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Recession Could Be Closer Than Most Realize

by Jim Rickards, DailyReckoning:

The conventional definition of gross domestic product, GDP, has four main parts. These are consumption, investment, government spending, and net exports.

This definition is usually expressed in equation form as GDP = C + I + G + (X – M). But, these parts do not affect the economy equally. Consumption is far and away the most important component.

Consumption is almost 70% of the total economy.

In the most recent quarterly report from the Commerce Department, total annualized GDP was $19 trillion and consumption was $13 trillion, or 68%. The impact of consumption does not stop there.

If consumption slows down, investment may slow down. Businesses will not invest in buildings and heavy equipment unless the customers are there to purchase the output needed to justify those investments in the first place.

Simply put: when the consumer catches a cold, the entire economy can get pneumonia.

Something like that appears to be happening. Retail sales are down sharply due to a combination of weak wage growth, income inequality (“average” gains have been heavily skewed to the wealthy, leaving most Americans worse off), and deflationary expectations.

Meanwhile, consumer confidence has fallen to the lowest level since November, and consumer spending fell in May. Inflation was also lower in May.

On top of this, the Fed is creating headwinds with rate hikes and by reducing the money supply through its new program of quantitative tightening, or QT. With stock market indices hitting new all-time highs almost daily, and the economy hitting stall speed, a severe stock market correction is in the cards.

How did we get here?

In the past seven years, major central banks have created over $15 trillion of new money, mostly through purchases of government bonds.

These money printing and bond purchase programs have been called QE1, QE2 and QE3 in the U.S., Euro-QE in Europe and QQE (quantitative and qualitative easing) in Japan.

All of these programs and exotic variations such as “Operation Twist” have failed to achieve self-sustaining growth anywhere near former trends, and have failed to achieve the 2% inflation targets of those central banks.

We have not had much consumer price inflation, but we have had huge asset price inflation. The printed money has to go somewhere. Instead of chasing goods, investors have been chasing yield.

But the stock market and the bond market are sending two different messages today.

The Dow is trading above 21,500 for the first time ever. And the S&P broke out to new highs less than three days after last Wednesday’s rate hike. Meanwhile, the Nasdaq continues its record run. Stocks seem to break records every other day.

If the Fed’s hiking rates to to take some steam out of the bull, it’s not working.

But the bond market is telling a different story. The 10-year Treasury bond yield has fallen from 2.4% in mid-May to 2.16% today. Falling yields suggest weakening growth or possibly recession ahead, the opposite of what the stock market is saying.

If bond yields are falling because deflation is ruining the Fed’s plans to reflate the economy, is that a reason for stocks to go up? If bond yields are signaling recession, should you really be bidding up stock prices to extreme levels based on a theory of yield “parity?”

This behavior defies common sense and economic history, but it’s exactly what we’re seeing in the markets today.

At some point, probably sooner than later, the reality of central bank impotence and looming recession will sink in and stock valuations will collapse. The drop will be violent, perhaps 30% or more in a few months.

You don’t want to be over-allocated to stocks when that happens.

Read More @ DailyReckoning.com

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