Is Congress About to Cause a Major Economic Slowdown?

The fiscal cliff, sequestration, higher taxes, and a pending budget debate may be too much for overly optimistic investors to handle. Volatility has started to rise and the market is looking weaker:

As I mentioned in last week's piece, some of the underlying market components are starting to weaken and investors seem to be losing faith that Ben Bernanke and the Fed can keep growth alive in the US economy.

I do believe that we are ending the current business cycle which started after the 2008 collapse. Unfortunately, the Fed doesn't have its normal tools available (such as lowering interest rates) to extend the current cycle much longer.

In addition, sequestration may take a bigger bite out of the economy than is predicted:

Most stated effects of the sequestration released over the past few weeks don't address how consumer confidence will impact the economy. I have stated time and time again that the US is a consumer based economy.

If the consumer stops spending, the economy stops growing.

Currently, the US Government (and more specifically, the Department of Defense)  is the world's largest employer.

Source: BBC

This means a large portion of the population will be affected by the sequester. The problem is in determining how it will impact these employees over the next few years. No one really knows yet. Some may be laid off, some may be furloughed, some projects may be delayed or canceled.

Now, if I am an employee of the US government or a defense contractor with an unknown future, do I continue my spending habits or save for a rainy day? This, in my opinion, will be the biggest impact the sequester will have on the US economy.

The Current Business Cycle

Even before the sequester, the Fed has been trying to extend the current business cycle. GDP has become more volatile and may be an indication that the current cycle is coming to an end:

Historically, the average length of a business cycle after WWII has been about 5 1/2 years. While the 1990s did see a period twice as long as the average, many economists believe that to be a "once in a generation" cycle.

Source: Federal Reserve Bank of Boston 

The end of the business cycle may mean more deflation is ahead.

In 1925, Russian economist Nikolai Kondratieff authored a book titled "The Major Economic Cycles" in which he identified economic waves in western countries. According to Kondratieff, capitalist societies rise in long waves of approximately 50-60 years.

Today, many economists question Kondratieff's theories. Some believe there are not enough data points to properly analyze the theory, while others such as the System Dynamics program at MIT have validated parts of Kondratieff's theories.

Who is correct? I will let future historians decide who was right.

What I do find useful about Kondratieff's wave theory is how it overlays with inflation/deflation concepts and the impact on various economic sectors on a smaller time scale.

Examining current economic data and comparing it to Kondretieff's "seasons" leads me to believe that we may be about to switch from a period of disinflation (a period of slowing inflation) to a period of pure deflation similar to what has happened in Japan.

Some signs of Autumn:

Here in the US, we have seen an impressive rise in the stock market since 2009. Interest rates are at historically low levels, and bond prices have risen dramatically.

We are also seeing inflation rates continue to drop:

 Source: Bureau of Labor Statistics

Mortgage rates (interest rates) are still falling:

Commodity cycle is weakening:

Autumn changing to Winter

Consumer confidence is starting to drop again:

And prices look to drop more:

Investors should take this time to re-balance portfolios and keep an eye on Washington. Investors seem to think this will just be another issue that Congress will delay for another day and all will be well. Congressional actions in March may be the deciding factor if the current business cycle can continue or not.

ARTAIS Model Update

Volatility in the market is starting to rise. Our ARTAIS model still remains conservatively invested. The strengthening US dollar and deflationary fears continue to negatively impact gold prices.

We will be keeping a close eye on the S&P 500 trend lines that have been in place since 2009. If these trend lines are broken, it is an indication that market sentiment has changed and we will begin to look at opportunities available to us in a declining stock market (such as inverse funds and safe haven investments).