Is The Reflation Trade Doomed?

Sayuri Shirai, professor of economics at Keio University, a former BOJ board member and the author of “Mission Incomplete: Reflating Japan’s Economy,” wrote a comment for the Japan Times, The truth about deflation:

Japan has been known globally as an economy struggling to overcome long-standing deflation and deflationary mindsets since the late 1990s. Major central banks have attributed Japan’s deflation to insufficient monetary easing. To avoid the same problem and reduce the risk of deflation, the Federal Reserve promptly and without hesitation adopted unconventional monetary easing measures in the wake of the global financial crisis. The Bank of Japan followed suit in April 2013 when it adopted quantitative and qualitative monetary easing (QQE) under new Gov. Haruhiko Kuroda.

The main measures under QQE were purchases of various assets. The BOJ further experimented a negative interest rate and yield curve control. These measures were expected to raise aggregate demand and accelerate inflation through a decline in long-term interest rates with a commitment to achieving a 2 percent inflation target. Stock prices and the yen’s depreciation were also expected through a portfolio rebalancing effect and interest rate differentials.

Four years later, overvaluation of the yen and undervaluation of stock prices have been corrected. But, the impact on the real economy has not been as strong as initially expected. Compared with the first quarter of 2013, households’ current real consumption dropped a little. Business investment remains well below cash flows due to stagnant sales despite historically high profits levels. Underlying inflation remains at around zero percent, a reflection of unimpressive aggregate demand. In 2017, inflation is expected to rise mainly due to the weakened impact of the oil cost drop on prices, but it is widely expected that the BOJ is unlikely to achieve inflation of around 2 percent stably anytime soon.

Why is it taking so long for the BOJ to achieve 2 percent stably? A well-known structural factor is unfavorable demographics and associated low potential economic growth. Another important, but less known factor is the public’s lack of understanding of the 2 percent target and strong resistances against price hikes due to upward bias in perceived inflation and inflation expectations. The BOJ’s opinion survey consistently reported that 60 to 70 percent of respondents indicated they had either never heard of the target or they had heard about it but do not know much about it. Contrary to generally held beliefs, moreover, households’ mind-sets are not deflationary since their perceived inflation and long-term inflation expectations are always positive and far exceed the rate of change in the consumer price index even in a deflationary phase. Such upward bias has hardly changed even since the advent of QQE. Naturally, the majority of those who reportedly felt a price rise have constantly viewed such prices as unfavorable.

The situation is quite different in the United Kingdom, where a similar survey is available. The Bank of England survey reveals that around 40 to 50 percent of respondents have for years consistently indicated that the “2 percent target is about right.” Combining this with “2 percent target is too low” responses, the ratio rises to around 60 percent. Clearly, U.K. households are more aware of the 2 percent inflation target and feel it’s reasonable. This suggests that U.K. inflation expectations are largely anchored to the 2 percent target. Upward bias in price perception and inflation expectations is also much lower in the U.K. than in Japan.

Why are households’ price and inflation expectations so high in Japan? They are a reflection of long-standing stagnant income growth and anticipated tighter household budgets. Households are very sensitive to food price hikes and often reduce their overall real spending when food prices rise sharply. The survey also reveals that since 2013, households’ tendency to increase (nominal) spending compared with the previous year has risen due to increased costs of consumer goods and services — not because of an increase in income or an increase in expected future income. Regarding the spending over the next year, by contrast, households were always planning to reduce total (nominal) spending even in a deflationary phase — rather than postponing their spending — because of higher expected general prices. In these circumstances, firms find it difficult to raise their sales prices continuously.

Firms reveal deflation-oriented mindsets in their cautious price-setting behavior, but this mindset cannot be seen in households’ behavior. Sudden higher prices generated by the yen’s depreciation and the consumption tax hike meant firms could not avoid raising sales prices in 2013-2015. Some of them managed to raise sales prices by providing higher value-added goods and services without a decline in real consumption. But many firms continue to make substantial efforts to contain price hikes. This behavior is consistent with the BOJ’s firm-level survey, in which about 70 percent of respondents have constantly chosen the “around zero percent” response on their planned sales price increases in the year ahead. Together with the “don’t know” response, the ratio has typically exceeded 80 percent.

