Prepare For Global Deflation?
China's manufacturing growth stalled for the second straight month in January and companies had to cut prices at a faster clip to win new business, adding to worries about growing deflationary pressures in the economy, a private survey showed.Chinese deflation is another source of great concern for global policymakers. If it continues, it means we're going to experience another wave of disinflation in the West and more deflationary pressure.
The HSBC/Markit Flash Manufacturing Purchasing Managers' Index (PMI) hovered at 49.8 in January, little changed from December's 49.6 and just below the 50-point mark that separates contraction from growth on a monthly basis.
A Reuters poll had forecast a second month of contraction with a reading of 49.6.
Reflecting the tumble in oil prices, which have more than halved in the last six months, a sub-index for input prices sank to 39.9, a level not seen since the global financial crisis.
But companies also had to cut output prices for the sixth straight month to sell their products, and more deeply than in December, eroding their profit margins.
"Today's data suggest that the manufacturing slowdown is still ongoing amidst weak domestic demand," Qu Hongbin, a HSBC economist in Hong Kong said on Friday.
"More monetary and fiscal easing measures will be needed to support growth in the coming months."
Falling prices are a concern for China, which wants to avoid Japan's fate of sinking into a 20-year deflationary funk that has depressed consumption and economic growth.
The survey showed final demand for China's factory goods rose this month, but only modestly as the sub-indices for new orders and new export orders stood close to the 50-point threshold.
Factories laid off staff for the 15th consecutive month in January in the face of tepid demand, the PMI showed.
DEFLATION SETTING IN?
There are already some signs of stubborn deflationary pressure in China.
Producer prices have fallen for almost three straight years. That helped to drag China's annual consumer inflation to a near five-year low of 1.5 percent in December.
To contain deflationary risks, economists at state think-tanks who are privy to China's policy discussions said authorities are ready to cut interest rates further and pressure banks to step up lending. The central bank unexpectedly cut rates in November for the first time in more than two years.
Some Chinese consumers are already postponing purchases in anticipation that prices will fall further in the future, a classic warning sign of deflation that would deal another blow to the Chinese economy, where growth hit a 24-year-low of 7.4 percent last year.
Although 2014 economic growth data was not as bad as some had feared, it suggested that a steady series of policy easing had not sustained activity as much as policymakers had hoped.
In a sign of the times, separate data on Friday showed the bad debt ratio at Chinese banks climbed to a five-year high of 1.64 percent at the end of 2014 as companies struggled to repay their loans in the dour business climate.
Indeed, Sany Heavy Equipment International Holdings Co Ltd said on Friday its 2014 net profit could more than halve after falling coal prices dented demand for coal machinery.
That followed a more dire forecast from Zoomlion Heavy Industry Science and Technology Co Ltd, another heavy equipment maker, which said on Monday that its 2014 net profit may have plunged 80 percent. The profit warning was its fifth in 21 months.
"Right now, I'm more worried about investment," said Chang Chun Hua, an economist at Nomura in Hong Kong. "The financing cost of investment is getting higher with deflation. Real interest rates are going up."
Economists polled by Reuters expect the economy to slow further this year to around 7 percent, even with additional stimulus measures. A cooling property market, high financing costs and heavy corporate and local government debt loads will likely continue to drag on activity.
Chinese Premier Li Keqiang acknowledged on Wednesday that the world's second-largest economy will face downward pressures in 2015 but said it was not heading for a hard landing.
And China's deflation dragon is spreading throughout Asia, wreaking havoc on other economies. Gaurav Raghuvanshi of the Wall Street Journal reports, Singapore posts second straight month of deflation:
Singapore's consumer prices fell nearly in line with analyst estimates in December and the island nation reported a second consecutive month of deflation as housing and transport costs continued to ease.And Gareth Hutchens of The Age reports, Is Australia's economy at risk of deflation?:
The consumer price index fell 0.2% year-over-year in December, compared with the median estimate for a 0.1% decline in a Dow Jones Newswires poll of six economists, and a 0.3% fall in November.
The cost of transportation, which has an index weighting of 16%, fell 4.1% in December from a year earlier due to lower private road transport costs, the data showed. Private road transport costs fell by a more moderate 5.7% from a year earlier, compared with the 7.0% decrease in November.
Housing costs, which make up 25% of the index, fell 1.4% because of lower rents.
Food prices, which have a 22% weighting in the index, however, rose 2.9% from a year earlier, mainly due to more expensive cooked meals, the data showed.
For the whole year, the consumer price index rose 1.0% in 2014 from 2.4% in the previous year.
The Monetary Authority of Singapore's core inflation, which excludes the costs of accommodation and private road transport, was 1.5% higher from a year earlier in December, similar to the preceding month, because of stable services and food inflation. For the whole of 2014, MAS core inflation edged up to 1.9% from 1.7% in 2013.
