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More on Europe's "coming deflationary crash"

More on Europe's "coming deflationary crash"
November 15, 2013
More on Europe's "coming deflationary crash"

So, let's take a closer look at some of his charts and what he's telling subscribers to his European Financial Forecast report.

First of all, a bit of background. Brian is an analyst at the Elliott Wave Institute, an investment forecasting company run by the legendary Robert Prechter.

To be sure, the Elliott Wave Principle is one of the more arcane branches of technical analysis.

In a nutshell, the Wave Principle says that financial markets - and pretty much everything else in the world - are driven by crowd behaviour.

And crowd behaviour tends to play out in series of predictable patterns, or waves.

Based on its analysis of the waves, the EWI's most eye-catching prediction is an inevitable slide into deflation in the developed world.

The EWI been forecasting this for some time, and has been buoyed lately by apparent signs of deflation in continental Europe.

Brian highlights the risk from tightening credit conditions in the eurozone with the following chart:

 

 

He writes:

“…Europe’s financial system depends so heavily on debt financing that even minor dips in credit activity will generate major tremors in economic activity. Shown here, outstanding eurozone loans have merely levelled off or fallen slightly since 2007-08. Yet the economic damage in some parts of the currency bloc already borders on cataclysmic."

He cites the cases of Cyprus, where small businesses are now running on a cash-only basis, and remote areas of Spain, where there are now no banks left.

More controversially, he sees credit collapse and falling prices as likely to make their way over the channel to the UK:

"Even as most people remain widely indifferent to the prospect of sustained deflation, a telling disparity has cropped up between inflation fears in Europe versus those in the UK. The top-line on the following chart plots the difference in yield between 10-year British gilts and their inflation-protected counterparts.

 

 

Called the "breakeven rate", the spread essentially tracks bond traders' fear of future inflation as it waxes and wanes over time. By this measure, fear of inflation peaked in July 2008, just as stocks, commodities, oil and precious metals began to plunge during the 2008 financial crisis. The lower line shows an equivalent index in the eurozone. It, too, peaked ahead of the financial crisis; however, in contrast to Britain, the index keeps declining. It's part of investors' mounting acceptance of sustained economic weakness. Before the reality of outright price deflation sets in, both of these spreads should fall well below zero."

Brian thinks that our thinking in Britain is overly influenced by our inflationary past, such that we’re missing the real threat. In this he sees a parallel with the switch from runaway inflation to deflation in interwar Germany:

"…even as the German consumer price index fell 22 per cent from 1929 to 1932, investors' earlier experience with hyperinflation proved so profound that deflation was able to catch them entirely off-guard. In fact, the spread between German government bonds and gold-backed bonds didn't peak until April 1932, meaning that bond investors still clamoured for inflation-protected securities even as outright price deflation crippled the German economy."

So, how best to protect ourselves from the deflation that Brian sees coming to these shores?

Well, not the usual way. Typically, long-dated government bonds - like our own 10-year gilts - would be expected to prosper in deflationary times, as their fixed interest and principal appreciate in real terms as prices fall.

But Brian and the EWI reckons that interest rates will rise, despite the deflationary carnage ahead.

 

 

"[T]he real reason for the coming rise in rates will be that investors will be selling bonds and demanding higher rates due to fear of default. We have seen this development already in the debt paper of Greece and other weak debtors. It should soon seep over to the stronger debtors."

Specifically, Brian is saying the British government won't be able to pay the interest and repay the principal amounts in full when the deflationary depression is in full swing.

Why? Because the authorities won’t be taking in enough in taxation revenues.

Naturally, stocks are also going to get hammered in this coming apocalypse. In the video, Brian forecasts that Germany's DAX and our own FTSE will end up taking out their 2009 lows, at 3589 and 3461, respectively. (Currently, these indices are above 9000 and 6700, respectively, implying drops of more than 60 per cent and 48 per cent.)

And, according to Brian’s interpretation of the waves, both price action and crowd sentiment could be close to making major highs right now.

"A multitude of measures that gauge investor sentiment reached extremes in September. DAX futures traders, for example, pushed to 94 per cent bulls, as measured by the Daily Sentiment Index (tradefutures.com). That’s the highest reading since February 2011, which precipitated a 30 per cent DAX sell-off later that fall."

Brian published this chart of the DAX index, the upper part of which shows a potential top forming in the price, and the lower part the state of sentiment.

 

 

"Nothing says that stocks must sell off in the face of such extreme optimism, but markets are notoriously unkind to investors who ignore these kind of sentiment extremes - especially when they are combined with bearish wave patterns," he observes.

Does Dominic agree with Brian about the outlook? Broadly speaking, no. While he does agree the European crisis isn't yet solved, he predicts that the European Central Bank will adopt ever more aggressive monetary measures to keep the financial system lubricated and ultimately to inflate away the debt. And he reckons that the 2009 lows in the FTSE and DAX won’t be breached.

Still, as Dominic points out in this week's Trader column, it's always worth listening to those who are standing apart from the consensus view. After all, the folks at EWI were predicting disaster before it hit in 2007, and also then rightly called for a major rally in stocks beginning in 2009. They haven't been so right lately, of course, but things can change instantly in the world of waves.