Home Deflation Warning – The Next Wave

Deflation Warning – The Next Wave

user profile picture Chris Martenson Oct 01, 2015
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The signs of deflation are now flashing all over the globe and we think that the possibility of an associated financial crisis is now quite high over the next few months.

As we’ve been saying for a while, our preferred model for how things are going to unfold follows the Ka-Poom! Theory as put out by Erik Janszen of

That theory states that this epic debt bubble will begin its fate with destiny by first deflation (Ka!), or imploding, before exploding (Poom!) due to additional massive printing efforts by scared central bankers.

First an inwards collapse then an outwards explosion. Ka-Poom!

We’ve been tracking the deflationary impulse for a while, and declared deflation the winner back in July of this year.

A Failed Strategy

First, what do we mean by deflation?  Back in 2008 the central banks of the developed world, as well as China, had a choice; admit that prior policies geared towards encouraging borrowing at a faster rate than income growth were a very bad idea, or double down and push those failed policies harder.

As we all know, they chose option #2, and here we are just 8 years later with nearly $60 trillion in new debt piled on top of the prior mountain while GDP grew just $12 trillion over the same period of time.

[img] Global GDP 9-29-2015 2-50-42 PM


[Note:  Global nominal GDP is projected to be $68.6 trillion in 2015, virtually unchanged from 2013]

In other words, instead of saying to ourselves, hey it was probably a very bad idea to pile up debt at 2x the rate of income growth, what the world did was to double down and pile on debt at 5x the rate of nominal GDP growth.

Lessons not learned, and all of that.

At any rate, what all of that money printing and new debt creation did was force money out all over the globe looking for something to do.  Absent any really good and creative ideas, that money chased yield.  It piled into risk assets like stocks and junk bonds, often in bubble-like fashion meaning in haste, and without proper due diligence.

The only way the central bank “strategy,” and we use that word very loosely, could have worked was if very rapid growth emerged to justify the accumulated levels of debt, comprised of both old and new borrowing.

But that growth, quite predictably (as forecast by yours truly among many others), did not emerge and perhaps Japan’s experience should have tipped us off.  Too much debt is the malady, not the cure.

Well, so here we are.  What are we to make of it all?  It is our view that the financial markets are an important place to keep one’s attention centered on because they will signal to us when sentiments have shifted and when the story is about to begin a new chapter.

We think that has happened and that this next ‘correction’ could be pretty rough for a lot of folks.

Bright Red Warning Lights

The global economy is just not doing all that great right now, and there are lots of flashing red warning lights indicating as much.

Doug Noland captured the emerging market pain caused by hot money that is now flooding out of those territories, as well as provided a great explanation of bubble dynamics:

The Federal Reserve is flailing and global currency markets are in disarray. Notably, the Brazilian real dropped more than 10% in five sessions, before Thursday’s sharp recovery reversed much of the week’s loss. This week the Colombian peso dropped 3.0%, and the Chilean peso fell 3.1%. The Mexican peso dropped 1.9%.

The Malaysian ringgit sank 4.5% for the week, with the South Korean won down 2.7% and the Indonesia rupiah losing 2.2%. The Singapore dollar fell 1.8%. The South African rand sank 4.4% and the Turkish lira fell 1.4%.

Notably, market dislocation was not limited to EM. The Norwegian krone was hit for 4.4%, and the Swedish krona lost 2.0%. The British pound declined 2.3%. The Australian dollar also lost 2.3%.

The global Bubble is bursting – hence financial conditions are tightening. Bubbles never provide a convenient time to tighten monetary policy. Best practices would require central bankers to tighten early before Bubble Dynamics take firm hold. Central bankers instead nurture and accommodate Bubble excess. It ensures a policy dead end.

As the unfolding EM crisis gathered further momentum this week, the transmission mechanism to the U.S. has begun to clearly show itself. While “full retreat” may be a little too strong at this point, the global leveraged speculating community is backpedaling. Biotech stocks suffered double-digit losses this week, as a significant Bubble deflates in earnest. It’s also worth noting that the broader market underperformed.


What does it mean when we see currencies across the globe in retreat?  It means that the hot, speculator money is rushing out and back towards the center.  This is consistent with a liquidity crisis, one where all the borrowed money used to spark all those heady asset gains and falling yields on the way out do the exact opposite on the way back.

And Doug is exactly right – there’s never a good time to pop a bubble.  So the Fed just sits, paralyzed, afraid to even raise rates by a token amount for fear that the bubble will burst as a result. They needn’t fear; the bubbles will burst no matter what the Fed does.

A credit default swap (CDS) is a bit of insurance you can buy if you own a bond and are worried that the issuer may default on that bond.  In a stable climate, the cost of that insurance (measured in percentage points above the stated yield on that debt) is pretty flat and close to the yield of the bond in question.

