Make no mistake, warns SocGen's Albert Edwards, this is the start of something big, something ugly. For while the west has been heaving a sigh of relief over the past few months that deflation pressures have abated somewhat – especially at the core level – we have been emphasising that deflation has only been intensifying in Asia and that like any puss-filled boil, this deflationary pressure would soon need to be lanced...
We have long believed that we are only one misstep from outright deflation in the west with core inflation in both the US and eurozone at just 1%. We expect the acceleration of EM devaluations to send waves of deflation to the west to overwhelm already struggling corporate profitability and take us back into outright recession. As investors realise yet another recession beckons, without any normalisation of either interest rates or fiscal imbalances in this cycle, expect a financial market rout every bit as large as 2008.
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Aside from the relentlessly weak economic and inflation data out of China in recent months (notwithstanding the surge in pork prices), the one thing that has changed dramatically over the last 18 months is China’s huge swing into a Balance of Payments deficit. This has exerted chronic downward pressure on the renminbi, forcing the Peoples Bank of China (PBoC) to start selling its vast foreign exchange reserves to prop up the beleaguered currency (FX reserves have slid $300bn over the last four quarters). Now, though it was only a little over two months ago the IMF declared the renminbi to be no longer undervalued, many of us felt the situation had gone far beyond that stage and that indeed, the currency was substantially overvalued, especially with the rest of Asia devaluing alongside the Japanese yen. The most shocking illustration of China’s loss of competitiveness in recent years is the 50% surge in its Real Effective Exchange Rate (REER) against the US (see chart below).
In some ways the question is not whether the renminbi is competitive or uncompetitive. The problem is that the renminbi is unambiguously less competitive than it was. This comes at a time when the Chinese economy is struggling and the stock market bubble is bursting. We have always said renminbi devaluation would not be a preferred policy lever, but it was one that would be yanked vigorously if needed – viz FX intervention to stop the renminbi falling is effectively a monetary tightening, the last thing China needs at present! Many had felt it would continue to keep the renminbi stable while the IMF was still deliberating whether to admit the renminbi into the IMF’s basket of reserve currencies (SDR). But the IMF’s announcement last week to defer a decision until the autumn of 2016 may well have been sufficient reason for the PBoC to stand aside from FX intervention and bow to the inevitable.
The key thing here is that Tuesday’s devaluation is not just a one-off – you will see persistent weakness from hereon in. For although the PBoC said the move was a one-time adjustment to reflect changes in the way it calculates the daily fix, it also said that the price would be set “in conjunction with demand and supply conditions in the foreign exchange market and exchange rate movements of the major currencies”. To all but the most PollyAnna’ish of observers that means this is the start of a major renminbi devaluation because of the massive downward market pressure the currency is under via the BoP deficit.
This move will transform perceptions about the resilience of the US economy. The recent strength of the trade-weighted US dollar has already contributed to deflation being imported into the US (see right-hand chart above), at a time when core consumer price inflation is already too low. Up until now Japanese yen devaluation has been the main driver of falling US import prices (see top right-hand chart above). Another way to view this is to look at the level of US import prices from various countries/regions since the start of this recovery (see chart below). Despite much talk of Japanese exporters maintaining dollar prices to expand margins and profits, dollar import prices have definitely slumped and China is about to catch up with Japan! For although the renminbi Is not actually included in the trade-weighted DXY calculation, the Fed estimate China’s importance to be 21% of their own broad tradeweighted dollar index - a steep rise from only 15% a decade ago. Japan by contrast currently accounts for 7% of the index, but it has been yen devaluation that has helped heap pressure on China to devalue. Watch that dark blue line below closely.
Many observers, such as myself, believe the US dollar has now entered a secular bull market irrespective whether the Fed raises interest rates in September or not. But in any case, with an ongoing renminbi (read EM …) currency devaluation now underway, the US will import even more of the world’s unwanted deflation. We see this as the end-game in this cycle. With US profits already falling (sharply in the case of whole economy profits), the cycle is already very vulnerable indeed, as it is the business investment component of GDP that causes recessions.
While investors have already talked about the eurozone looking similar to Japan, a deflationary recession also beckons for the US. Core inflation on the Fed’s preferred measure (core PCE) is hovering around the 1% level and a new round of in the currency war will see a move in core inflation below zero to accompany the headline rate.
Prepare for sub-1% 10y Treasury yields and another financial crisis as policy impotence is soon revealed to all.