Gary Shilling: Deflation Likely; Fed ‘Completely Clueless’

Gary Shilling knows a thing or two because he’s seen a thing or two, to paraphrase a current TV commercial. Indeed, seeing things that other economists fail to perceive has been the secret to Shilling’s accurate economic and market forecasts for more than 50 years now.

Going beyond the consensus view that’s been priced into markets, he looks for “strange” and “exotic” indicators not expected by most observers, Shilling tells ThinkAdvisor, in a wide-ranging interview.

This year, the biggest threat to the market is complacency, he argues, and deflation — falling prices — could be just around the bend. That’ll be no surprise to Shilling: In late 2010, he released the bestselling “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation” (John Wiley).

For the rest of 2017, he looks for flat GDP growth, of about 2%, because President Donald Trump’s promised fiscal stimulus, once in place, has little chance of becoming effective for another two to three years thereafter, he says.

Shilling, 80, president of A. Gary Shilling & Co., an economic consultancy and investment advisory firm, is famed for forecasting market bubbles and pinpointing when they’ll burst. Among other events, he forecast the 1960 and 1991 recessions; the end of a long stretch of severe 1970s inflation; and in 2003, that the Federal Reserve would cut short-term interest rates the following year.

He started out as a physicist, then switched careers to financial services, working at the Federal Reserve Bank of San Francisco and Bank of America. He was Merrill Lynch’s first chief economist and later, senior vice president-chief economist of White Weld & Co. Thirty-nine years ago, he launched his own firm.

ThinkAdvisor recently interviewed the Bloomberg View columnist, on the phone from his office in Short Hills, New Jersey. Shilling declared the Fed to be “completely clueless”; discussed the future of passive investing and robo-advisors; and opined that Trump is “impeding his ability to get much done in Washington.” Here are excerpts from our conversation:

THINKADVISOR: What’s the biggest threat to the stock market this year?

GARY SHILLING: Overconfidence and complacency. The VIX [Index] has just hit an all-time low. But [people are], “What, me worry?” Another thing is that a very limited list of stocks has accounted for a lot of the advance. It reminds me of the “Nifty Fifty” of the early 70s: You only buy; you never sell. It got to the point that the only thing people wanted to buy was amusement parks, motor homes and cameras. That was entertainment, not the guts of the economy.

How does this relate to what’s happening now?

Social media is entertainment, at best. It doesn’t have a lot to do with what I consider the basic economy. It shows you that people aren’t interested in the fundamental assets of things.

You’ve spotted bubbles and predicted their death. Do you see a bubble in the market today?

I don’t see any huge ones right now. The exuberance in stocks is overdone, but it isn’t anything like the dot-com nonsense of the late 90s or the subprime mortgage exuberance in the mid-2000s. Maybe it will get there, but it’s not quite yet at that level.

I suppose there’s also the possibility of a geopolitical event to jolt the market.

That’s true. We might have a shock out there. If we get another big decrease in oil prices, that could constitute a shock, or if something financial blows up in China, or if there’s all-out war in the Middle East.

What does history say about recoveries?

In modern history, economic expansion ends when the Fed, worrying about an overheated economy, jacks up interest rates or when there’s a shock, which is what happened at the end of the 1990s: the collapse of the dot-com stocks and then the debacle in subprime mortgages.

What’s your outlook for the bond market?

Despite the Fed’s raising rates and now their talk about selling off their portfolio, bonds have done beautifully. They’ve actually rallied. One reason is the economy isn’t that strong. Secondly, deflation is more likely than inflation. There are some tremendous deflationary forces. Goods are in deflation, and so are [some services], like financial services.

What else is in play related to bonds?

Look at what online retailing is doing to brick-and-mortar stores. The third thing is the safe haven of the dollar, one of the few in a sea of global trouble. The final reason is U.S. Treasury yields: as low as they are, they’re still much higher than in most other developed countries.

You mentioned the possibility of the Fed’s selling the Treasuries and mortgage-backed securities it bought. Would that cause a recession?

[Selling those] is a very difficult maneuver. We’ve never had quantitative easing in the history of the Fed or any other central bank before. The Fed has had over a century’s experience trying to regulate the economy with interest rates, and they’ve failed miserably at affecting soft landings. By my reckoning, in the post-World War II period, they’ve tried 12 times to mitigate what they saw as an overheating economy without precipitating a recession.

And what happened?

In 11 of the 12 times, they failed and got a recession. The only soft landing was in the mid-90s. Trying to unwind quantitative easing, with which they’ve had no experience, and given their track record with interest rates, what are the odds that they’ll be able to reduce that portfolio substantially without upsetting the financial apple cart? I’d say they’re very, very small.

What do you predict for GDP growth this year?

In 2010, I forecast 2% real GDP growth until all the deleveraging and effects of globalization have been worked off. So far in this recovery, which started in the middle of ‘09, growth has been [at] 2.1%. I think that will continue until we get this massive fiscal stimulus in place. But it will probably be two or three years down the road before it really becomes effective.

That’s quite a while. People had been dissatisfied with the rate of recovery for a long time.

Yes. I don’t think the Fed realizes the kind of environment we’re in. They think we’re in a typical postwar cycle, so they’re worrying about inflation and overheating the economy. Well, inflation is receding. Economic growth is low, if not declining. Interest rates are declining.

So you’re saying the Fed isn’t facing the reality of the situation?

I think these guys are way off the mark in terms of what’s going on. They keep wondering why the economy doesn’t pick up growth and why inflation doesn’t pick up. I think they’re completely clueless.

What’s the main thing indicating we’re not in a typical postwar cycle?

We’re in this huge deleveraging, still working off a lot of the excesses built up in the ’80s and ’90s and the mid-2000s that culminated in the big subprime housing bubble and collapse.

The Fed seems to be giving mixed signals. First it said it would increase interest rates rather aggressively, but now that doesn’t seem to be the plan. Doesn’t that confuse investors?

Yes. The Fed’s credibility is very low. In fact, I think the only reason they finally raised interest rates in December 2015 was because they wanted to save face. They were becoming a laughing stock.

President Trump hasn’t been able to deliver on his campaign promises. Are you surprised?

Last December, I said that the huge fiscal stimulus — deregulation, tax cuts, replacement for Obamacare — wasn’t going to happen instantly. It takes lot of time to get [things] through Congress; and even though it has a majority of Republicans, Trump doesn’t have Congress in his pocket. I think he’s making things more difficult.

Will his base continue to be loyal to him while waiting for the stimulus?

They’re going to be loyal to the voters. It’s only the top tier that’s had any gains in over a decade, and [other] people’s attitude was “I’m mad as hell, and I’m not gonna take it anymore!” There’s been a decline in purchasing power for most.