So you might have to pay 1% to 2% (i.e. 100 to 200 basis points) above the yield on, say a Brazilian ten year bond, to insure it against a default.  As things begin to break down and become less certain, that cost will rise. 

[img] CDS EM 9-29-2015 8-18-43 PM


Look at those CDS ‘spreads’ blowing out to the upside.  See that?  That’s the sort of thing I was tracking in 2008 that gave an early warning that things were about to fall apart.  While these levels are not flashing the same level of danger that we are seeing in the CDS paper for Glencore (which is almost certain to go bankrupt now) and for US shale drillers (tons of bankruptcies coming there too), they are flashing pretty serious warning signs.

Why would the sovereign debt of Russia, Turkey, Brazil, and Malaysia be spiking right now?  Because the hot money is flooding out and there is now an elevated risk that they may default on their bonds in the future.

These emerging market countries are being squeezed from every direction, but especially those that borrowed in dollars (or other stable currencies).  From the WSJ  (Sept 29) we see the magnitude of the predicament for companies located in EM nations:

Developing-country firms quadrupled their borrowing from around $4 trillion in 2004 to well over $18 trillion last year, with China accounting for a major share.

Now, prospects in industrializing economies are weakening fast even as the U.S. Federal Reserve is getting set to raise interest rates for the first time in nearly a decade, a move that will raise borrowing costs around the world.

The burden of 26% larger average corporate debt ratios and higher interest rates come as commodity prices plummet, a staple export for many emerging-market economies.

Compounding problems, many firms borrowed heavily in dollars. As the greenback surges against the value of local currency revenues, it makes repaying those loans increasingly difficult.


So the afflicted countries are going to see vastly weaker exports, plunging currencies, and local corporations unable to pay off dollar denominated loans.  From $4 trillion in 2004, to over $18 trillion just 11 years later.  It’s an amazing statistic, one of many fostered by a cluster of central banks that know everything about blowing bubbles but nothing about ending them.

The punchline from the above article is this: That massive debt build-up means it is “vital” for authorities to be increasingly vigilant, especially to threats to systemically important companies and the firms they have links to, including banks and other financial firms, the IMF said.”

Decoded that means that $18 trillion is a big number and if even a small portion of that goes into default it could easily drag down whole swaths of the developed world’s financial corporate structure.

Well, based on this ETF which holds bonds priced in local currencies, we can get a sense of the pain those EM companies that are holding dollar denominated loans but being paid in local currency are feeling.

[img] EM debts local currency 9-30-2015 4-04-43 PM

Ouch!  Based on the above chart, the past year has been rough for those emerging market corporations and governments. 

Not So Fast There….

One so-called ‘bright spot’ in the world economy is the US, which supposedly is doing better than anyone else.  As you know, I consider US GDP statistics to be nearly useless because of all the statistical tricks and gimmicks that are now deployed (such as now counting ‘intangibles’ to go along with Owner Occupied Rent which records the price value of people not paying themselves rent, etc.,) to make things look better than they are.

But I’m having trouble believing the US economy is doing all that well when our major trading partner to the south is struggling so much due to a drop in exports:

Mexico factory exports slump by most in over 6-1/2 years in Aug

Sept 25, 2015

(Reuters) – Mexico's factory-made exports slumped in August by the most in more than 6-1/2 years after uneven growth in the first half of 2015, data showed on Friday, while consumer imports rose.

Manufactured exports sank 7.2 percent in August compared with July, falling back after two months of gains, the national statistics agency said in a statement. It was the biggest month-on-month drop since December 2008, data showed.

Mexico exports mostly manufactured goods like cars and televisions and about three-quarters are sent to the United States.


It’s hard to imagine that the US economy is doing fine when a major trading partner who exports 75% of their finished product to the US is experiencing a deep export slump.

But it’s not just Mexico that is seeing a big decline in export activity:

For the first seven months of 2015, U.S. exports dropped 5.6% to $895.7 billion. The value of South Korean exports shrank a revised 14.9% in August from a year earlier, the sharpest fall in six years, as shipments to China dropped. Chinese imports in August fell 13.8% in dollar terms from a year earlier, after an 8.1% decrease in July.

(Source – WSJ)

If this keeps up, 2015 will see the worst global trade performance since…wait for it…2008.  For the US, 2015 will be the first year that exports have declined since the financial crisis.  Ditto for a number of other countries.

Beyond exports, the surveys of US manufacturing and service sector activity are also flashing recession warning signs.  In fact, the manufacturing survey has only been this low in the past during recessions.  Maybe this time is different?

[img] MFG ISM 9-15

[img] Reg surveys  in recession 9-30-2015 10-38-53 AM


On the plus side for the US are reasonably robust housing activity, low initial claims for unemployment, and growing income and expenditures. 

