The End Of The Deflation Supercycle?

Ambrose Evans-Pritchard of the Telegraph reports, The world economy as we know it is about to be turned on its head (click on images to enlarge):

Workers of the world are about to get their revenge. Owners of capital will have to make do with a shrinking slice of the cake.

The powerful social forces that have flooded the global economy with abundant labour for the past four decades years are reversing suddenly, spelling the end of the deflationary super-cycle and the era of zero interest rates.

"We are at a sharp inflexion point," says Charles Goodhart, a professor at the London School of Economics and a former top official at the Bank of England.

As cheap labour dries up and savings fall, real interest rates will climb from sub-zero levels back to their historic norm of 2.75pc to 3pc, or even higher.

The implications are ominous for long-term US Treasuries, Gilts or Bunds. The whole structure of the global bond market is a based on false anthropology.

Prof Goodhart says the coming era of labour scarcity will shift the balance of power from employers to workers, pushing up wages. It will roll back the corrosive inequality that has built up within countries across the globe.

If he is right, events will soon discredit the sweeping neo-Marxist claims of Thomas Piketty, the best-selling French economist who vaulted to stardom last year.

Mr Piketty's unlikely bestseller - Capital in the 21st Century - alleged that the return on capital outpaces the growth of the economy over time, leading ineluctably to greater concentrations of wealth in an unfettered market system. "Piketty was wrong," said Prof Goodhart.

What in reality happened is that the twin effects of plummeting birth rates and longer life spans from 1970 onwards led to a demographic "sweet spot", a one-off episode that temporarily distorted labour economics.

Prof Goodhart and Manoj Pradhan argue in a paper for Morgan Stanley that this was made even sweeter by the collapse of the Soviet Union and China's spectacular entry into the global trading system.

The working age cohort was 685m in the developed world in 1990. China and eastern Europe added a further 820m, more than doubling the work pool of the globalised market in the blink of an eye.

"It was the biggest 'positive labour shock' the world has ever seen. It is what led to 25 years of wage stagnation," said Prof Goodhart, speaking at a forum held by Lombard Street Research.

We all know what happened. Multinationals seized on the world's reserve army of cheap leader. Those American companies that did not relocate plant to China itself were able play off Chinese wages against US workers at home, exploiting "labour arbitrage". US corporate profits after tax are now 10pc of GDP, twice their historic average and a post-war high.

It was much the same story in Europe. Volkswagen openly threatened to shift production to Poland in 2004 unless German workers swallowed a wage freeze and longer hours, tantamount to a pay cut. IG Metall bowed bitterly to the inevitable.

Cheap labour held down global costs and prices. China compounded the effect with a factory blitz - on subsidised credit - that pushed investment to a world record 48pc of GDP and flooded markets with cheap goods - first clothes, shoes and furniture, and then steel, ships, chemicals, mobiles and solar panels.

Lulled by low consumer price inflation, central banks let rip with loose money - long before the Lehman crisis - leading to even lower real interest rates and asset bubbles. The rich got richer.

..

This era is now history. Wages in China are no longer cheap after rising at an average rate of 16pc for a decade.

The yuan is overvalued. It has appreciated 22pc in trade-weighted terms since mid-2012, when Japan kicked off Asia's currency war. Panasonic is switching production of microwaves from China back to Japan.

But the underlying causes of the deflationary era run deeper. The world fertility rate has steadily declined to 2.43 births per woman from 4.85 in 1970 , with a precipitous collapse over the past 20 years in east Asia.

The latest estimates are: India (2.5), France (2.1), US (two), UK (1.9), Brazil (1.8), Russia and Canada (1.6), China (1.55), Spain (1.5) Germany, Italy, and Japan (1.4), Poland (1.3) Korea (1.25), and Singapore (0.8). As a rule of thumb, it takes 2.1 to keep the population on an even keel.

The numbers of working-age rose sharply relative to children and - for a while - the elderly. The world dependency ratio dropped from 0.75 in 1970 to 0.5 last year. This was the sweet spot.

"We are on the cusp of a complete reversal. Labour will be in increasingly short supply. Companies have been making pots of money but life isn't going to be so cosy for them anymore," said Prof Goodhart.

The dependency ratio has already bottomed out in the rich countries. It is now rising far more quickly than it fell as baby boomers retire and people live much longer.

China will face a double hit, thanks to the legacy effects of the one-child policy. "They kept it going 15 years too long, disastrously," said Prof Goodhart. China's workforce is already shrinking by 3m a year.

It is widely assumed that the demographic crunch will pull the world deeper into deflation, chiefly because that is what has happened to Japan - probably for unique reasons - since it pioneered mass dotage 20 years ago.

