Investors are focused on the possible tapering of U.S. stimulus and starting to take some money off the table after a strong equities rally year-to-date. Less attention is being paid to the biggest source of risk at present: deflation in the developed world. All of the past week's data point to heightened deflationary risks. Paltry U.S. consumer price index (CPI) figures, German producer prices undershooting and another bout of weakness in commodity prices, particularly oil, suggest deflation is winning the battle over central bank stimulus. Which is something that Asia Confidential has been forecasting for some time.
It's no coincidence that at the same time, the Japanese yen has reached four month lows versus the U.S. dollar. Japan is printing an enormous amount of money in a bid to end its 20-year affair with deflation. It wants inflation at all costs and the yen is collateral damage. Lowering the yen increases the competitiveness of Japanese exporters, resulting in more cars, robots and flat-panel TVs being shipped abroad. And that means Japan is exporting deflation, and resultant lower prices in these goods, to the rest of the world. Key competitors in China and South Korea are starting to fight back but are being hampered by their strong currencies versus the yen.
There's increasing talk that Europe will resort to more stimulus soon to wade off deflation. The euro has been remarkably strong compared to other currencies, making the region's exporters increasingly un-competitive. Across the Atlantic, Bernanke and co. have been further hinting at QE tapering, but with rising deflation risks, any tapering seems unlikely. If Japan succeeds in weakening the yen further, you can be sure that other countries will start to complain and print money to lower their own currencies. The phrase "currency wars" may come back in vogue soon enough.
What does all this mean for markets? Well, it increases the odds of a further stock market correction before year-end. And a bond rally would seem overdue. But more broadly, it means the tussle between deflation and central bank stimulus should continue. That means more money printing and low interest rates for the foreseeable future. Which could push asset prices higher from already elevated levels, raising the odds of a major correction down the track.
I've spoken of deflation so far, but it's really disinflation (falling inflation) that's occurring. A host of recent data suggests that this remains the primary threat to global economies, including:
1) The U.S. inflation rate fell to 1% annualised in October, the lowest figure in almost 50 years, excluding the 2008 financial crisis. Inflation in America peaked in 2011 and remains way below the Fed's 2% target rate. The chart below is courtesy of Business Insider.
2) U.S. bank loan growth is showing a similar slowdown. Stimulus isn't resulting in increased lending and therefore isn't filtering through to the real economy. There's just not enough end-demand for loans as businesses and consumers remain cautious about taking on debt.
3) The German producer price index (PPI) fell 0.2% month-on-month in October, more than expected. On an annualised basis, the PPI fell 0.7%. It points to slower inflation ahead.
4) The trend of slowing inflation is a Europe-wide issue. No wonder the European Central Bank cited falling inflation as a factor in its decision to cut rates earlier this month.
5) It's not data as such, but softening commodity prices also point to falling inflation. The correction in oil prices is particularly pertinent.
These are just a few of the signs that deflation remains firmly in charge.
Why Japan's largely to blame
Japan is back on the radar of investors given a breakout in its stock market and the yen reaching a four-month low. There's a larger story brewing though. And that's growing evidence that the grand experiment of Abenomics has been a complete and utter failure.
Recent third quarter GDP of 1.9% was half the level of the second quarter. More importantly, personal incomes have barely budged while the cost of living has soared, thanks to the falling yen. This week's trade figures showed imports surging 26% year-on-year (YoY) in October, versus 19% expected, due to soaring fuel imports. This overshadowed exports rising 19% YoY, more than analyst forecasts. Consequently, Japan's trade balance (difference between exports and imports) fell to the third lowest level on record.
Why does this matter? Well, Japan runs a budget deficit of close to 10%. It used to run a major trade surplus, which has now turned into a trade deficit. If you run budget and trade deficits, you need to plug the gap either via private savings or the central bank printing massive amounts of money. The problem with the former is that using private savings to finance the gap means there'll be less savings for private investment, a key growth driver for the economy. This means that you can expect Japan to print increasing amounts of money and for the yen to weaken further.
Besides the yen, the other point of interest will be Japanese government bonds. If Japan accelerates the monetisation of debt (central bank buying bonds to finance government), that'll crowd out private players in the bond market. In fact, this is already happening. The so-called crowding out effect will almost certainly lead to increased volatility as private players are marginalised.
This is important because Japan desperately needs bond yields to stay low. The government's enormous debt load (nearing 245% of GDP) means that just a small increase in bond yields and interest rates would lead to interest expenses on government debt reaching intolerable levels (a 2% rate would have interest expenses covering 80% of government revenues).
As Asia Confidential has highlighted on several occasions, Japan is in a desperate situation where there are no happy endings. There are only bad and worse outcomes. The government has chosen an extraordinary experiment which could well pave the way for the worst outcome to occur.
But this isn't just a Japan issue. Other countries aren't going to sit idly by and watch Japan steal market share due to the softening yen. At some point, they're going to hit back with currency devaluations of their own. And then the real currency wars will begin in earnest. History shows these wars never end well as global trade suffers from the tit-for-tat between countries.
Are bonds set to come back?
Markets have largely ignored deflationary risks thus far. Stocks have surged, with few corrections, while bonds have spluttered. Given stagnant to falling GDP in the developed world and declining inflation, the bond market action has been particularly puzzling. Usually, government bond yields closely correlate with nominal (real plus inflation) GDP. If nominal GDP is falling, then so too should government bond yields.
This is why you should expect government bond yields in the developed world to head lower given the current deflationary threats. And it should also mean stocks have a further correction in the near future.
Short-term market action is always difficult to call though. Long-term trends are easier to distinguish. And on this front, little has changed. You have an ongoing battle between deflation and central bank government efforts to prevent it via QE. Deflation is winning right now, which is why you should expect more QE, not less, going forward.
If that's right, stimulus and low interest rates could be with us for some time yet. Asset prices may be bid up further. And the market bears may have to wait before a more serious correction happens. The catalyst for that is likely to be a loss of faith in central bank stimulus.