Add it all up, and there are a number of signs that not only is the US economy is far from robust, and may even be teetering on the verge of a recession, but the global economic landscape is decidedly tilted towards contraction, not expansion.

However, the big dog in this show is China, which has been the most voracious engine of commodity consumption and economic expansion for the past 8 years. 

The Chinese GDP Lie

Right off the top, China is not growing anywhere near the 7% they claim.  That’s just a politically useful lie that they tell to the world as much as they tell to themselves.

Fortunately, hardly anyone is falling for that particular fib any longer.  Let’s start with the completely obvious manufacturing slump that has hit China.

Chinese Factory Gauge Slumps to Lowest Level Since March 2009

Sept 22, 2015

A private Chinese manufacturing gauge fell to the lowest in 6 1/2 years, underscoring challenges facing the economy as its old growth engines splutter.

A global sell off in riskier assets gained pace after the preliminary Purchasing Managers’ Index from Caixin Media and Markit Economics dropped to 47.0 in September. That missed the median estimate of 47.5 in a Bloomberg survey and fell from the final reading of 47.3 in the previous month. Readings have remained below 50 since March, indicating contraction.

Premier Li Keqiang’s growth target of about 7 percent for this year is being challenged by a slowdown in manufacturing and exports even as services and consumption show resilience.


The way a PMI reading works is anything over 50 indicates expansions and anything under 50 indicates contraction.  Anybody care to explain to me how China can be sporting sub-50 readings every month since March, that’s five months, and still be claiming to be aiming for a 7% growth target?  You know, because China is first and foremost a manufacturing center?

Unless my math is shaky, is hard to achieve growth from something that is shrinking.

Along with the PMI, electricity use and railway freight volumes in China have also fallen over the past year.  Confirming those readings are the massive declines in the prices and export volumes of the commodities that a growing country would need.

Copper, coal, oil, steel, and cement are all down hard this past year.

And yet China persists in saying that it is targeting 7% growth.  More and more analysts are openly scoffing at this fiction, which is a good thing, but many have not yet come to my view which is that China is actually in contraction, not merely growing slower than 7%.

Given the enormous impact China has on world pricing for commodities, and the even more enormous increase in Chinese debt over the past eight years, I cannot imagine anything other than a hard landing for the Chinese economy. 

Their only ‘hope,’ such as it is, would be to severely devalue the yuan and try to export their way out of the mess they are in.  This way China would export falling prices to the rest of the world, which the Fed would call ‘deflation,’ and possibly buy themselves a soft landing.

The only problem with this cunning plan is that China would then be importing inflation, especially for food and fuel, two items that tend to make the poorer elements of society a bit restive and unhappy.

From The Outside In

One of the main purposes of gathering all this information is to keep track of where we are in the story.  Our view is that trouble always begins at the edges and works its way towards the center.  It goes from the outside in.

In the global story the edges are the emerging markets, the countries with weaker economies, which are usually commodity and export dependent, thin capital markets, and sometimes saddled with poor or corrupt governance.

When the trouble starts, these countries are always the first to signal it.  Given the importance of exports to emerging economies, how have those been doing of late?

[img] EM Exports 9-30-2015 4-05-52 PM


Well, truthfully EM exports are in territory they have only ever been in during recessions in the past.  So far all we can say is that they are worse than the plunge in 2001 and not as bad as in 2009 (so far).

Looked at more comprehensively, I really like this next chart which measures EM pain along three separate dimensions; the unwinding of china leverage, dollar strength and domestic credit.

[img] EM Triple Threat 9-30-2015 4-06-32 PM

No surprises there I guess; in the center we find Malaysia, Indonesia, South Africa and Brazil.  All four have been in the news a lot as they undergo painful realignments and financial capital hastily flees these countries.

The amounts have been significant:

Investors Pull About $40 Billion From Emerging Markets in Current Quarter

Sep 29, 2015

Foreign capital is gushing out of emerging markets.

Global investors are estimated to have yanked $40 billion from emerging-market stocks and bonds during the current quarter, the most for a quarter since the depths of the 2008 global financial crisis, according to the latest data from the Institute of International Finance.


Again, is it significant that we are seeing events that can only be compared to 2008?  You bet it is.  The landscape has shifted and until or unless the central banks apply a LOT more QE or try something completely different, the rot will continue to spread from the outside in.

The Commodity Rout

Every bubble is in search of a pin.  Last time it was subprime mortgages and the collapse of Lehman. 

There are so many important developments we could and should cover, but it’s really too many for one report.  So I’m going to focus on one possible ‘pin’ in this story, and that’s the collapse of commodities and several gigantic companies associated with commodities and mining.