A few years ago conservatives in the United States were hyperventilating about the then-chairman of the US Federal Reserve, Ben Bernanke, because they believed his radical monetary policies were going to lead to an uncontrollable outbreak in inflation that would decimate the economy.In my opinion, the Reserve Bank of Australia will follow the Bank of Canada, which just shocked markets with a rate cut, and proceed with its own interest rate cut (keep shorting the Aussie and loonie!).
Remember these accusations?
Newt Gingrich, while running for the Republican presidential nomination in 2012, warned voters that Bernanke was "the most inflationary, dangerous" Fed chairman "in history".
Texas Governor Rick Perry, who also ran for the nomination, claimed Bernanke was "almost" treasonous.
"If this guy prints more money between now and the election, I dunno what y'all would do to him in Iowa, but we would treat him pretty ugly down in Texas," he thundered.
They were cynical statements then and they look ridiculous now – the US economy is actually showing signs of healthy life these days, while it still faces very little inflationary pressure. It's obviously too early to claim victory, but it looks like Bernanke's policies may have worked.
Looking around the world, other major developed economies aren't worrying about inflation at all, despite the amount of money printing that has gone on in recent years.
The thing they are more concerned about is deflation.
Shane Oliver, the chief economist of AMP Capital, felt deflation was enough of a concern that he sent a note to his clients this week explaining what it was and why Australia faced some deflationary risks.
I'll do my best to summarise what he says.
Firstly, he says the absence of inflationary pressures around the world is a good thing, because it means the global "sweet spot" of OK economic growth, low interest rates, and low bond yields can continue.
But a steep fall in bond yields over the last year, to record or near record lows, is warning us that the world may face a period of "sustained deflation".
What is deflation? It refers to persistent and generalised price falls, and it is not necessarily a bad thing. Whether deflation is good or not depends on the circumstances in which it occurs.
As Oliver explains, in the period 1870-1895 in the United States, deflation occurred against the background of strong economic growth, reflecting rapid productivity growth and technological innovation.
This was "good" deflation.
Australians have enjoyed this type of deflation for years in the prices of electronic goods. That's why so many of us can afford to have large flat-screen TVs and other things.
Deflation becomes "bad" when it is associated with falling wages, rising unemployment, falling asset prices and rising real debt burdens.
In the 1930s, and more recently in Japan, deflation reflected an economic collapse and rising unemployment, which was made worse by a combination of high debt levels and falling asset prices.
"[And] in the current environment sustained deflation could cause problems," Oliver says, speaking about the global economy.
"Falling wages and prices would make it harder to service debts. Lower nominal growth will mean less growth in public sector tax revenues, making still high public debt levels harder to pay off. And when prices fall people put off decisions to spend and invest, which could threaten economic growth."
He believes the decline in inflation globally has raised concerns that we may see sustained deflation around the world.
Annual inflation rates are low everywhere.
They are just 0.8 per cent in the United States, -0.2 per cent in Europe, 0.5 per cent in the UK, 0.4 per cent in Japan, and 1.5 per cent in China.
In Australia, annual inflation is still officially sitting at 2.3 per cent, which is much better than other economies, but it looks likely to fall below that next week when new figures come out.
And if that happens, things could get interesting.
The Reserve Bank is meeting in a couple of weeks to decide on interest rates, knowing full well that economists from major banks have been calling on it to cut rates further.
Its job is to try to keep inflation within a 2-3 per cent range, so if annual inflation falls below the 2-3 per cent target it will strengthen the case for the bank to cut rates again.
Rates are already at a historic low 2.5 per cent. If inflation falls below 2 per cent next week, all eyes will be on RBA governor Glenn Stevens.
But is there a risk that Australia faces bad deflation? Oliver thinks it's unlikely.
He says deflationary forces will be felt in Australia as global prices fall, for commodities such as oil and energy, but those forces won't be serious.
He believes a sustained 1930s or Japanese-style deflation is likely to be avoided globally, too.
That's because the US Fed is likely to delay its first interest rate hike if core inflation continues to fall. Japan will likely continue with its aggressive quantitative easing program for some time yet. And China and India look likely to ease monetary conditions further.
Oliver also believes a further interest rate cut is likely in Australia.
That loosely co-ordinated global monetary easing should help to ensure that global growth continues, and in turn prevent a slide into sustained deflation, Oliver argues.
So even though global inflation will remain low, it is unlikely to collapse into sustained deflation.
But a key thing to watch will be the success of the European Central Bank and the Bank of Japan in boosting their countries' growth rates with looser monetary policy.
"The most likely outcome is that inflation will remain low over the year ahead, with improving growth helping it bottom [out], but still significant spare capacity preventing much of a rise [in inflation]," he argues.
