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Recession & Deflation On The Horizon? A Look
At The Economy, Interest Rates, Stocks & Oil

By Gary D. Halbert
July 12, 2005


1.  Is The U.S. Economy Faltering?

2.  The Interest Rate “Conundrum”

3.  The Global Glut Of Savings

4.  Inflation, Deflation & The Fed

5.  A Buying Opportunity In Stocks

Is The U.S. Economy Faltering?

If you listen to the media, you would think that the US economy is falling into a slump.  However, the latest data suggest otherwise. On June 29, the Commerce Department raised its estimate of 1Q Gross Domestic Product from an annual rate of 3.1% to 3.8%, well above expectations.  The government reported that personal spending and exports were above previous estimates in the 1Q as well, plus inventories rose more than expected. 

Personal consumption spending, which accounts for over two-thirds of GDP, rose at an annual rate of 3.6% in the 1Q - again, well above economists’ expectations.  We are told that consumers are in a funk, largely because of the war in Iraq, but guess what – the Consumer Confidence Index jumped to a three-year high in May (latest data available).

The unemployment rate has declined steadily this year.  The latest data for June shows that the national unemployment rate fell to 5.0% last month, down from 5.1% in May and 5.2% in April.  While the number of new jobs created (146,000 in June) is still lagging, the trend is improving and the overall unemployment rate has not fallen to 5% in almost four years.

The Institute for Supply Management’s (ISM) manufacturing index rose to 53.8% in June, marking the 25th consecutive monthly increase.  Any reading in the ISM Index above 50 represents a growing manufacturing economy.  US manufacturers have increased spending on new plants and equipment to the highest rate since 2001 according to the latest Census Bureau report released earlier this month.

The housing boom also continues.  Single-family housing starts jumped another 4.7% in May (latest data available), at an annual rate of 1.7 million new homes to be built.  There was a significant drop in housing starts in March, which made many commentators suggest that the bubble was bursting, but housing starts increased 11% in April/May. 

I think we can all agree that the housing market is increasingly becoming a speculative bubble, but this bubble could well last another year or two.  Remember when we all thought the high-tech stocks were in a bubble in late 1998 when the Nasdaq Index hit 2000?  It went on to top 5,000 in the next two years.  Bubbles tend to go farther and last longer than conventional wisdom would suggest.  The housing boom may be yet another example.

All of the analysis above looks very positive, but there are also some negatives.  Most notably, the Index of Leading Economic Indicators has fallen over the last six consecutive months.  The LEI has fallen 2.2% over that period.  This suggests that GDP will not match the 1Q’s 3.8% annual rate in the 2Q and the 3Q.  Based on the reports cited above, however, I expect the LEI to turn higher for July.

In summary, the US economy remains on sound footing.  GDP growth should be above 3% for all of 2005, even if GDP growth slows somewhat in the 2Q and 3Q.  Most analysts I respect believe that 2006 will also be a positive year for the US economy.  Longer-term, there is a recession in our future, and I fear that it will be a very serious one.  The only question is when.

The Interest Rate “Conundrum”

Perhaps the largest market miscalculation in recent years has been the sharp drop in long-term interest rates at a time when 1) the economy has recovered strongly, and 2) the Fed has been raising short-term rates.  Other than the deflationists and some in the gloom-and-doom crowd, very few analysts predicted that long-term rates would fall as they have.

As of July 7, the yield on the 30-year Treasury bond had slipped to 4.32%; the 10-year T-Note was down to 4.07%; and the 1-month Treasury bill was at 2.96%.  The national average 30-year fixed mortgage rate (80% of value) is hovering just above 5.5%. 

These low rates defy conventional analysis.  In testimony before the congressional Joint Economic Committee earlier this year, Fed chairman Alan Greenspan described it as a “conundrum.”  He admitted that he is at a loss to explain how long-term rates have fallen so far in the midst of a strong economy and the Fed raising rates aggressively on the short end.

The Fed raised short-term rates by another quarter-point at the end of June, for the ninth consecutive time.  The official Fed Funds rate now stands at 3.25%, and the Fed language after the June increase remained the same – that they will continue to raise short rates at a “measured pace.”

So why have long rates dropped so much, contrary to their long history of rising when the economy rebounds?  Quite simply, because 1) there is global glut of excess savings and huge oil profits that continue to buy US Treasuries and other fixed-income securities, and 2) inflation is not rising as it historically has when the economy rebounds.  These two factors are the main reasons why long rates have moved lower than just about anyone predicted.

