Deflation or inflation? That has been a question many have debated, but it appears that deflation has been the problem. Despite massive Government spending and Fed activity, inflation has been tamed (at least measured by CPI). Many of the hyper inflationists happen to be big bears. However, one big bear is much more fearful of deflation, and not just deflation but really bad deflation. Albert Edwards who warned us of Japanese policy leading to another Asian crisis, now has a new report today in which he states ‘ the latest inflation data out of both the US and eurozone should ram home the fact that we are now only one short recession away from Japanese-style outright deflation.’ The full (short) report from the SocGen analyst along with nice little charts can be found below:
Ice Age data shows US and eurozone sliding towards Japanese-style deflation
Over the last 15 years most investors have refused to contemplate that events in the West are playing out in a similar fashion to Japan in the 1990s. But the latest inflation data out of both the US and eurozone should ram home the fact that we are now only one short recession away from Japanese-style outright deflation. Similarly, investors refuse to believe that equities can fall in an environment of rampant QE. They are wrong.
Recent real economy data has been weak, most especially the regional PMIs in the US. But investors may have missed the slip-slide towards outright deflation, highlighted by the latest data out of the US and eurozone. For not only has headline inflation in both regions slowed to around 1% yoy, but the underlying consumer inflation rate (excluding food & energy) has also slowed to 1% in the eurozone and 1.1% in the US (using the Fed?s favoured personal consumer expenditure (PCE) deflator rather than CPI ? see chart below).
We remain overweight government bonds on a short-term cyclical view that the US economy remains close to recession. And with core inflation of only 1% we are only one short recession away from outright deflation. Hence we see US 10y yields converging to Japanese-style sub-1% levels. This event will of course generate extreme central bank QE hyperactivity and despite our short-term cyclical bullishness (retaining a maximum overweight bond position), we remain of the view that on a 3-5 year time horizon bonds will prove to be a toxic investment and rapid inflation is the likely longer term outcome.
With the backdrop of virtually unlimited QE, we still meet almost no-one who thinks equities are at risk of a substantial decline, even if the US economy slides into recession. The intoxicating potency of QE has drugged investors into believing they must participate in this liquidity fuelled frenzy. I repeat my thoughts of 2007 when I reminded investors that this liquidity argument is merely “Lies, rhubarb, poppycock, bilge and utter nonsense”. Then, as now, ?Dr Copper? is leading the way downward. The unfolding recession accompanied by full-blown deflation will result in a loss of investor confidence that central banks are able to prevent a Japanese-style deflationary event. The equity market will riot, Japan-style.
Although a US consumer price index (CPI) release gets the attention of the financial markets, the Fed?s preferred measure of inflation is the personal consumption expenditure (PCE) deflator. March?s data was released last Friday and showed that the recent sharp slowdown of core PCE continued apace in March to 1.1% yoy from 1.3% in February. If, core CPI begins to track the core PCE downwards, as is usually the case, this will attract far more attention from the investor community and lead to a strong reaction in the bond market.
US core consumer price measures tend to move together (yoy%)
Doug Short of Advisor Perspectives points out that ?2% had generally been understood to be the Fed’s target for core PCE inflation. However, the December 12 FOMC meeting raised the inflation ceiling to 2.5% for the next year or two while their accommodative measures (low FFR and quantitative easing) are in place.? (Doug and friends now have one of my must-read blogs and I thoroughly recommend it ? link).
With inflation now massively undershooting the Fed?s own 2-2½% target range there is nothing to stop the Fed keeping their foot pressed down hard on the gas pedal. Indeed Jon Hilsenrath, the Fed deep-throat at the WSJ, reports that many Fed governors are more worried about inflation being too low than any future rise on the back of their QE ? link.
The rapid fall in core PCE inflation comes despite a recent sharp rise in unit labour costs, which most economists see as the primary driver of inflation. Indeed I wrote last month that I thought that this would exert a temporary, late-cycle upward pressure on core inflation. I was wrong. Clearly underlying deflationary pressures seem to be more entrenched than even I had thought. The bottom line is that with unit labour costs rising above rapidly falling core inflation, corporate profit margins will have begun to be squeezed far harder than many expect.
US unit labour cost inflation has risen above core PCE, squeezing corporate margins
We have long believed that the post-bubble economic outturn would closely resemble what we saw in Japan. Indeed since the peak of inflation in the early 1980s, each cycle has seen inflation progressively squeezed out of the system and nominal cyclical variables registering lower lows in the downturn and then lower highs in the recovery. Since the bubble burst the trend towards lower nominal quantities has continued despite massive QE. US nominal GDP growth may have peaked out in this recovery at an unprecedentedly low 4% yoy (chart below).
US nominal GDP and wage bill show a series of lower highs and lower lows (yoy% 6mmav)
The trend towards low nominal quantities is an essential plank to our Ice Age thesis. The equity bulls, using the Fed valuation model (bond/equity earnings yield ratio), see lower inflation and bond yields pushing PEs higher. But in the Ice Age we said that this would be more than offset by lower long-term profit expectations (profits and nominal GDP rise in line in the medium term), and the equity risk premium would rise as the economic and profits cycle became more volatile in a world of very low inflation. In the Ice Age, equity PEs contract despite falling bond yields. This was a maverick view back in the late 1990s.
Another maverick view we had back in 2007 is also very relevant today. Back in 2007 investors were convinced that markets would remain buoyant because there was ample liquidity. In a note back then we said that this was a false crutch for investors and that the liquidity would vanish from the markets if price momentum took a turn for the worse. I have exactly the same view now. In the same way that QE seems, in large part, to be bypassing the real economy, liquidity will evaporate from equities if we dive into a deflationary recession. Where will all the liquidity then go as QE is ramped up still further? It will go into ridiculously expensive bonds. Copper is acting exactly as it did when I wrote about the impotence of liquidity in the face of the (then imminent) 2007 recession. Once again it is giving us an early warning that liquidity will not save risk assets: time to get out of equities.
‘Dr Copper ’ telling us that the party’s over – Don’t be the last to leave