These stories tell us that the truth about Japan’s deflation is far more complex than generally held beliefs, which typically attribute it to temporary insufficient aggregate demand. In fact, Japan’s deflation is more structural than cyclical. Without correcting households’ upward bias and increasing their tolerance of price rises, achieving 2 percent inflation stably seems a distant prospect.

Looking ahead, sustainable high corporate profits in conjunction with labor shortages may help improve households’ actual income and income outlook, and thus their tolerance of price rises, thereby helping to correct households’ upward bias. But more importantly, the government must tackle social security system reforms given the public’s concerns about life in retirement and the financial sustainability of national pensions. The lack of trust is reflected in the high non-payment ratio of premiums (over 30 percent) for many years — especially among the younger generation.

It may be time for the government to realize that simple prescriptions that combine monetary and fiscal expansionary policies will not cure Japan’s deep-rooted economic problems.

It's been a long time since I last covered what I believe is the most important topic, the ongoing, relentless trend of global deflation.

Economists will love professor Shirai's insights into Japan's deflationary trap. I certainly do and think he raises many important issues in his comment.

For me, this was the most important passage:

But more importantly, the government must tackle social security system reforms given the public’s concerns about life in retirement and the financial sustainability of national pensions. The lack of trust is reflected in the high non-payment ratio of premiums (over 30 percent) for many years — especially among the younger generation.

Why? Because when you mix an ageing population with retirement angst, it simply doesn't bode well for aggregate demand.

Recall the six structural factors that I continuously refer to when discussing global deflation which I brought up most recently in my comment on Buffett being baffled by 30-year bonds:

• The global jobs crisis: Jobs are vanishing all around the world at an alarming rate. Worse still, full-time jobs with good wages and benefits are being replaced with part-time jobs with low wages and no benefits.

• Demographics: The ageing of the population isn't pro-growth. As people get older, they live on a fixed income, consume less, and are generally more careful with their meager savings. The fact that the unemployment rate is soaring for younger workers just adds more fuel to the fire. Without a decent job, young people cannot afford to get married, buy a house and have children.
• The global pension crisis: A common theme of this blog is how pension poverty is wreaking havoc on our economy. It's not just the demographic shift, as people retire with little or no savings, they consume less, governments collect less sales taxes and they pay out more in social welfare costs. This is why I'm such a stickler for enhanced CPP and Social Security, a universal pension which covers everyone (provided governments get the governance and risk-sharing right).
• Rising inequality: Rising inequality is threatening the global recovery. As Warren Buffett once noted, the marginal utility of an extra billion to the ultra wealthy isn't as useful as it can be to millions of others struggling under crushing poverty. But while Buffett and Gates talk up "The Giving Pledge", the truth is philanthropy won't make a dent in the trend of rising inequality which is extremely deflationary because it concentrates wealth in the hands of a few and does nothing to stimulate widespread consumption.
• High and unsustainable debt in the developed world: Government and household debt levels are high and unsustainable in many developed nations. This too constrains government and personal spending and is very deflationary.
• Technology: Everyone loves shopping on-line to hunt for bargains. Technology is great in terms of keeping productivity high and prices low, but viewed over a very long period, great shifts in technology are disinflationary and some say deflationary (think Amazon, Uber, etc.).

These factors are the reason why I told my readers after Trump was elected and yields rose that nothing trumps the bond market and why at the beginning of the year I dismissed the notion that it's the beginning of the end for bonds.

Earlier this week, I wrote on a comment on CPPIB sounding the alarm where I went over some of my market thoughts, stating this:

[..] I always warn my readers that "markets can stay irrational longer than you can stay solvent," which is a quote often attributed to Keynes but it comes from Gary Shilling.

