Recession Could Be Closer Than Most Realize

The conventional definition of gross domestic product, GDP, has four main parts. These are consumption, investment, government spending, and net exports.

This definition is usually expressed in equation form as GDP = C + I + G + (X – M). But, these parts do not affect the economy equally. Consumption is far and away the most important component.

Consumption is almost 70% of the total economy.

In the most recent quarterly report from the Commerce Department, total annualized GDP was $19 trillion and consumption was $13 trillion, or 68%. The impact of consumption does not stop there.

If consumption slows down, investment may slow down. Businesses will not invest in buildings and heavy equipment unless the customers are there to purchase the output needed to justify those investments in the first place.

Simply put: when the consumer catches a cold, the entire economy can get pneumonia.

Something like that appears to be happening. Retail sales are down sharply due to a combination of weak wage growth, income inequality (“average” gains have been heavily skewed to the wealthy, leaving most Americans worse off), and deflationary expectations.

Meanwhile, consumer confidence has fallen to the lowest level since November, and consumer spending fell in May. Inflation was also lower in May.

On top of this, the Fed is creating headwinds with rate hikes and by reducing the money supply through its new program of quantitative tightening, or QT. With stock market indices hitting new all-time highs almost daily, and the economy hitting stall speed, a severe stock market correction is in the cards.

How did we get here?

In the past seven years, major central banks have created over $15 trillion of new money, mostly through purchases of government bonds.

These money printing and bond purchase programs have been called QE1, QE2 and QE3 in the U.S., Euro-QE in Europe and QQE (quantitative and qualitative easing) in Japan.

All of these programs and exotic variations such as “Operation Twist” have failed to achieve self-sustaining growth anywhere near former trends, and have failed to achieve the 2% inflation targets of those central banks.

We have not had much consumer price inflation, but we have had huge asset price inflation. The printed money has to go somewhere. Instead of chasing goods, investors have been chasing yield.

But the stock market and the bond market are sending two different messages today.

The Dow is trading above 21,500 for the first time ever. And the S&P broke out to new highs less than three days after last Wednesday’s rate hike. Meanwhile, the Nasdaq continues its record run. Stocks seem to break records every other day.

If the Fed’s hiking rates to to take some steam out of the bull, it’s not working.

But the bond market is telling a different story. The 10-year Treasury bond yield has fallen from 2.4% in mid-May to 2.16% today. Falling yields suggest weakening growth or possibly recession ahead, the opposite of what the stock market is saying.

If bond yields are falling because deflation is ruining the Fed’s plans to reflate the economy, is that a reason for stocks to go up? If bond yields are signaling recession, should you really be bidding up stock prices to extreme levels based on a theory of yield “parity?”

This behavior defies common sense and economic history, but it’s exactly what we’re seeing in the markets today.

At some point, probably sooner than later, the reality of central bank impotence and looming recession will sink in and stock valuations will collapse. The drop will be violent, perhaps 30% or more in a few months.

You don’t want to be over-allocated to stocks when that happens.

This analysis applies to more than just stocks. It applies to a long list of risky assets including residential real estate, commercial real estate, emerging markets securities, junk bonds and more.

It only takes a crash in one market to spread contagion to all of the others.

The inability of central banks to deal with crisis and the complete loss of confidence by investors in the efficacy of central bank policy.

The last two global liquidity panics were 1998 (caused by emerging markets currencies, Russia, and Long-Term Capital Management) and 2008 (caused by sub-prime mortgages, Lehman Brothers and AIG).

Another smaller liquidity panic arose in 2010 due to problems in Middle Eastern and European sovereign debt (caused by Dubai, Greece, Cyprus and the European periphery). In all three cases, central bank money printing combined with government and IMF bail-outs were enough to restore calm.

But these bailouts came at a high cost. Central banks have little room to cut rates or print money in a future crisis, even with the Fed’s recent hikes. That’s why the Fed is so determined to raise rates, so it can cut them again when it needs to. Of course by raising rates into a weakening economy, the Fed could be creating the very crisis it’s trying to avoid. The strategy might sound nuts, but that’s how they think.

Meanwhile, taxpayers are in full revolt against more bailouts. And governments around the world are experiencing political polarization. There is simply no will and no ability to deal with the next panic or recession when it hits.

With central banks around the world doing everything possible to cause inflation (QE, ZIRP, NIRP, helicopter money, currency wars, forward guidance, etc.), what does it say about confidence in central banks that inflation expectations are falling, not rising?

The systemic dangers are clear. The world is moving toward a sovereign debt crisis because of too much debt and not enough growth. Declining productivity is the last nail in the coffin in terms of countries’ ability to deal with the debt.

Inflation would help diminish the real value of the debt, but central banks have proved impotent at generating inflation. Now central banks face the prospect of recession and more deflation with few policy options to fight it.

Persistent low rates have not caused inflation, but they have caused asset bubbles, which threaten to pop and unleash a financial panic on their own — independent of tight financial conditions.

When this new panic hits (either from a liquidity shortage or bursting asset bubbles), investors will have no confidence in the ability of central banks to limit the panic. Unlike 1998 and 2008, the next panic will be unstoppable without extreme measures — including IMF money printing, lock-downs of banks and money market funds, and possible martial law in response to money riots.

You should have gold and other hard assets to weather this storm.

One sign that investors sense a coming crisis is that demand for secure vaulting space in major financial centers like London and Frankfurt is soaring. There are plenty of bank safe deposit boxes in those cities, but investors are insisting on non-bank vaults because they understand that the banks cannot be trusted in a panic.

As a result, proprietors of non-bank vaults can’t build them fast enough.

This is one indicator that reveals three important facts. The first is that investors feel a panic may be near and the time to act is now. The second is that investors don’t trust banks. And the third is that investors are buying gold to protect themselves since that’s the main tangible that people put in their private vaults.

Don’t wait until the panic hits to secure your gold and make arrangements for safe storage. The time to act is now.

You should never go “all in” on any one asset class including gold, which is why I recommend putting only 10% of your investable assets in gold.

But you want to own gold now, before the next crisis strikes. It could be here much faster than you think.

Regards,

Jim Rickards
for The Daily Reckoning