Albert Edwards: Europe Is On The Edge Of A Deflationary Precipice That Will, Paradoxically, Usher In 20-30% Inflation
A few days ago we pointed out that the latest Japanese GDP deflator came at multi-decade lows, this despite years of printing, pumping and other -ings. Today, Albert Edwards takes the observation of rampant regional deflation and concludes precisely what we have long claimed, that once rampant deflation is finally acknowledged by central bankers everywhere, and they are now running out for time, their only natural response to preserve the system will be to do what Japan has been doing for decades (successfully, they will claim) and respond with the most extreme round of monetization ever seen, "inevitably driving us towards out ultimate destination - 1970's style 20-30% inflation." Edwards also has an interesting observation in the aftermath of Tuesday's "no more incumbents" Primary Election results - with the administration now realizing it is losing the economic battle, it will instead focus on keeping some political credibility. To do that, Obama will attempt to focus voter anger abroad. And the resulting trade tensions, particularly with China, will be the catalyst for "shock Chinese yuan devaluation." Needless to say, we wholeheartedly agree with Edwards conclusion that "a global downturn is close." We also do not disagree with his bullish case for gold in the least.
From Soc Gen's Albert Edwards: The US and eurozone now stand on the edge of a deflationary precipice.
Amid all the recent euro-related turbulence, the markets have not focused enough attention on the rapidly vanishing core CPI inflation rates in the US and eurozone. With both moving below 1%, we are now only one cyclical mishap from joining Japan in outright deflation. Given our view that this cyclical recovery will end surprisingly early, slipping into the deflationary mire will trigger further, more extreme rounds of Central Bank monetisation, inevitably drivingus towards our ultimate destination – 1970’s style 20-30% inflation will surely return.
Of all the inflation data released this week, the one that caught the markets? attention was the UK?s dramatically higher than expected 3.7% yoy rise for April. Even the core measure of CPI managed to creep up above the 3% mark. Meanwhile the old RPI, to which most state benefits are indexed, rose a heady 5.3% -? the highest pace since July 1991. While many commentators proceeded to berate the Bank of England for consistently underforecasting inflation in recent years, many also saw the first signs of the quantitatively eased pigeons coming home to roost.
But I would argue that in a year or so, we will see the UK?s relatively high inflation rate as a godsend. For elsewhere, it went almost unnoticed this week that core CPI inflation rates in the US and eurozone continue to slip-slide their way down towards zero (see chart below). Although this is seen as buoying bond prices at the margin, it is a pernicious development that investors will focus on when this cycle starts to fail. Regular readers will know that I believe that in a post-bubble world, recession follows recession with surprising rapidity. We are now only one cyclical failure away from Japanese-style outright deflation in the US and the eurozone at a time when de-leveraging still has years to run (falling prices bring the risk of a classic debt deflation trap). Impending cyclical failure and a deflation scare will trigger new lows in equities as the valuation bear market finally plays itself out with the S&P falling below 500. We therefore maintain our long-standing target of sub-2% US 10y bond yields -? and that is the point when QE will really begin to get serious.
Dylan Grice has shown us clearly over the past few months that governments are insolvent. At some point, as can be seen most vividly along the periphery of the eurozone, the market demands action. And amid renewed zeal for fiscal retrenchment within the new UK government, it is worth repeating one key point ?- namely, premature fiscal retrenchment was one of the key policy errors Japan made in a post-bubble, de-leveraging economy (see GSW 12 Feb, To cut or not to cut? Actually it doesn’t really matter. We’re stuffed anyway! -? link).
I remain persuaded by Richard Koo?s book about the lessons from Japan?s balance sheet recession. The crux of his analysis is that governments have no option but to stimulate aggressively all the while the private sector is de-leveraging. ANY attempt at fiscal cuts simply results in renewed recession and a further loss of confidence, thus making it even harder and more costly to sustain any subsequent recovery ? and hence the budget deficit ends up bigger than before (see chart below). A repeat of Japan?s mistakes is exactly the outcome I expect. Renewed recession awaits and with the eurozone and the US core CPI inflation less than 1%, the icy tentacles of outright deflation are now just within reach. (Attached is a link to an interview by welling@weeden with Mr. Koo. It is well worth a read – link.).
Competitive devaluation is one way to try and wriggle free from the deflationary quicksand.
The UK has clearly embraced this option with gusto and is enjoying the benefits of a relatively high inflation rate. This resembles closely the UK?s experience of the 1930s when it was ejected from the Gold Standard, only to devalue aggressively and so suffer a relatively mild "?depression"? compared to those who remained on gold. The eurozone clearly needs to devalue and the Greek crisis is allowing that much needed adjustment to occur. Competitive devaluation might allow the eurozone overall to escape the deflationary fate of some of its most vulnerable members (see chart below) and export its deflation elsewhere.
But as my old friend Jim Saft pointed out in his Reuters opinion piece yesterday, it won?t just be deflation the eurozone will be exporting but also trade tensions as the dollar rises? - link. Jim makes the very good point that "?the US primary elections on Tuesday showed voter anger is focused on incumbents in general and Washington in specific. It would not be a surprise for the administration to try and focus that anger outside of the country.?" A renewed global downturn with rising trade tensions is exactly the environment that will see the shock Chinese yuan devaluation. I continue to remain of the view that a global downturn is close. Too many are focusing on the buoyant economic data that is entirely consistent with continued strength of the coincident indicators, yet all the while the leading indicators continue to slow (see chart below). Renewed recession will never be forecast until after we are back in one!