety of gold, U.S. and German government bonds," essentially the investors' crisis textbook response of almost every past crisis.
Chart A: The Biggest U.S. Contraction since 1Q2009
A large scale financial collapse could start with a bubble in junk corporate and government bonds around the world popping, leaving U.S. investors who have piled into them holding the bag. It would be essentially a reverse 2008 crisis: This time an asset bubble overseas would push the U.S. economy into a recession, or worse.
And what would the Fed do in that event? Would it use even more stimuli to re-inflate the bubble that the U.S. and other global central banks created and then popped? That's a scary scenario.
Federal Reserve Chair Janet Yellen has argued that in increasing capital at banks around the world has made the financial system more stable, but her central bank colleagues have sounded the alarms that the financial system continues to be at risk, and the Federal Reserve appears to be overlooking this.
As investment guru Seth Klarman put it: "Inside the giant Plexiglas dome of modern capital markets, just about everyone is happy, the few doubters are mocked and jeered, bad news is increasingly ignoredn… The artificiality of today's markets is pure Truman Show."
Many financial experts, and your correspondent, still believe that deflation should b! e the big! gest concern on investor minds. The Wells Fargo chief economist said in February that a new model his team developed forecasts a 66% chance of deflationary pressure.
Failure to Launch
It's difficult now to get excited about inflation, especially when recent revisions show the U.S. economy had a much more dramatic contraction in the first quarter than we thought even a few months ago. In fact, the U.S. economy looks far from reaching "escape velocity," or exhibiting sustainable growth, the necessary precursor to inflation.
The Fed's real GDP growth estimate for 2014 was revised to 2.1%–2.3% from 2.8%–3% at the end of the March FOMC. And the Wall Street Journal found that consensus economist estimates projected lower GDP growth than the Federal Reserve.
As we have advised investors in the past, see A Portfolio Against War, Inflation and Bubbles and The $45 Billion Tipping Point, portfolios can be constructed that simultaneously protect against inflation and deflation, when such outcomes are not clear, and should be implemented well in advance.
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