A Deflationary and Debt Death Spiral: How Should Investors Proceed?

A Deflationary and Debt Death Spiral: How Should Investors Proceed?

Dear Reader,

Eroom’s Law.

A cheeky spin on the traditional ‘Moore’s Law’ may be what’s behind the next ‘tech wonder stock’ of this decade.

Ryan Dinse, editor of Money Morning and Exponential Stock Investor, made the bold call yesterday that the next ‘Google’ or ‘Apple’ or ‘Amazon’ wonder stock wasn’t going to be some tech start-up.

Rather it’s going to be in the little-known industry called ‘synbio’. Never heard of it? Me neither. However, as Ryan told me during a video chat earlier in the week, this sector could mean the end of pandemics.

I’ll leave the rest up to Ryan to explain down below.

But before we get to the world of what synbio could mean for us, let’s hear from Jim.

On Monday, Jim Rickards touched on the longer-term impact of COVID-19. In a surprise to no one, he indicated there’d be economic suffering for years to come.

In today’s edition, Jim pinpoints some of the factors at play, including a ‘doom loop’, a supply shock, and the wealth effect. He also offers an answer to the million-dollar question: What will the recovery look like — and how should investors proceed?

Until next time,

Shae Russell Signature

Shae Russell,
Editor, The Daily Reckoning Australia

A Doom Loop, a Supply Shock, and the Wealth Effect

In the US, government programs such as the Paycheck Protection Program (PPP) and other direct government-to-business loans will not come close to compensating for the losses incurred by COVID-19. Many firms will not meet the qualifications for these loans. For many others, the loans (which can turn into grants) will help for a month or two but are not a permanent solution to lost customers.

For still other firms, the loans won’t help at all because the firms are short of working capital and will simply close their doors for good and file for bankruptcy. This means the jobs in those enterprises will be permanently lost.

According to Jim Rickards, the recent market crash we’ve witnessed is just the beginning. A total financial collapse might be next. Learn how to protect your savings and investments before it’s too late. Download your free report now.

From these straightforward events (lost individual income, lost business income, dividend cuts, and bankruptcies) come a host of ripple effects.

Once the government aid is distributed, many recipients will not spend it (as hoped) but will save it. Such savings are called ‘precautionary’. Even if you are not laid off, you may worry that your job is still in jeopardy. Any income you receive will either go to pay bills or into savings ‘just in case’.

In either case, the money will not be used for new spending. At a time when the economy needs consumption, it will not get it. The economy will fall into a ‘liquidity trap’ where saving leads to deflation, which increases the value of cash, which leads to more saving. This pattern was last seen in the Great Depression (1929–40) and will soon be prevalent again.

Even if individuals were inclined to spend (they’re not), there would be reduced spending in any case because there are fewer things to spend money on. Shows and sporting events are called off. Restaurants and movie theatres are closed. Travel is almost non-existent, and no one wants to hop on a cruise ship or visit a resort until they can be assured that the risk of COVID-19 is greatly reduced.

We’re in a doom loop where individuals don’t want to spend and even if they did, there’s little to spend money on. This will guarantee a continued slow recovery and persistent deflation, which makes the slow recovery worse.

The supply shock

In addition to these constraints on demand, there are serious constraints on supply. Global supply chains have been seriously disrupted due to shutdowns and transportation bottlenecks. Social distancing will slow production even at those facilities that are open and can get needed inputs.

One case of COVID-19 in a factory can cause the entire factory to be shut down for a two-week quarantine period. Companies that depend on the output of that factory to manufacture their own products will also be shut down.

Beyond these direct effects of lost income and lost output, there are significant indirect effects on the willingness of entrepreneurs to invest and of individuals to spend. First among these is…

The wealth effect

When stock values drop 20–30% as they have recently, investors feel poorer even if they have substantial net worth after the drop. The psychological effect is to cause people to reduce spending, even if they can afford not to.

This means that spending cutbacks come not only from the middle class and unemployed, but also from wealthier individuals who feel threatened by lost wealth even if they have continued income.

Negative wealth effects are not limited to stock market losses. Many individuals own corporate bonds that will now go into default as the corporate issuers file for bankruptcy. Finally, real estate values will collapse as tenants refuse to pay rent and landlords default on their mortgages, putting properties into foreclosure.

None of these negative economic consequences of the New Depression are amendable by easy fixes by the Congress or the Fed. Deficit spending will not ‘stimulate’ the economy, as the recipients of the spending will pay bills or save money. The Fed can provide liquidity and keep the lights on in the financial system, but it cannot cure insolvency or prevent bankruptcies.

In short, lost output, business failure, and lost consumption will happen no matter what the Fed and Congress do. Once these losses become clear, the negative wealth effects will cause another downturn in spending. The process will feed on itself expressed as deflation, which will encourage even more savings and discourage consumption. We’re in a deflationary and debt death spiral that has only just begun.

What shape will the recovery be?

Based on this analysis, investors should expect the recovery from the New Depression to be slow and weak. The Fed will be out of bullets. Deficit spending will slow growth rather than stimulate it because the unprecedented level of debt will cause Americans to expect higher taxes, inflation, or both. The US economy will not recover 2019 levels of GDP until 2022. Unemployment will not return even to 5% until 2026 or later.

This means stocks are far from a bottom. The S&P 500 Index could easily hit 1,870 (it’s at 2,900 as of this writing) and the Dow Jones could fall to 15,000 (it’s at 24,300 as of this writing).

Those are levels at which investors might want to consider investing in stocks. Any effort to ‘buy the dips’ in the meantime will just lead to further losses when the full impact of what’s described above begins to sink in.


Jim Rickards Signature

Jim Rickards,
Strategist, The Daily Reckoning Australia

PS: Jim Rickards warns that a total financial collapse is imminent. Learn how to protect your savings and investments…before it’s too late. Click here now.