Our Base Case is Moderate Deflation but Stagflation is a Strong Possibility

At Nariman Point our picture of the world has become more clear over the past few weeks. Now that it seems the big Q4 bear market rally is behind us, I am more confident leaning against the dismal truth of the global economy. Its going to get worse, much worse. The Q4 rally, which I warned our customers about in late September, was not as long lived as I expected although markets rose more than I anticipated. Despite feeling that the market was well primed for a big reversal in October, adherence to the truth prevailed and we clung to our bearish positions and added to them.

So now that the melt-up is over we can get back to understanding what is really going on around the word. Markets have calmed down a touch and there does not seem to be the same level of irrational panic in the November declines as in August and September. This is a troubling observation as it tells us that while the world may not end tomorrow sideways to negative markets will be a longer term trend and probably not a short term reaction.

This means that our general base case is approximately a 70% chance of moderate economic contraction to very low economic growth for the majority of 2012 and possibly well into 2013 for most of the 34 member OECD.  Also, a 70% likelihood of moderate deflation to very slight inflation again for OECD nations.  

A two standard deviation move from our expectations would be a scenario of significant deflation to a scenario of moderate stagflation. Essentially “significant deflation” would be the result of the following:  a meltdown in Europe in conjunction with Chinese economic growth falling between 4% and 6%, as well as retirees in the U.S. liquidating speculative assets and American corporations and individuals deleveraging  causing a sharp decline in prices across the board. Ill timed reductions in military spending or deleveraging by the US government (although great for the long-term) would only strengthen the deflationary argument.

The flip side to this would be given the same scenario, Central Banks around the world panic and attempt to re inflate global asset prices by printing more money leading to a period of stagflation. Inflation with no economic growth. As the Fed, BOJ and BOE cannot lower rates any further money printing is the only arrow left in the quiver. 

A three standard deviation move from our base case projection and we see two more scenarios:

Either, an explosion of political unrest around the world due to high unemployment, ineffective bureaucrats, rising education costs, falling wages, and higher food and energy costs. This is already happening to some extent but picture a more violent version of Occupy Wall Street. The outcomes of this would be difficult to predict but its impact would be profound. 

Or, a significant inflationary  scenario based on a muted economic recovery in Europe, a major boom in technology in the U.S., no reduction in Chinese growth and a decoupling of other emerging markets from developed nations increasing their current pace of growth and domestic consumption.

Admittedly, most of these scenarios are gloomy; however, the world has been avoiding its medicine since 2001 and now it seems the time has come where there is no where else to hide. On the brighter side, I believe that once Europe, the US, and Japan deal with their issues, and China moves past its short-term real estate crash the world will enter a historic secular bull market led by mind blowing technological innovation, population and wealth explosions in places like India, and the shift of power from developed to emerging markets. 

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