Expert Commentary

Deflation Is More Than Just "Lower Prices"

Editor's Note: Elliott Wave International is the world's largest independent market-forecasting firm. Its monthly Financial Forecast Service has been serving subscribers with monthly big-picture updates since 1998 under the editorial guidance from Steven Hochberg, Peter Kendall and EWI's long-time president Robert Prechter. The Service has been a leading authority on deflation since inception. In addition, Robert Prechter's Conquer the Crash, now in 2020 edition, is widely recognized as the definitive guide for surviving a deflationary depression.

Here is an excerpt from the May Elliott Wave Financial Forecast:

Economy & Deflation

A deflationary crash is characterized in part by a persistent, sustained, deep, general decline in people's desire and ability to lend and borrow. A depression is characterized in part by a persistent, sustained, deep, general decline in production. Since a decline in credit reduces new investment in economic activity, deflation supports depression. Since a decline in production reduces debtors' means to repay and service debt, a depression supports deflation. Because both credit and production support prices for financial assets, their prices fall in a deflationary depression. As asset prices fall, people lose wealth, which reduces their ability to offer credit, service debt and support production.

--Conquer the Crash 2020

The key phrase with respect to the start of the deflationary spiral described in CTC is "as asset prices fall." That's why the February EWFF highlighted clear signals in "the behavior of many commodities. Deflationary pressures abound. Our stance remains the same: U.S. economic measures will hold up until the stock market starts a bear market. When stocks decline, the economy will follow." Three months later, further evidence abounds of the "decline in production" described in CTC. According to the Federal Reserve, manufacturing output dropped 6.3% last month, led by plunging production. Overall, industrial production, which includes that from factories, utilities and mines, plummeted 5.4%. The declines were the biggest since 1946. According to The New York Times, the drop was "far worse than what economists had expected." First quarter GDP fell 4.6%, but the bite will be far larger in the second quarter. Current estimates range from a decline of 25% to 40%. As we said last month, the U.S. is already in recession. A March retail-sales decline of 8.7% shows that the engine of the U.S. economy, the consumer, is sputtering. All the deflationary drivers are in place: falling asset prices, slackening production, and a credit market contraction that has already claimed its first financial institution. A West Virginia bank failed in early April. The Bond Market section describes the outset of a new age of carnage for the credit markets. Even though many of them lived through a condensed version of this process in 2007-2009, economists and market professionals almost universally reject CTC's recipe for deflation. Here's a representative headline from April 16:

Deflation Angst Seen Overblown
By Funds Betting On Price Gains

"Unlike in 2008, when we had a banking crisis, this is more like a natural disaster," explained one inflationist. "Demand, in an otherwise healthy economy, can recover faster." A Los Angeles Times analysis concurs, arguing that the "conditions underlying the current slowdown are plainly unique. The conditions leading to the Depression developed over a longer period of time--by some reckonings, a decade or more--and reflected structural flaws in the global economy that had gone undetected in the years following the World War I armistice." The Times argues that in the 1930s, the Fed "had only rudimentary tools of monetary policy. The Fed's attempts to quash stock market speculation via moral suasion prior to the 1929 crash were regularly flouted." In our view, those "structural flaws" of old are actually far more pronounced today. The Fed's interventionist stance is a perfect example. The Fed was formed more than a century ago, and by the beginning of the Great Topping Process, it had almost totally abandoned efforts to rein in speculative excesses. If anything, the Fed's unprecedented willingness to buy up companies' junk-rated debt shows that it will try virtually anything to revive the animal spirits of the old uptrend. This policy is heartening to junk bond issuers and speculators, but it is also evidence that the Great Bailout will fail. The Fed's viability is subject to the whims of social mood. Only at the end of a long advance would government chart such a course. The deflationary dynamic described in CTC will play havoc with these efforts.