The Global Glut Of Savings

Falling long-term rates are not simply a US phenomenon.  Long rates are falling in almost all of the major economies around the world.  The fact that long rates are falling significantly in most parts of the world is a sign that there is a large excess of savings around the world. 

The Asian economies have recovered along with the US economy, and the Asians continue to be a high savings society.  They receive US dollars for the imports we buy from them, and they in turn pour much of that money right back into the Treasury markets.

Every oil producing country in the world is experiencing a windfall of profits with oil soaring above $60 per barrel.  Oil is bought and sold in US dollars.  Not surprisingly, much of that windfall is buying Treasury securities, thus driving rates even lower.

Since we are running the largest budget deficits in history, the US government has been the beneficiary of this global glut of savings, in that interest rates have plunged and we are now paying much less to finance the national debt. 

The masses of foreign buyers of Treasury debt know this is not a good thing, that it can’t continue forever, and that the party will come to an ugly end at some point.  But for now, the lines are long (so to speak), and the world’s savers continue to lend to the world’s biggest borrower, Uncle Sam.    

Inflation, Deflation & The Fed

How could anyone say that inflation is not a problem with oil prices soaring above $60 per barrel?  Yet even with the explosion of energy prices, the Consumer Price Index has only risen to the 2.8% level over the last year according to the Labor Department.  If we look at the “core rate” of inflation (excluding food and energy), we find that consumer prices are increasing at an annual rate of only 1.6%. 

It is the core rate of inflation that the Fed focuses on, not the CPI.  At a rate of only 1.6%, the Fed is actually quite comfortable that inflation is under control – even though they don’t say so.  If this is true, then the logical question is, why does the Fed continue to ratchet up short-term rates? 

The reason is that the Fed is “reloading” out of fear of deflation.   The Fed realizes that the next recession in the US could present a very serious financial dilemma.  With America running huge budget and trade deficits, and with the decline in the US dollar over the last couple of years, the next recession is likely to be a severe one.  If the US goes into a recession, most of the rest of the world will follow.  The long lines of foreigners who are soaking up record amounts of US debt today could largely disappear – and very quickly - if the US goes into a recession.   Or should I say when the US goes into a recession.

The Fed wants to raise short rates as much as it can so as to have more ammunition to fight the next recession whenever it unfolds.  This explains why they continue to raise rates even though the core inflation rate has stabilized at around 1½%.      

There is a very real possibility that we could be facing a deflationary environment whenever the next recession unfolds.  No doubt, the policymakers at the Fed know this, and they also know that with the Fed Funds rate at 3¼%, they don’t have a lot of room to slash short rates to fight a recession and a deflationary trend.

How High Is High Enough?

For the last couple of months, I have been suggesting that the Fed might stop hiking short rates after the August FOMC meeting when they will almost certainly raise the Fed Funds rate to 3½%.  More and more analysts have come to agree with that outlook.  But are we just hoping?

At the latest FOMC meeting in late June, the Fed governors reportedly voted unanimously to increase the rate by another 25 basis-points to 3¼%.  As noted above, they also voted to maintain the policy language indicating more increases at a “measured pace.”  If the Fed is seriously worried about deflation, they may not stop at 3½%.  Only time will tell.

A Buying Opportunity In Stocks?

Stocks remain in the trading range we’ve seen for the last year and a half.   On the downside, stocks are supported by low bond yields, the firm economy and increasing earnings expectations.  On the upside, stocks are constrained by rising short rates, soaring oil prices and general investor apathy toward equities.

Over the past couple of months, I have made the case that there will be a buying opportunity in stocks sometime this summer, and that equity prices in general will break out of the current trading range to the upside.  Actually, stocks have held up quite well given the Fed’s rate hikes and oil soaring over $60 a barrel.

If either of these two negatives were to dissipate, or even go on hold in the case of the Fed, I believe there is a very good chance that stocks will breakout to the upside.  

I do not expect equity prices to explode upward should we break out of the current trading range, but I do believe it will be a move worth participating in – assuming you don’t wait until after the breakout is confirmed to move to a fully-invested position (which is exactly what many investors will do, unfortunately).

I still believe the most likely scenario is that the Fed will end its rate hiking cycle, or at least go on hold, at the August 9 FOMC meeting.  But as discussed above, there is a chance that the Fed will not decide in August to end (or put on hold) its rate hiking cycle.  If the Fed sticks with its “measured pace” language in August, this will be bad news for stocks, which should send the major market indices back to the low end of the trading range.

