Outlook 2015: Deflation Remains the Dominant Theme

Below is an excerpt from my last research note entitled "Outlook 2015: Deflation Remains the Dominant Theme"  Happy holidays!  Chris


Outlook 2015: Deflation Remains the Dominant Theme


December 16, 2014

Since the start of the 2008 financial crisis, central banks around the world have been trying to avoid asset price deflation and debt reduction, two necessary components of the economic healing process which must inevitably follow any credit bubble. Now, under pressure from falling commodity prices, the process of deflation seems to be gathering speed. While the Federal Reserve Board and other monetary authorities have targeted a 2% annual inflation rate in their policy formulations, it is pretty clear that as 2014 ends, deflation remains the dominant theme in the global economy for the New Year in 2015.

Because of the deflationary cast to the global economy, Kroll Bond Rating Agency (KBRA) does not expect to see a meaningful increase in U.S. interest rates until at least this time next year regardless of any nearterm change in guidance by the Federal Open Market Committee. The reason: The global economic recovery remains fragile and tentative, with mixed indicators of growth, job creation and the stability of commodity and asset prices.

Even with several months of stronger job numbers, the overall employment situation in the U.S. remains mediocre by historical standards. Meanwhile, slack demand in many key consumer and industrial sectors is pushing down prices for key commodities. The housing sector is also showing signs of weakness. After three years of double-digit gains, for example, Weiss Residential Research reports that a growing number of residential homes in the U.S. are starting to decline in price.

Last week, the major U.S. equity indexes gave up substantial ground because of growing investor concerns about the outlook for the global economy. Some observers believe that the prospect for higher interest rates was behind equity market weakness. Brian Wesbury, of First Trust Advisors, notes: “At first, good November jobs data was good for stocks. Then, good news became bad when investors started to worry about Federal Reserve interest rate hikes.”

One key indicator of deflation that seems to be even more worrisome to investors, however, is global commodity prices and what commodity price weakness suggests for demand. Copper fell over 12% in 2014, largely due to slumping demand in China and other industrial economies. Natural gas prices have fallen more than 12% this year. And oil prices have fallen by over 40% due to a glut of new supply and weak demand growth in many developing economies. The International Energy Agency has cut its estimates for demand for crude five times in the past six months, The Wall Street Journal reports.

The negative impact on incomes due to the decline in oil prices is a global issue, with nations such as Russia, Nigeria and Venezuela in visible financial distress. The price of the Russian ruble has declined in tandem with oil prices, raising concerns about whether Russia will be able to service its hard currency debt. But the decline in oil prices is more than just a supply phenomenon. The lack of growth in the demand for oil, coupled with rising supplies in the U.S. and elsewhere, has raised concerns about the overall health of the global economy.

We believe that the weakness in U.S. equity and debt markets stems from a more fundamental problem than concerns about future growth, namely that investors are once again starting to seriously question the disclosure from the largest banks and investment houses regarding their credit exposure to highly leveraged borrowers. This concern is evidenced by weakness in the equity market valuations of lenders with exposure to the oil sector as well as the recent changes in the relative position of spreads in the U.S.bond markets.

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