The Goodhart paper makes the opposite case. Healthcare and ageing costs will drive fiscal expansion, while scarce labour will set off a bidding war for workers, all spiced by a state of latent social warfare between the generations. "We are going back to an inflationary world," he said.

China will no longer flood the world with excess savings. The elderly will have to draw down on their reserves. Companies will have to invest again in labour-saving technology, putting their great stash of idle money to work.

We will see a reversal of the forces that have pushed the world savings rate to a record 25pc of GDP and created a vast pool of capital spilling into asset booms everywhere, even as the global economy languishes in a trade depression.

The "equilibrium rate" of real interest will return to normal and we can all stop talking about "secular stagnation". Central banks can stop fretting about the horrors of life at the "zero lower bound" (ZLB), and they are certainly fretting right now.

The Bank of England's chief economist, Andrew Haldane, warned in a haunting speech last week that we may be stuck in a zero-interest trap for as far as the eye can see, with little left to fight the next downturn - typically requiring three to five percentage points of rate cuts to right the ship.

"Central banks may find themselves bumping up against the ZLB constraint on a recurrent basis," he said. His answer is a menu of quantitative easing so exotic it trumps Corbynomics for heterodoxy.

Professor Goodhart makes large assumptions. He doubts that robots will displace workers fast enough to offset the labour shortage, or that greying nations are culturally able to absorb enough immigrants to plug the jobs gap, or that India and Africa have the infrastructure to repeat the "China effect".

The world has never faced an ageing epidemic before so we are in uncharted waters. What is clear is that the near vertical take-off of the dependency ratio is about to shatter all our economic assumptions.

The last time Europe's serfs suddenly found themselves in huge demand was after the Black Death in the mid-14th century. They say it ended feudalism.

This is a great article for deflationistas like me who think the world is heading into a prolonged period of global deflation. I like being challenged so I welcome these views from professor Goodhart and Manoj Pradhan.

Unfortunately, while talk of the end of the deflationary supercycle and revenge of labor sounds fantastic, workers of the world shouldn't unite and rejoice just yet as the shift discussed above, if it materializes accordingly, will take decades and there are plenty of pitfalls that can arise along the way.

For the foreseeable future the global economy is mired in deflation. The Financial Times reports that Japan has fallen back into deflation for the first time since April 2013 in a symbolic blow to prime minister Shinzo Abe’s economic stimulus program.

Andrew Sheng and Xiao Geng wrote an excellent comment for Project Syndicate explaining why China now faces the same debt-deflation challenge that much of the rest of the world must address. the authors end on this cautionary note:

The advanced countries have fallen into the debt-deflation trap because they were unwilling to accept the political pain of real-sector restructuring, relying instead on financial engineering and loose monetary and fiscal policies. Here, China’s one-party system provides a clear advantage: the country’s leaders can take politically painful decisions without worrying about the next election. One hopes that they do.

But I'm not sure Chinese leaders are willing to take politically painful decisions and judging by their response after the bursting of the China bubble, including using the country's pension fund to bolster the plunging stock market and devaluing the yuan, I worry that the response from China's leaders will be similar to that of leaders from advanced countries (ie. extend and pretend). 

The slowdown in China is wreaking havoc on commodity-exporting nations and the world economy. It's also influencing monetary policy around the world, including in the United States where there's a sea change going on at the Federal Reserve. 

In fact, too many analysts are underestimating China's deflation threat, much to their demise. Already you have retail giants like Wal Mart (WMT) putting the squeeze on their Chinese suppliers to lower prices of the goods they're offering and no doubt other global companies are doing the exact same thing. This is all stoking fears of deflation.

No wonder the European Central Bank will likely increase its quantitative easing program following a report which shows that efforts to bring inflation levels up in Europe may be failing. Europe is still a structural mess but the decline of the euro will help bolster growth temporarily.

Finally, there's the United States, the last bastion of global growth. While many hailed the August jobs report as unemployment fell to 5.1%, the lowest rate in more than seven years, the reality is wage growth remains slight and millions remain relegated to the sidelines of the job market.

This is the new normal folks. Get used to lower growth around the world and take all this talk of the end of the deflation supercycle with a shaker of salt. The global economy is sick and will remain weak for a very long time even if there are cyclical spurts of growth along the way.

Below, Albert Lu of the Power & Market Report welcomes Michael Pento, the founder and president of Pento Portfolio Strategies and author of The Coming Bond Market Collapse. I obviously don't agree with Pento and other bond market bears but it's worth listening to his views.

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