Given the background noise that is always present within financial markets, and which can from time to time confuse even the most seasoned of investors, every so often it can be useful to consider longer term – and relatively simple - charts in order to regain some form of perspective. In this vein, we have constructed the following chart which simply shows the level of core goods prices within the US economy over the last 65 years. The data clearly illustrates the immediate post war stability in prices; the progressive descent into the high inflation of the 1970s; the great moderation in inflation that occurred over the 1980s. Finally, the chart also shows all too clearly the deflation that has dogged goods prices since the mid-1990s.
Crucially, we believe that the latter has been at least as significant to the behaviour of financial markets as was the rise in inflation in the 1970s; while higher inflation eroded the valuations of financial assets (bonds and equities), the recent period of goods price deflation created the ‘myth’ of Goldilocks and has clearly helped to inflate financial market valuations by fostering the ultra-low interest rate environment that the world has witnessed for almost two decades now.
USA: CPI Durable Goods Index
From a practical perspective, inflation trends within the domestic service sectors of most countries tend to move along quite predictable and smooth cyclical paths and as such tend to produce very few significant surprises for either markets or policymakers. Instead, we find that it has been trends in goods prices that have been both the more volatile and crucially they are much more likely to be affected by global events. Indeed, a number of authors and historians over the years have noted that periods of ‘instability’ within goods prices (particularly to the downside / deflation) have tended to be correlated with changes within the ‘world order’.
Of course, the rise in influence of the OPEC cartel was of course a contributory factor to the inflation of the 1970s (although some would suggest that the political problems in the USA and the breakdown of the Breton Woods system were more important factors) but more often than not it seems that the emergence of a new economic power tends to have deflationary consequences for the global economy.
As such, the long decline that has occurred within goods prices since the mid-1990s (which bears comparison to the experiences of the 1920s, a period during which the US emerged as a manufacturing power on the back of a surge in price-level-reducing productivity) and the mid Nineteenth Century (the UK’s ascendency) would seem to fit with the widely accepted – although still unproven - assertion that the late Twentieth Century would see Asia / China’s emergence as a global super power.
We would, however, suggest that where this history-based theory might be in need of some modification is that, unlike the previous examples, the presumed emerging power on this occasion has not hitherto been a profit maximising entity.
As we have recounted many times before, we are firmly of the view that the outright deflation in goods prices that has occurred since 1994 is the result of the emergence of the non-profit maximizing Chinese economy into the global system. Although it is now a matter of conventional wisdom to date the beginning of the Asian Economic Crisis as being the Spring of 1997, when Thailand first began to wobble and then devalued the THB, in reality the Asian Crisis probably had its true genesis during early 1994 when the Chinese authorities were obliged to devalue the RMB by almost a third (whilst in the midst of their own domestic inflation and banking crises).
Almost certainly, it was China’s devaluation that resulted in the 1994 global inflation scare proving to be so short-lived and, once the rest of Asia had followed China’s lead over 1997-98, deflation became – and has so far remained - a major worry for central banks.
What we find both interesting and immensely significant is that, although the Asian Crisis was at its heart a banking system crisis (or more particularly a bank funding crisis) that was ultimately reflected in sharp falls in the currencies, it is nevertheless a matter of record that, as a region, the countries of Asia have continued to ‘pile on’ debt since the 1994-1997 Crisis. Just as the Global Financial Crisis in 2007 had been expected to wean the West from its credit addiction (but of course it didn’t) the Asian Crisis was supposed to create an unwinding of the Asian debt financed / non-profit-maximising / production volume maximizing model. Of course, this plainly has not been the result and instead we find that the Asian economies have continued to raise their debt to income ratios - usually with the tacit approval and practical assistance of Western investors and bankers.
Although a significant part of this debt has been used to fund property speculation and the like, much of the increase in credit has been required simply to bridge the gap between the amount that companies were spending and what they were earning.
NICs + PRC Domestic Credit % GDP
Particularly in the case of China, corporate expenditure has systematically been inflated by the elevated levels of CAPEX that were necessary to achieve full employment but at the same time corporate sales revenues were depressed by the need to offer low selling prices so that the output of all of this capacity could be disposed of abroad. Clearly, corporate behaviour did not change following the Crisis of the 1990s and instead companies in the Asian Region have simply become ever-more indebted over the last 20 years - and it has not only been China’s credit system that propelled this increase in leverage: all of the Asian Region has until recently at least witnessed a similar dynamic at work.
Crucially, we would however argue that, over recent months, Asia’s banks have finally become much less able to support this perpetually rising leverage process. For example, we firmly believe that it has been a funding problem that has caused China’s rate of credit growth to slow so sharply over the last six months while in Korea the country’s banks appear capital constrained and their share price relative continues to languish. In both Hong Kong and Taiwan, we also find that the banks’ share price relatives and hence their abilities to raise capital are languishing at levels that have not been witnessed outside of crises periods, while in Singapore credit trends remain relatively subdued by that economy’s standards.
Consequently, we fear that the region’s banks can no longer finance the Post War Asian corporate business model and that this is the reason that the regional corporate sectors are being obliged finally to close their financial deficits. Indeed, in the case of Korea, the shift in corporate sector financial behaviour over recent years has been quite remarkable – the once almost unbelievably large deficits have seemingly been eliminated not only via the control of capital expenditure and other forms of corporate spending but also increasingly by the simple expedient of the adoption of higher pricing regimes.
Korea: Nonfinco Financial Balance and GDP
It is of course early days in this particular story but we must wonder if the mounting problems within the domestic banking systems, and therefore a reduction in the availability of credit to companies, has begun to force a change in the corporate business model and in particular a move away from incessant output price deflation of the last 20-30 years. (N.B. had Asia’s companies been charging “full prices” for their wares during this period, they would not have run such extreme deficits and hence they would not have continued to rack up such immense debt burdens).
In short, we wonder whether the banking systems of Asia have finally reached some form of practical limit as to their size and that – somewhat counterintuitively – this increasingly binding dearth of credit is forcing companies to begin to charge more for their output. If this is the case, then we must wonder if the goods price deflation trend of the last 20 years that we showed in our first chart is about to change quite fundamentally.
As we suggested earlier, this analysis of course falls into the category of a longer-term theme and we would reiterate that over the longer term, we do believe that inflation will return to the global economy. At the same time, we must also be aware that in the very short term at least, if China’s authorities do not ease their current monetary policy settings in short order, and instead allow a banking crisis to envelope their economy, then global financial markets may have to contend with yet another bout of deflation or potentially even stagflation in the immediate short term. At the very least, we could expect a reversal in the recent global reflation trade later this year were China to be allowed to suffer a financial crisis of its own in the near term, not least of all when we consider just how important China’s late 2016 growth spurt was towards fostering the global recovery story.
However, it does seem to us that despite the potential for problems in China in the near term, the world may be approaching the cusp of a meaningful change in global price trends that will have immense implications for the valuations of financial assets, both bonds and equities. If Asia begins to export inflation as a matter of course, then global interest rates will have to change accordingly over the medium to longer term.