One Recession Away ‘from Japanese-style outright deflation’: SocGen

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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.

inflation vs deflation Eurozone and US Chart

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.?

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