In my opinion, there is still a lot of juice in the system to drive risk assets higher but I have warned my readers that the Trump rally won't go on forever, regardless of the proposed tax cuts and plans to revamp US infrastructure.

This is why I've been telling people to ignore the reflation chimera and bond bears that are getting slaughtered and keep buying the dips on US long bonds (TLT) to sleep well at night because if we get any negative surprises in the second half of the year, long bonds will rally a lot further (click on image):

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Again, given my views on the reflation chimera and a potential US dollar crisis despite the recent selloff, I would be actively shorting emerging markets (EEM), Chinese (FXI), Industrials (XLI), Metal & Mining (XME), Energy (XLE) and Financial (XLF) shares.

The only sector I like and trade now, and it's very volatile, is biotech (XBI) but technology (XLK) is also doing well, for now. As I stated above, if you want to sleep well, buy US long bonds (TLT) and thank me later this year.

I foresee very choppy markets in Q2 but the risks of a reversal are high, so be prepared for a downturn. Of course, if we have a melt-up like 1999-2000, stocks are heading higher, but the risks of a bigger downturn down the road will be magnified (who knows, we shall see).

It's been a rocky week in markets, we are entering a new quarter, geopolitical tensions are high and some big funds are undoubtedly de-risking and taking profits but it's still too early to tell whether there is an important Risk-Off shift developing.

I still maintain that the best risk-reward trade is to buy US long bonds (TLT) because there are still plenty of speculators buying the reflation trade hype and shorting US Treasuries, completely misunderstanding what is going on in the world.

In another comment this week, I defended a bigger CPP yet again and touched upon the ongoing retirement crisis in the US, UK, and Canada:

[last] weekend, John Mauldin posted a great comment, Angst in America, Part 3: Retiring Broke, which is a must read for all of you. In the UK, one in five Brits have no pension savings and face retirement poverty. The situation in Canada isn't any better where nearly half of working-age Canadians are not saving for retirement, which is why enhancing the CPP is so critically important.

Sure, we can discuss whether a 3.55% actuarial real rate of return target is realistic over the next 75 years, or whether we need to introduce more risk-sharing in a "fully funded" Canada Pension Plan so if there is a persistent shortfall, benefits need to be cut or contributions raised, but it's too early to worry about these issues and they certainly shouldn't be used as an excuse to question the expansion of the CPP, which is good pension and economic policy, period.

We have the best defined-benefit pension plans in world in Canada. Instead of acknowledging this and building on their success, some think tanks are criticizing them and question their long-term sustainability without highlighting their success or the abject failure of the private sector's solutions to our ongoing retirement crisis.

Professor Shirai discusses the need to bolster Japan's social security system but I think it's pretty much a given that every major developed country faces similar problems.

Obviously, America's crumbling pension future worries me and I openly wonder whether collapsing US pensions will fuel another crisis, one that will have a profound impact on markets and the global economy.

This is why I don't agree with those who think the reflation trade isn't dead and do agree with those who think it's dead or are at least souring on it recognizing that price pressures have peaked.

In Europe, the Telegraph's Ambrose Evans-Pritchard reports, Deflation danger over for European Central Bank but fresh debt drama looms:

The European Central Bank has declared victory over deflation in a watershed shift in policy, clearing the way for an end to negative rates and emergency bond purchases after years of deep economic malaise.

Triple tail-winds from QE, a cheap euro, and the end of fiscal austerity have all combined with powerful effect, at last lifting the economy out of a low-growth trap, or ‘Lost Decade’ as some economists describe it.

A blizzard of new figures paint a picture of accelerating growth across the region, with with unemployment falling to an eight-year low of 9.5pc - though it is still twice the level of the Anglo-Saxon and non-euro Nordic states. The eurozone’s jobless rolls have dropped by 1.24 million over the last year.