For guidance to its full onset, we will stick with our market orientation, which EWFF described this way in January 2018: "For viable information about the economy's future potential, we prefer to look to the markets themselves. The oil market can be particularly insightful." The April 2020 issue showed that oil prices had crashed 68% over the course of the first quarter of the year, consistent with EWFF's forecast, and concluded, "Deflation data should line up fast with the new economic reality." Since then, oil futures contract prices declined another 100%, to zero, and then went to negative $40.32 on April 20. The implications are not hard to grasp. A New York Times columnist contemplated the asset price deflation. He concluded that negative oil futures prices point "to a deflationary collapse--a glut of supply of goods and services, and consequently falling prices--that surpasses anything seen in most people's lifetimes." As the headline above and the chart at the top of this issue suggest, however, most investors are oblivious to any such threat.

It's not just oil. EWFF discussed many other deteriorating financial and economic sectors over the course of 2019. The job market is another contributor to the deflationary outlook. EWFF identified the potential for a major reversal months ago. In May 2019, when The Economist published a cover story that touted the "The Great Jobs Boom," EWFF showed in our July issue a steady long-term deterioration in the rate of job growth and labeled the chart "Job Bust Ahead." We wrote, "As the reversal grabs hold, jobs that seemed safe will suddenly become vulnerable." This is the new reality, as more than 30 million workers have filed for unemployment insurance in the six weeks that ended last week. The peak unemployment total during the Great Recession was 15.3 million. In its May 2019 issue, The Economist also noted that "wages are at last accelerating." After years of trailing wage growth (see October 2018 issue, chart p.9), the July 2019 EWFF observed that employers were, in fact, offering greater wage concessions, but we surmised that it was "more likely a prototypical capitulation at the end of a long trend." According to the Atlanta Fed's U.S. wage growth tracker, wage growth peaked at 3.9% in July 2019 and fell to 3.5% in March 2020. With the labor pool swelling, wages will continue to fall.

Sales of the second biggest item in the budget of most consumers--automobiles--won't be far behind. In December, when the economy was still expanding, EWFF noted that U.S. auto sales had quietly slipped lower some time ago. In fact, the U.S. monthly sales peak came more than five years ago, in August 2015, at 18.44 million units sold. The December 2019 issue (see chart, p.9) showed that global demand fell off even more dramatically. We think that decline will continue. According to Statista Research, global light vehicle sales will likely fall 23% in 2020. As EWFF stated in December, "'peak car' is now positioned squarely in the rearview mirror." Despite the reversal, the bull market continued to express itself in the extreme size of some of the latest models. Just after the S&P's final high, USA Today on March 5 reported that some new SUVs and pickups got "so large that they're struggling to fit into garages and public parking spaces." Elliott Wave International has long observed that the biggest car models accompany the biggest stock market peaks.

200508 - GE

The real estate market is another economic mainstay that EWFF observed teetering over the course of 2019. Several bellwether markets topped a long time ago. In London and New York City, for instance, home prices peaked in 2017. But the reputed strength of the overall housing market continues to inspire confidence. The larger U.K. market, for instance, rose through December 2019, causing a British economist to call the recent market freeze "a shutdown not a crash. Recent events mean the property market is being put into an induced coma. That is likely to lead to a record drop in property transactions--not prices." We'll take the same position we held in early 2006 when home sales slipped. As we predicted, a few months later home prices followed sales into the steepest decline in more than 50 years. The top graph on the chart shows the median price paid for houses sold in the U.S. It sports the same five-wave form shown for new home prices in the December issue. Median home prices peaked at $337,900 in the fourth quarter of 2017. In the first quarter of 2020, the median price was $327,100, just as it was at the end of 2019. So, the quarterly data capture "the price freeze" nicely. In addition to the terminal five-wave form of the rise, a key to the forecast is seen on the bottom graph. It shows the dramatic divergence in home sales, which retraced just 45% of the 2005-2010 decline. The 19.3% sales decline from January to March this year should be regarded as the kickoff of the next real estate debacle.

The initial credit spasm described above will play a key role. Because most property purchases require borrowed money to complete the transaction, real estate prices are heavily dependent on expanding credit. This is one reason CTC called for an across-the-board decline in real estate values.

A major stock market decline is enough by itself to portend a tumble in real estate prices. Usually the culprit behind these joint declines is a credit deflation. If there were ever a time we were poised for such a decline, it is now.

To update: If there were ever a time we were in such a decline, it is now.