Research & Commentary

Investors are Ignoring Warning Signs of Deflation

In this new interview with Brian Whitmer, the editor of Elliott Wave International’s European Financial Forecast, he stresses that investors are in a risk-on mindset, something we’ve seen “time and time again.”

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[Editor’s note: A text version of the interview is below.]

Dana Weeks: Welcome to ETV. I’m Dana Weeks and today I’m joined by Brian Whitmer, editor of Elliott Wave International’s European Financial Forecast. Brian, let’s start with one of the most prominent market headlines the last few quarters: emerging markets and high yield. Why are they getting so much attention?

Brian Whitmer: Well the basic reason is that high-yield continues to be the most compelling bullish story. Prices are up, yields are down, spreads are the lowest they’ve been in a year. And really the only thing that’s outperforming emerging-market debt or high yield are longer-dated bonds. So essentially what you have is investors are scouring the globe again, they are searching returns, searching for yield in this low rate environment and they’re looking for that not just by buying the debt of lower quality borrowers, but they’re buying longer and longer dated debt.

Dana: So lower credit quality and being forced out of the yield curve, that sounds dangerous.

Brian: It is and that’s really the point. This risk-on mindset becomes widespread, becomes prevalent after a long trend in the market and really when that trend is getting ready to reverse. We see it time and again. We saw it in tech stocks in 99; real estate in 2005. All the warning signs were there. It’s just that in an environment of optimism, investors choose to ignore those warning signs and I think that’s exactly what we’re seeing in bonds today. Investors are sitting back. Brexit has come along, that didn’t really have an effect on the market. The ECB is not only purchasing sovereign debt now, but purchasing corporate debt. The Bank of England just lowered rates for the first time in seven years, they’re going to start purchasing corporates debts. So I think investors are sitting back saying, “‘Hey, the skies are clear. No need to prepare for a storm.” This is a trend we see time and again and it indicates that optimism is high and that markets are ready to reverse.

Dana: Interesting. Ok, narrow the focus for us. You’ve been watching a few benchmark European stocks and recently wrote about the correlation between deflation and Airbus as an example. Walk us through that.

Brian: Well, in this case, we have a trend that has very clearly reversed already. It’s a deflationary trend we’ve noticed, where expansion gives way to contraction. Where luxury gives way to economy. I talked about the airlines last month because the sector really embodies this movement to cut back. Airbus in particular is fascinating. If you remember back to ’07, when stocks were peaking, the company puts into service the A380. It’s the largest passenger jet in the world. Airlines start outfitting the planes with all the luxuries: double beds, leather armchairs, showers. That was a sentiment signal that optimism had reached some kind of extreme. And of course, we now know what happened, the financial crisis hits, deflation starts spreading throughout Europe and demand for these huge planes just dries up and really it’s never recovered. Airbus is cutting production on the A380 and some experts say they’re just going scrap the plane altogether. The key is that this sector offers a great window into the future. This same kind of downsizing is about play out in numerous other sectors. Auto sector, manufacturing — in essence the economy is going to get a lot smaller, just about everywhere.

Dana: OK, let’s widen this out one time. There seem to be crosswinds blowing through the European economy. Put this in macro perspective. Is Europe on the road to recovery or on the slippery slope towards deeper deflation?

Brian: The answer is deeper deflation, unfortunately. What’s going on here is that central bank policy just becomes ineffective once public psychology is trending toward pessimism. For example, negative rates, like you say. At a negative rate, it is costing banks to hold their reserves at the central bank. They’re meant to incentivize banks to lend, but that’s not happening. What’s happening is that banks are finding creative ways to get around the fees. For example, they’re holding cash notes in their own vaults. Several banks have taken this step because at a certain negative rate, it costs them less to store cash notes, to transport cash notes, to even insure cash notes. It costs less to do all that than it costs to hold reserves at the central bank. So if we really drill down into that, think about that for a second. Holding cash notes in this way means that banks are not paying interest charges to the central bank. What it is that they’re not affected by official interest rate cuts anymore. So, essentially, the main policy tool that central banks have been relying on for decades to steer the economy, that tool suddenly becomes totally useless. This is just a great example where the market is sidestepping the actions of central banks, and the markets are driving this trend toward deflation and central banks just aren’t.

Dana: Understood. OK, Brian, as always, it’s been great talking with you. Thank you so much for your time today.

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