My advice is that if stocks move back to the low end of the range anytime this summer, you should be adding to your holdings.

Obviously, my advice is that you participate in the stock market under the direction of one of the Investment Advisors I recommendIn the latest issue of The Bank Credit Analyst, the editors continue to recommend active management strategies:

“…investors will be living in a world of moderate financial asset returns, and the key to good performance will depend more than ever on successful market timing and stock and sector selection. On that basis, it will be appropriate to use periods of equity weakness to build positions given our view that the monetary tightening cycle is moving into its final stages.”  [Emphasis added, GH]

It may interest you to know that most of the equity managers I recommend have already begun to rebuild long positions in the various mutual funds in which they invest.  Given my market outlook noted above, I believe that NOW is an excellent time to open accounts with any of the Investment Advisors I recommend that invest in equity funds.

What’s Ahead For Oil Prices?

As this is written, crude oil prices have slipped slightly below $60 per barrel after peaking at $63 last week.  Who would have thought that we would be wishing for $50 oil!?  The oil market is clearly in a speculative frenzy at the moment, and no one knows for sure where prices should really be.  I think we can agree, however, that the market is overbought at levels above $60 per barrel.

There is an old saying in the commodities markets: “The solution to high prices is, high prices.”  At first glance, this saying seems to make no sense.  However, the higher prices go, the more demand is reduced and supply is increased.  Also, the longer that prices remain high, the greater supply will increase.

Now, in the current case, there are some compelling arguments for high oil prices: 1) the supply of crude oil cannot be increased significantly overnight; 2) China’s demand for oil will very likely increase even if prices remain high; and 3) even if oil supplies do increase, there is not enough refining capacity around the world.  These are unusually bullish factors.

Nonetheless, oil is still a commodity, and what goes up eventually comes down.  The commodities markets have a long history of topping out just when things look the most bullish (and everyone has bought in).  Likewise, commodities tend to bottom out just when things look the most bearish.

Along this same line, it is very common for there to be sharp downward “corrections” even in powerful bull markets.  In the case of oil, I would not be surprised to see a $15-$20 selloff at any time, especially given the magnitude of the latest run-up above $60.

I do not pretend to know where oil prices will top out, but they will top out at some point, and almost certainly a nasty selloff will follow. 

I mention this only in order to tie back into my advice on the stock markets.   If oil prices top out this summer, and a significant selloff occurs, this should be very bullish for stocks.


The US economy remains on sound footing, even though GDP growth is not likely to match the 1Q pace of 3.8% in the 2Q and 3Q, but growth should be 3% or above for the year overall.  There is a good chance that at least the first half (and maybe all) of 2006 will also see solid economic growth.

As for the interest rate “conundrum,” there is no conundrum .  There is a glut of global savings that is soaking up US Treasury debt and inflation is low, thus driving long-term rates lower and lower both in the US and abroad.  The greater threat in our future is deflation, not inflation.

The Fed continues to hike short-term rates, not because it fears inflation, but because it fears that deflation could take hold in the next recession.  They are in a balancing act – on the one hand, they don’t want to choke off economic growth; on the other hand, they want to raise short-term rates (reloading) so as to have more room to cut rates when the next recession unfolds.

If the Fed stops raising rates later this year, or if there is a meaningful drop in oil prices – or both – this should be very positive for stocks.   I continue to believe that stocks have a good chance to breakout into a higher range sometime this summer or early fall.  As a result, I believe investors should be adding to equity positions on weakness just ahead.

As always, I recommend that you use professional money managers who use “active management” strategies for a significant part of your equity portfolio.  If you agree that the next recession will be a severe one, including a deflationary threat, then you want to have plenty of exposure to active management strategies that will exit the market if conditions warrant, and/or that can “hedge” long equity positions in the event of a severe market downturn.

If you have been reading this E-Letter for some time, but you’ve been procrastinating about hiring the active money managers I recommend, I suggest you get off the dime and get started this summer.  Unless you are happily retired with plenty of money, you need to participate in the next upward move in the stock market.  But you also need professional systems that will get you out (or hedged) when the next recession rolls in.

Call us at 800-348-3601 and we’ll help you get started.

Very best regards,

Gary D. Halbert


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Forecasts & Trends E-Letter is published by Halbert Wealth Management, Inc. Gary D. Halbert is the president and CEO of Halbert Wealth Management, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, Halbert Wealth Management, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.

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