Gary Shilling

You could say that Gary Shilling, economist and eponymous CEO of an advisory firm, is obsessed with deflation. He’s been writing about it for over 20 years.

He correctly forecast In the early 1970s that runaway inflation was ending and in the early 2000s that a subprime mortgage bubble was growing.

Now Shilling says the slowing global economy is heading toward a period of deflation and likely recession, which will harm highly leveraged individuals and corporations, emerging market equities, commodities and multinationals.

Indeed, the Federal Reserve Bank of New York recently reported that a record 7 million Americans, many subprime borrowers, are at least 90 days late on their auto loan payments,.

“More attention should be paid to the leaps in lower quality borrowing such as subprime auto loans, peer-to-peer lending, credit card borrowing, leveraged loans, junk bonds and BBB bonds, heavily issued by energy companies and only one notch away from junk status,” writes Shilling. “The total corporate debt-to-GDP ratio has reached all-time highs and resembles the mortgage debt explosion a decade ago.”

On the flip side, those living on fixed income, homebuyers, long-term Treasuries and the U.S. dollar will benefit, according to Shilling. He says the yield on the 10-year Treasury may drop from around 2.7% to his target of 1% while the 30-year Treasury yield falls from 3% to 2%.

In his latest monthly insight report, Shilling spells out the multiple sources of deflation, most relating to long-term trends, including those below.

1. Globalization and wages. Globalization — “probably the most significant worldwide economic  development in the last three decades — continues to flood the West with cheap goods from China and other low-cost Asian lands” and it will likely continue to put downward pressure on prices “unless Trump builds a sky-high tariffs wall all around America, which we doubt.”

Globalization has “decimated” manufacturing employment and high-paid union jobs in the private sectors and is responsible for a lack of real wage growth in G-7 countries for more than a decade, leading to spreading populism around the globe, says Shilling. In the U.S., he highlights far fewer jobs in utilities, oil and gas fields, delivery services and retail — the latter due in large part to the “Amazon effect.”

Shilling notes that U.S. inflation numbers don’t register the full impact of falling prices because the Bureau of Labor Statistics has not kept up with the explosion of new technology products.

2. Slowing global economy and increasing odds of a global recession. The International Monetary Fund and World Bank have both cut earlier forecasts for GDP growth this year to 3.7% and 2.9%, respectively.

Forecasters surveyed by the European Central Bank cut their forecast for eurozone growth from 1.8% to to 1.5% this year and to 1.6% next year. The German government slashed its growth forecast for this year from 1.8% to just 1% and China’s growth, which Shilling says is “overstated by her government,” is falling, to 6.4% in the fourth quarter of 2018 and to 6.6% for the full year.

(Related: Gary Shilling Sees 66% Chance of Recession in 2019)

In the U.S., the Federal Reserve has downgraded its 2019 GDP growth forecast from 2.5% to 2.3%, noting that “near-term growth momentum is likely to be weaker than previously anticipated.” A recent Fed survey also showed that 41% of adults would have to sell something, borrow or default just to pay an unexpected $400 bill.

In addition, U.S. job openings declined to 6.89 million in November from from 7.08 million in October, even though the unemployment rate remains historically low.

3. Weaker commodity prices. Slowing global economic growth is pushing down commodity prices. Prices of copper, an “excellent indicator” of global goods production with no cartel supporting the market, continue to fall.

“With slowing global growth, supplies of commodities will be even more ample, depressing prices further,” writes Shilling.

4. Falling drug prices. U.S. pharmaceutical prices fell 0.6% in December from a year ago, which isn’t much but could reflect a growing trend. Johnson & Johnson’s CEO said the company’s average drug prices fell between 6% and 8% in 2018, and he expects the trend to continue.

In addition, Amazon could potentially enter the market, putting even more pressure on prices, and the White House has said it wants to cut prices that Medicare pays for drugs and require drug companies to include prices on the TV ads, writes Shilling. Drug costs are a big part of spending for health care, which accounts for 18% of U.S. GDP.

5. Deflating financial services costs. The trend that begin in 1975 when the New York Stock Exchange ended fixed commissions has accelerated, according to Shilling. Fees are declining throughout the financial services industry as a result of the increasing popularity of ETFs — a $3.5 trillion industry — robo-advisors, pay for performance and the poor performance of active managers, whose funds charge a lot more than passively managed funds.

As a result of all these and other indicators of what the Fed is calling “muted inflation pressures,” Shilling expects central banks to be more accommodative in the future, ending rate hikes or slowing them down.

Although the Fed may tighten further to have room to cut when the next recession comes and to curb investors’ appetite for yield, the federal fund futures markets are expecting a better than even chance that the Fed won’t raise rates this year, writes Shilling.

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