The comments are significant since Mr Praet has long been viewed as an arch-dove on the ECB’s executive council. Analysts at Citigroup say that German-led hawks in Frankfurt appear to be gaining the upper hand in their fight against quantitative easing (QE), raising the risk of a tightening signal over the next two policy meetings.

Mr Praet said last year’s blast of stimulus by G20 authorities in response to the Chinese currency panic had averted a worldwide downturn and was now feeding through into full-blown recovery. “This coordinated reaction was very effective,” he told the Spanish newspaper Expansion.

What is not yet clear is whether the eurozone is entering a virtuous circle - driven by rising investment - or whether the current cyclical recovery is largely a sugar rush that will fade as stimulus is withdrawn.

To the extent that reflation and recovery gather force, they create a whole new set of risks for the eurozone since nobody knows what will happen to Italy, Portugal, and other high-debt states when the ECB stops buying their sovereign bonds.

The ECB is to cut its monthly bond purchases from €80bn to €60bn this April, a move seen as “tapering” by investors. David Owen from Jefferies said the ECB is already buying $160m less of Italian debt every day as a result.

Markets are afraid that the governing council could sketch out a hawkish timetable for monetary tightening at any meeting over coming months.

Athanasios Vamvakidis from Bank of America said the ECB will have to act as a reflation gathers force, and as it does this will rip away the protective shield for the weakest states.

“ECB support cannot last long and a number of indicators raise red flags to us in relation to the periphery’s vulnerabilities in the years after QE. It is a matter of time when markets will start questioning the sustainability of the eurozone again,” he said.

The tensions are already evident in bond auctions. The yield spread on Italian 10-year debt over German Bunds has doubled to 203 basis points since early last year, a foretaste of what could happen once the country faces the chilly reality of the markets again.

A report by Mediobanca said the ECB covered Italy’s entire budget deficit last year and financed the roll-over of existing bonds. "Tapering will leave the Italy without the key buyer of its debt. The debate regarding a unilateral exit from the eurozone and a return to the lira looks likely to gain momentum,” it said.

Bank of America said the public debt ratios of Italy, Spain, Portugal, Cyprus, and Greece, are all higher than they were at the onset of the debt crisis in 2012. Their central banks today also owe more to the ECB through the internal Target2 payments system than they did at the worst moments of that episode. “Our economists our particularly concerned about Italy,” it said.

The bank said there is still yawning gap in competitiveness between Germany and southern Europe. The periphery has clawed back some ground through internal devaluations but these gains have gone into reverse since 2015. Above all, Germany’s exchange rate remains 15pc undervalued, yet the country refuses to take any serious steps to narrow the gap by stimulating internal demand.

As ever, the root problem is the unfinished structure of EMU. The currency still lacks a fiscal union, eurobonds, and counter-cyclical transfers needed to make it viable over time.

A group of leading economists and thinkers for the Jacques Delors Institute warned in a seminal report last year that EMU states will have to accept a supra-national system with a pooling of debts - anathema to the creditor bloc of Germany, Finland, Holland and Austria.

“At some point in the future, Europe will be hit by a new economic crisis. We do not know whether this will be in six weeks, six months or six years. But in its current set-up the euro is unlikely to survive that coming crisis,” they said.

The markets are for now focusing on the risk of reflation and the end of ECB tapering, almost as if recovery were an established fact. There could be a major upset in the opposite direction if global growth proves weaker than assumed - as some monetarists fear. Core inflation in the eurozone actually fell from 0.9pc to 0.7pc in March, lower than where it was a year ago.

“The ECB has to talk up the recovery but they know they still have a serious problem,” said Mr Owen from Jefferies. “They are not able to generate higher core inflation and they can’t do that on their own without help from fiscal policy. So what happens when the next downturn hits?” he said.

The Bank of Japan learned the hard way from a series of false dawns that deflation is extremely hard to defeat once it becomes lodged in the system. Every time it tried to tighten, it was soon forced to retreat. Japan is now on its ninth and biggest iteration of QE.

