The Market's Measure
Deflation and Recession: Yes or No?

Deflation and Recession: Yes or No?

A couple of indicators look ominous.

Remember when inflation was a worry? How long ago was that?

Nowadays it’s deflation, or disinflation if you prefer, that keeps people up at night. The signs are all around, particularly in the ETF market.

Case in point: Compare the performance of commodities to that of bonds to get a quick read on investors’ inflationary/disinflationary expectations. I created a daily inflation index by tracking the price spread  between the GreenHaven Continuous Commodity Index ETF (NYSE Arca: GCC) and the iShares 20+ Year Treasury Bond ETF (NYSE Arca: TLT), a metric that rises (commodities over bonds) in inflationary upswings and falls (bonds over commodities) when deflation is anticipated.

Guess where the index is now?

 

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A glut of oil, weak demand for copper and a speculative exit from gold have driven GCC’s underlying commodity index to six-year lows. Overlay the recent rebound in the bond market and TLT’s price and voilà, a deflation tilt.

Now, if you drill further down into the commodity sector, you can see the twin demons of deflation and recession roiling the market. Oil and gold, taken together in ratio, act as bellwethers of economic booms and busts.

Calculation of the gold/oil ratio is simple: just divide gold’s price by that of oil (I use spot prices for Comex gold and WTI oil futures as my factors). The ratio represents gold’s buying power. A ratio at 15, for example, tells you an ounce of gold will buy 15 barrels of oil at current prices.

The ratio’s historical average is between 15 and 16 barrels. A significant upward or downward skew in the ratio, like a swing in barometric pressure, is a weather forecast.  A spike above 20 barrels indicates crisis, usually associated with recession. Deep dips below ten barrels have been most recently correlated with an overheated economy and inflation.   

Look at the chart. Forays above 20 coincided with the 2008 financial crisis, the 2011 European debt mess and the current Iran/Greece maelstrom. In May, the ratio looked like it was headed south but now has ricocheted and is rising again.

 

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Is there another crisis looming? Or will there be a rebound in the inflation index and a drop in the gold/oil ratio? One thing is certain. When the indicators are at these levels, safety is paramount in nervous investors’ minds. It’s going to take some time for a growth mentality to become pervasive again.

 

 

Brad Zigler is REP./WealthManagement's Alternative Investments Editor. Previously, he was the head of marketing, research and education for the Pacific Exchange's (now NYSE Arca) option market and the iShares complex of exchange traded funds.

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