News In Charts: The Long March to Deflation?

Volatility has returned to financial markets, just as we warned that it might. Consequently, the big picture asset allocation that we set out three months ago has paid off, with bonds outperforming equities more or less across the board. By region, our short-term underweight euro area assets, and short-term overweight US assets has worked well too. Two of the risks that we have been highlighting for some time may now be crystallizing. China’s inability to halt its slowdown, particularly in the property market, has moved it materially closer to a hard landing; while the euro area has continued its slide towards outright deflation and recession. In our view it is the nagging fear that policy makers in these two economies, which together account for almost a third of global GDP, may already have left it too late that is behind the recent reappraisal of risk pricing.

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If this particular cloud has a silver lining it is that we may at last be moving towards the endgame of the great global debt crisis. China’s long economic march – towards what could yet turn out to be a period of global deflation – began in the late 1990’s. After witnessing the turmoil suffered by the likes of Thailand, Indonesia and South Korea during the Asian Crisis, China’s policy makers resolved never to be beholden to the West. Rather than rely on inflows of foreign capital, which is the textbook approach for a developing economy, China instead pursued growth through a combination of investment and net trade. Between 2001, when China joined the WTO, and 2007, China’s trade surplus soared from just over 1% of GDP to more than 10%. As a result, it is now one of the world largest creditors, second only to Japan. Germany lies in third place. The United States, as the world’s largest debtor, was the first to feel the consequences of the great global debt crisis. But time has moved on, and now it is the creditor nations that are suffering. There could yet be a positive outcome for the global economy – but that depends on decisions taken by those countries that have lent too much.

China in the foothills of a hard landing

Before he became China’s Premier, Li Keqiang announced that he had little faith in China’s GDP figures. He preferred instead to look at electricity consumption, at rail freight volumes and at credit growth. We have used these more timely measures of economic activity to construct what we have called a ‘Li Keqiang momentum index’ for China – and it does not look good. Although data released earlier this week showed growth of 7.3% in the four-quarters to 2014 Q3 – 0.1 percentage points ahead of expectations – we do not take them entirely at face value, particularly when our momentum index, based on things that are far easier to measure, is falling so sharply.

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When assessing the situation in China today, it is worth recalling the sequence of events that led up to the global financial crisis of 2008/09. Through the early 2000’s, a period of exceptionally easy money caused US house prices to reach levels that were unsustainable. Prices peaked in 2006 Q1, before starting to fall sharply. Only in 2008 Q1 did the US enter recession, and only at the end of 2008 Q3 did Lehman’s go bust. In China house prices have now fallen for five months in a row. The economy is undoubtedly slowing, and on some measures it is slowing rapidly. China does not have a banking crisis yet – though it may be close. In our latest Global Economic and Markets Outlook, we give 35% weight to a risk scenario where China’s policy makers have already left it too late. China’s mounting non-performing loan problem, which follows years of over-investment, becomes a crisis. Systemically important banks and non-banks fail. Growth slumps, hitting just 2% next year.

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Financial integration between China and the rest of the world is low. If China does suffer a hard landing, it is trade links that will count. Hardest hit will be the commodity exporters, including Australia and much of sub-Saharan Africa, alongside those who export ICT equipment and other capital goods, such as Malaysia and Germany. But potentially more damaging than the direct hit to global GDP will be the consequences for global inflation. We have already seen significant downward pressure on the prices of commodities, including energy and base metals. In our risk scenario, it does not stop there. Measured in US dollars, the price of US imports from China has risen just 4% in ten years. Measured in renminbi, it has fallen more than 20% over the same period. The own-currency price of China’s exports is on a clear downward trend, reflecting that country’s significant over-investment in productive potential. In our hard landing scenario, that trend will accelerate. Combine that with an end to the dollar peg, and a weaker renminbi, and the disinflationary pressures are profound.

The euro area the has most to lose

The euro area recovery ground to a halt in Q2, with output unchanged across the region as a whole. The core countries, by and large, fared worse than the periphery. Indeed, Germany saw an outright contraction, of 0.2% – and monthly activity data hold out little hope of a bounce back in Q3. Core inflation across the single currency bloc has fallen by a percentage point over the past two and a bit year to 0.7% – the lowest on record. The fall in commodity prices means that the drop in the headline rate has been larger still. On this measure, more than one third of euro area countries are already in outright deflation. A hard landing in China would, in our view, push the region into outright deflation, once again raising the spectre of a total break-up of the single currency bloc.

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The rather large elephant standing awkwardly in the middle of the region’s living room is, of course, Italy. We have written at length about that country’s unpleasant debt dynamics. Even if both growth and the primary balance were to return to their long-run averages, Italian debt would be unsustainable at an inflation rate of 0.6% – the rate currently implied by five-year breakevens. A sustained period of outright deflation in our hard-landing scenario would merely bring matters to a head more quickly.

The ECB, together with politicians across the single currency bloc, is fully aware of the brewing Italian debt crisis. Measures announced to date, such as TLTROs, and the ABS and covered bond purchase programmes, will not be enough to generate the inflation that Italy so sorely needs. That is why we continue to expect a programme of sovereign bond purchases, probably in the early part of next year.

Forecast revisions and asset allocation

In our central scenario, to which we attach a 65% weight, not only do European policymakers do the right thing and begin a programme of sovereign bond purchases just in the nick of time, but China’s authorities finally face up to the dangers facing their economy and pull out all the stops to engineer a soft landing. This involves more fiscal largesse, more over-investment in infrastructure, and more imprudent lending. In this environment, China’s re-balancing, when it eventually comes, will be more painful still. But in the near term, a crisis is averted. Growth still dips below 6% next year.

A sharper slowdown in both China and mainland Europe than had seemed likely three months ago means that we have revised down our central projections for growth and inflation more or less across the board. Risks to these central projections are, of course, firmly to the downside.

In this environment, our allocation by broad asset class is little changed – we remain underweight equities and overweight bonds. By region, we are now underweight euro area equities at three-, six- and twelve-month horizons. We retain our overweight position in US equities.

This research note is provided by Fathom Consulting. All of the charts below and many many more, covering a range of topics and countries on both the macroeconomy and financial markets are available in the Chartbook to Datastream users at www.datastream.com. Alternatively you can access Fathom’s Chartbook at www.fathom-consulting.com/TR.

 
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