Obviously it’s been a dire couple of years for coal companies, crushed between abundant and cheap and clean natural gas on one side, and China’s waning demand on the other.  It got so bad, that in August (2015) we were treated to this headline:  No Coal Companies Went Bankrupt Last Week

When it’s news that no coal companies went bankrupt over an entire week, it’s not a good sign.

But coal companies are small fry in the overall scheme of big business and bigger finance.  Who’s large enough to be that pin?

Glencore is one obvious candidate, it’s huge, has mining operations all over the world, and has a gigantic trading arm that has commodity trades in the tens of billions with counterparties all over the globe.

Headquartered in Switzerland, this company had a market capitalization of nearly $70 billion in 2013, but now has one of just $19.8 billion.  Worse, its enterprise value, what someone would pay for it considering its entire load of debts and whatnot, stands at -$39 billion.

[img] GLEN 9-30-2015 4-46-55 PM


That’s a harsh fall for a very large company.   And how’s the CDS paper doing for Glencore?  I’m glad you asked.  It’s positively blown out to the upside in a fashion that is nearly always a sign of imminent bankruptcy.


There are still people trading in and out of the stock for giggles, but anybody holding this stock stands a good chance of riding it to zero.  This is the Enron of our times.  Or at least this week.

The only chance this company has of being saved is if commodities stage a very quick turnaround, but for the reasons listed above regarding China, that does not seem very likely.

Nor does this chart of commodity prices look very promising:

[img] Commodity index 9-30-2015 8-20-02 PM


That’s a 4 year return of -48%, a 1 year return of -26% and a YTD return of -16%.  As I said, not very promising.

The entire mining sector is an absolute bloodbath of plummeting stock prices and mountains of debt waiting to be triggered.  Could these be the pin9s) that prick the bubble, or will it be something else?


We track all of this because seeing these signs early gives us a better chance to mentally and physically prepare for the next shock.  The press does a very good job of constantly painting everything in a rosy light, and that’s fine, but it’s not very helpful if it also misleads.

Lots of people are woefully unprepared for what’s coming next.  Heck, I doubt that more than a few of the public employees and retirees in Chicago have really accepted the fact that they are never going to receive anything more than a tiny percentage of their promised pensions. 

And that situation could not be any clearer, more direct, or easier to understand.  There’s no possible way to tax the citizens of Chicago enough to make up the shortfalls and so compromises are going to have to be made.

For many it will be a shock.  Not because they couldn’t see it coming years in advance and made their own mental and financial adjustments on their own terms, but because they wouldn’t.  Preferring to avoid an unpleasant truth they put it out of sight and out of mind, hoping that somehow things would work out in their favor.

This is the exact same dynamic that the Fed and everybody hoping the central banks can ‘fix everything’ are stuck in.  And the Chinese and Indian and Australian, and Brazilian leadership and citizens, like everyone else, are stuck there too.  It’s a form of willful denial and it is a dominant human trait found in all cultures, and at all levels of society.

And so here we are, finally seeing the cracks in 6 longs years of willful denial, hope, and futile attempts to print our way back to prosperity.  It seemed to work for a while, and had all the appearances of working – for some at any rate, not everybody – as all good printing efforts do in the beginning.

In the history of John Law and the Mississippi bubble in France in 1718-1720 it was noted that when that bubble was roaring, Paris was full of shops selling the finest tugs, furniture, carriages, and all the other trappings of extreme wealth.  Everyone was happy, delirious even.  But then it all fell apart and people became quite unhappy again.

As with any bubble, all that’s needed is a pin.  While we can only ever know in retrospect what that pin turned out to be, we do know that a good candidate will be something that breaks the illusion.  A major company default might do the trick, but a sovereign default would be an almost certain winner.

Or it could be extreme volatility simply shaking the markets apart as the money flows from China and OPEC violently reverse course shuddering and heaving everything out of their way.

Who knows?

All we know for certain is that the periphery is already suffering greatly (with more to come), and another round of QE is probably not going to do anything more than elevate western stock markets for a few weeks or months.

Which brings us to the eventuality of helicopter money.

Please build up your cash reserves, carry as little unproductive debt as you can, and assemble a list of things that you’d like to own when/if that helicopter money finally arrives.  Because when it does, it won’t be long before we are on the final Poom! Stage of this little adventure we are all on.

In the meantime, please convert as much of your financial wealth as you can into real things.  Living wealth, and social capital, emotional resilience and material capital are all examples of things that you should be building no matter what.  Hopefully keeping an eye on the “outside in” story helps to keep you focused on what’s important and motivated to continue building your personal resilience.

In closing the words of John Stuart Mill, the 19th century economist come to mind:

Panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works.

A whole lot of capital has been previously betrayed and the central banks have a big heaping of responsibility for setting the table for that particular buffet.

~ Chris Martenson


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