The bottom line is Europe is still a structural mess and I wouldn't worry about reflation there, structural deflation is still the main threat in that continent. Too many economists and strategists are confusing a cyclical upswing due to currency devaluation with a structural one that can only happen through rising wages and rising aggregate demand.

Last but not least, there is China where last summer people were claiming the end of deflation will be felt all over the world. That was a premature call because while China's economy is holding steady, wobbly signs are emerging as the momentum, fueled by government-directed spending and low-cost funding, is proving tough to sustain.

China has all sorts of structural problems, including a demographic problem. Wu Ruibing and Li Rongde of Caixin report, Expert Doubts Incentives Would Boost China’s Birth Rate:

Proposed incentives for couples to have a second baby—including tax breaks and extra maternity leave—won’t lead to a significant spike in China’s birth rate, a renowned demographer said.

Liang Zhongtang’s comments come amid growing concerns about the nation’s aging population, and government discussions on correcting the problem.

Enticements were proposed in Beijing this month at the National People’s Congress and a coinciding gathering of top government advisers as a way to ease the financial burden for couples who decide to have a second child.

But Liang said he doubts that incentives will be enough to prompt couples to have a second child because young Chinese women are inclined to have only one child—or none at all.

Liang, a longtime critic of China’s family planning policies, is calling on the government to let couples have more than two children or simply remove itself from family planning entirely. If the subsidies don’t work, “why can’t the government just scratch the family planning policy altogether, as we want to see more babies born in China?” he said.

Liang, a Shanghai Academy of Social Sciences professor, is a former member of a consulting body to the National Health and Family Planning Commission.

China eased its decades-long limit of one child per couple in 2014, when it allowed couples to have a second child even if only one of the parents was an only child. Previously, both parents had to be only children to be allowed to have a second child. Last year, the government began allowing all couples to have two children.

The number of births rose by 1.31 million to 18.76 million in 2016, or about 8 percent over the previous year. Of all of the births, about 45 percent, or 8 million, were the second child of a couple, according to the commission.

The National Health Commission predicts that the number of new births is expected to be 17 million to 20 million each year over the next five years.

The number of children each woman has in her prime childbearing years, defined as 15 to 49 years old, will rise from the current level of 1.4 to 1.6 to about 1.8, according to a study by Liang Jiangzhang, a demographics commentator, and Huang Wenzheng, a Johns Hopkins University demographics researcher.

That level is still below the international level of 2.1 children for each woman in the childbearing-age range needed to sustain a country’s population of 1.4 billion, according to the two demographers.

The increase in the birth rate in China is largely due to a rush of women deciding to have a second baby before they are too old to give birth, Liang Zhongtang said.

The increase in the average number of children women have will level off in the coming year and will not help avert the aging population, he said.

As of the end of 2015, more than 16 percent of China’s population was 60 or older, while 10.5 percent was older than 65, according to official statistics.

What's that old saying, demographics is destiny? No wonder the Chinese have enlisted the help of CPPIB to help them fix their state pension system.

Anyway, I just gave you a brief global macro overview of why I think the reflation trade is overhyped and why we are headed toward an era of low growth, low inflation and possibly deflation for a long time. It goes without saying that we all need to prepare for lower returns ahead.

What about the big, bad bond bears? Just do what I do, ignore them.

Below, Bloomberg reports US payroll gains slowed in March while the jobless rate unexpectedly dropped to the lowest in almost a decade, suggesting the labor market is returning to a more sustainable pace of progress.

Clearly US employment growth is slowing and as leading indicators start rolling over, job growth will further decelerate. This is why the Trump administration desperately wants to pass tax reforms and its fiscal stimulus plan to invest in America's infrastructure.

Unfortunately, there is so much gridlock in Washington that I doubt they can pass anything in a bipartisan fashion, and even if they do, it won't make a huge difference. The US economy is rolling over as global deflation picks up steam. In this environment, stay long bonds, the reflation trade is doomed.