(Sept. 21, 2009 - by Erwan Mahe) We are regularly asked by clients if we have (at last) changed our extreme outlook on inflation price indices in G7 nations.
The (hyper) inflation vs deflation debate has lost none of its virulence and, now that the biggest part of the base effect on headline indices from last summer’s commodity price surge is over, the pseudo-Friedmanite camp is finally rearing its collective head in anticipation that the massive liquidity injections carried out by central banks in the past year, along with government stimulus spending, will lead to a prodigious ris in CPIs.
This debate remains a priority in our macroeconomic scenario, since its outcome will have a big impact on the asset allocation process, not just in terms of the fundamental choice between equities and bonds, but also in sector preferences and the so-called peripheral markets (currencies, commodities, real estate, etc.).
We are not overly concerned with the base effect relating to commodities. Not only is this effect easily identifiable, but, its predictability is obviously based on changes in commodity prices, and wise is the man who can predict today what oil or copper will be selling for in 18 months.
While it was fairly easy last summer to predict the sharp correction in oil prices, with the price per barrel totally disconnected from economic reality (collapse of demand), I would not want to bet on prices in the medium term, although I remain convinced that they merit a nice premium given the financiarization of demand (ETF, diversification of pensions funds).
In fact, we continue to believe that the unfolding of the death of securitisation process, triggered by the implosion of the Bear Stearns hedge funds, with its dramatic consequences on the V factor (velocity of money) in the well-known equation M*V=P*Q, and the ensuing debt deflation, to be the most important factor in anticipating future price index behaviour. (My apologies to my long-time readers for the repetition).
This implacable process is characterised by such inertia that I support without the slightest hesitation the strong actions taken by central banks.
As it turns out, the credit situation in the economy continues to deteriorate month after month and statistic after statistic, as illustrated by:
* the contraction in outstanding bank loans;
* the persistent contraction in money supply;
* the regular debt-to-equity swap deals carried out by creditors trying to avoid a hit on their uncollectible loans.
China is obviously the big exception, but I remain convinced that it is perched unsteadily on a rung of the Minsky ladder.
As a case in point, one of the reasons for the fall in Japanese stock prices is the follies of Aiful Corp (-27%), the country’s second largest consumer lending institution, which is seeking to delay payment on part of its Y915bn in debt.
Japan is really the perfect example of deflationary entropy, as illustrated anew by two statistics published this morning:
-Department store sales in Japan in August fell 8.8% y-o-y, following -11.7% in July, the 18th straight month of decline. Just to get a perspective on this contraction, consider that sales in the reporting month totalled Y456.86bn, the largest year-on-year decline for the month of August since 1965 when comparable data became available, while sales for August of 1991 totalled Y627.91bn! Luckily, prices on food items only declined 4.4% (they still need to eat), while home electronics appliance sales “rebounded” 0.2%, owing to the government's "eco-point" program to reward purchases of environmentally friendly consumer appliances, otherwise the total figure would have been even more catastrophic.
-Average nationwide prices of commercial land dropped 5.9% y-o-y while those of resident land fell 4.0% y-o-y, the steepest decline in 5 years, down for the 18th consecutive year!
I invite you to check out the following article on the United States: “Gloomy U.S. holiday shopping seen despite upturn”, which clearly explains how rising unemployment, in the context of restrictive credit markets, is incompatible with growth fuelled by household consumption.
On the anecdote front, here are two events worth noting:
-Lloyds scheme fails FSA stress tests, which tallies with our belief that the Western banking system is not about to pump large amounts on money into the economy any time soon. How ironic that this news comes out just as Barclays decides to relaunch the SIV fashion.
-And Chinese companies (SOEs) caught going the wrong way in their currency and commodity derivative transactions are still threatening to renounce their commitments to Western investment banks. There are billions of dollars at stake here, and I fear that if the threats are carried out, certain firms will have a hard time recovering from the hit.
Should we pay heed to rumours, like that of Medley yesterday afternoon which suggested that two Fed Board members favoured hiking rates faster than expected? It was denied shortly thereafter, but we are still feeling a ripple effect.
Or should we instead listen to the BoE (King, Miles) and the SNB, which argue that short-term rates will remain low for some time to come?
Decide for yourself: You know where I stand.
We remain favourable to fixed interest rate instruments, now with a bias more favourable to the 5-10 year range than to our 2-year champion.
We say the same thing for stock markets. We have considered it prudent to avoid participating in the recent rally, since the risk/profitability ratio does not look all that sexy…
But we prefer waiting until we get to the 2850-2900 range, before suggesting real delta negative hedging strategies.
PS: A taboo question that someone asked me in the wake of the BoE’s statements on the remuneration of bank surpluses: why does the ECB pay required bank reserves at the benchmark rate, that is 1%, when the Eonia is paying between 0.25% and 0.30%?