"[And] as the generally easy global and Australian monetary environment continues, it will help underpin further gains in growth assets like shares, albeit with more volatility."
Australian interest rates will obviously remain low for the rest of the year.
In fact, Australia is even more cooked than Canada because of its closer trading relationship with China. And just like Canada, it's in the midst of a huge real estate bubble that will eventually burst, a point recently underscored by Australian economist Steve Keen:
Steve Keen, head of economics, politics and history at London’s Kingston University, envisages the RBA making a couple of cuts this year - "and possibly more than that".I strongly doubt a slowdown in China will mean a boon for real estate in Australia, Canada and other hot spots, like London.
"The unemployment in Australia now is the worst it’s been in 10/15 years, and the only thing keeping it up is the housing bubble because that is pumping borrowed money into the economy, people are spending that money, and of course also foreign buyers pumping money and buying real estate," he told Lelde Smits from the Finance News Network .
"Those are really the only two massive inflow sources into the economy.
"If the housing bubble pops then that inflow also stops and we therefore have a downturn driven by having finally a housing bubble bursting.
"So those dangers are there, you can see plenty of reasons for the cash flow spigot to be turned off, I can’t see many ways of turning it on anymore."
He would be surprised to see it below the 2%, but wouldn’t be amazed.
He suggests what he sees as the bubble could keep going, "but what it means is we are more and more fragile on the bubble continuing indefinitely".
Asked for the catalyst for the property bubble to pop, Keen sees two things.
"Partly the economy itself slowing down so much that the negative returns in rental become excessive.
"Those people are having carrying costs and of course passing those carrying costs on to the Australian public through negative gearing, but they none the less have those carrying costs to handle.
"And also, if there is anything going wrong in China.
"Things going wrong in China can go in both directions, we have a serious downturn in China, then it’s quite possible Chinese capital could respond by going offshore and do more buying overseas.
"So a slowdown in China, because it is a speculative slowdown, doesn’t have to mean a slowdown in demand for Australian real estate."
As far as the argument that Shane Oliver made in the previous article, that loosely co-ordinated global monetary easing should help to ensure that global growth continues and prevent a slide into sustained deflation, I think this is wishful thinking.
As I stated in my last comment, the ECB's new QE measures are a day late and a euro short. And if the Fed makes the silly mistake of raising rates this year, Larry Summers is right, it will risk a deflationary spiral and a depression-trap that would engulf the world for decades.
Unfortunately, no matter what the Fed does, deflation is coming to America. Bond markets around the world have been telling us this for a long time. DoubleLine's Jeffrey Gundlach, the new bond king, explained why this time it's different. The inexorable slide in rates is telling us that the world will face a prolonged period of debt deflation.
Most institutional and retail investors are not prepared for what lies ahead. Some investors are preparing for a deflationary boom, but they're not ready for the eventual deflationary bust that will happen when global investors start questioning the Fed and other central banks. This will be our Minsky moment and will engender a major crisis in capitalism as we know it.
But for now, don't worry, there is still plenty of liquidity to drive risk assets much higher in the next couple of years. This is why in my Outlook 2015, I'm still bullish on bonds and stocks, but I also warned you to choose your stocks and sectors very carefully.
Given deflationary pressures around the word, I'm not surprised to see utilities (XLU), healthcare (XLV) and telecoms (XLT) continuing to do well but I'm far more bullish on technology (XLK) and especially biotech (XBI) because I think defensive stocks are getting stretched and their valuations will make asset allocators take money off the table. Then again, in a deflationary environment, you might see bubbles in high dividend defensive sectors but my bet remains on tech and biotech.
As far as pensions are concerned, I openly question whether their risk departments are preparing for global deflation and what devastation this could mean across public and private markets. I think it's nice to take the long, long view when it comes to managing pension assets, but I would agree with OMERS and others that are worried about deflation.
Finally, I ask many of you who regularly read me to show your financial support and donate or subscribe to this blog via PayPal at the top right-hand side, right under my bio. I thank the institutions and individuals that have donated and subscribed but I would appreciate a lot more of you to step up to the plate and pay up for the great insights I regularly provide you on pensions and investments. If you take the time to read my comments, please take the time to send me money.
Below, Kyle Bass, Hayman Capital Management, shares his thoughts on the ECB's bond-buying plan and its impact on the euro. Bass thinks euro parity is coming and I agree and warned my readers not to bet against the mighty greenback for now (until the Fed takes a step back).
Interestingly, Bass was featured in Chapter 1 of Steven Drobny's new book, The New House of Money, which has yet to be released. However, you can read Charter 1 by clicking here, and read Bass's take on why he's short Japan and why U.S. pensions are in big trouble (I agree with the latter, not the former).
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