Deflation usually occurs when too much debt in the system directs the economy’s income into debt servicing and repayment. This detracts from discretionary spending causing a slowdown in consumption, which in western economies generates around 70% of economic growth.
The resultant slowdown in economic growth causes an increase in unemployment, which in turn impacts the ability to service debt, leading to an increase in bad loans and a weaker banking system (sound familiar?). Unchecked, the negative feedback loop compounds and the deflation becomes embedded, until the debt load is purged from the system.
While this is the free market way of a system correcting imbalances, we do not exist in a free market. Huge government intervention, in the form of monetary and fiscal stimulus, has been aimed at slowing the correction down, and eventually reversing it.
High private sector debt levels are effectively being transferred to the public sector. Inflation will begin to surface when there is not enough demand for all the government paper, and governments need to print (create) money to enable the ongoing issuance of debt. That situation is not upon us yet, but if history is any guide, it will be soon enough.
Moving on to the credit markets, the thaw that began a few weeks ago has continued, albeit slowly. While still very high by historical standards, the extreme fear we saw in October looks to be receding, as illustrated by the VIX index. However the process is a slow one and the VIX has spiked again in recent days.
The TED spread (the difference between 3 month LIBOR and 3 month US Treasury’s) has also declined in recent weeks, although it still remains elevated. This suggests that concerns remain about who is solvent and who is not. The latest data from the Fed shows banks continuing to deposit excess funds at their reserve banks rather than lend it out. This is something the authorities will be concerned about.
As is evident from recent trading, much uncertainty still exists with respect to the outlook for the economy and markets. The falls we have witnessed over September and October priced much of the bad news into equities and investors are currently grappling with the question, has enough bad news been priced in? We can’t say for sure, but it is evident that the market is trying to find a bottom at these levels.
From a technical perspective, the S&P500 has entered a period of consolidation, between support at 839 and resistance in the region of 1007 to 1044. As evident on the chart, this follows an accelerated decline, which saw the index decline by as much as 35% in just six weeks.
In our opinion, further consolidation within the noted range is likely in the weeks ahead. However, considering the direction of the broader trend, while ever the index remains below resistance, we cannot rule out a continuation to new lows. In saying that, a break above 1044 would greatly improve the near term outlook.
