- China has played a huge role in keeping global inflation low
- As this reverts, expect prices to rise until they hit a demand wall
- Upcoming recession necessary if markets are to realign with reality
Low-priced Chinese exports have held inflation at bay, but this is reverting. Photo: iStock
By Steen Jakobsen
Global deflation is ebbing lower, but is inflation coming back?
Yes it is!
The main impact, though, will be less consumer spending as China’s low export prices have kept US consumers in play through ever-lower prices, and this is now reverting. This will also mean a weaker CNY and higher inflation expectations from here (globally), which of course is a classic end-of-cycle reaction and confirms my main macro thesis:
We stand in front of massive macro paradigm shift away from “easy money”, through recession, and toward “helicopter” money.
China PPI (year-over-year) and OECD CPI:
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Source: Saxo Bank
Looking at the correlation between China's y/y PPI – now positive – and OECD CPI inflation, it is clear that China has played a central role in global disinflation (or deflation)
This is also why inflation has been subdued despite massive quantitative easing.
Furthermore, it’s important to understand that falling Chinese prices have kept pretend-and-extend alive for longer than might have been the case otherwise as import prices in net deficit countries (like the US, UK, South Africa, etc.) have been collapsing.
This in turn has created room for the stabilising or even the improvement of purchasing power in an environment with less growth and earnings.
This trend, if confirmed next few month, could be a major harbinger for inflation concerns coming back into focus. To me, this is another end-of-cycle sign; as Albert Edwards and others have pointed out, it’s pretty classic that inflation rises into a recession. Late in a cycle, prices peak before running up against a lack of new demand.
Five-year/five-year US inflation swap:
Source: Saxo Bank
Our overall macro outlook
The fourth quarter of 2016 (and heading into Q1'17) will see tighter money market conditions combined with the Federal Reserve raising rates in December – that will be the peak of the US dollar's strength and the meagre growth improvement to come in Q4
(Portfolio strategy: be long USD versus a basket of deficit currencies – ZAR, TRY, AUD, and CAD. Be underweight equities/fixed income and overweight cash. Buy optionality on the downside in the S&P 500 and Dax, and to the upside on GBP (one-year) and the Swiss franc.)
In Q2-Q3'17 we will move towards recession in the US. This of course coincides with an election cycle which will see voters head to the polls in the US, Italy, the Netherlands, France, and Germany, so there will be little room for fiscal support during this period, making uncertainty the name of game.
US core GDP outlook:
Very few people in the market are willing to accept that a few short weeks ago, the Bank of Japan changed the “lower for longer" game to one of “preparing for helicopter money” – this may be the single most important policy change since the start of the great financial crisis .
The newly announced target rate of 0% in 10-year Japanese government bonds (from negative) is a back door that will allow the Japanese government to create more fiscal deficits, and through this a full helicopter money approach.
Having a 0% targeted yield in JGBs means this is no longer a hindrance for prime minister Shinzo Abe to go "all-in" on further deficit creation.
Japan remains the leader in experimental economic and monetary policy; just observe how the Fed, the Bank of England, and the European Central Bank trail behind Japan's innovation with a delay of years.
This new direction (target rates for government yield) will ultimately be the policy response from Europe and the US when we run into the next banking and economic crisis in 2017, as their traditional monetary response since Greenspan – cutting steering rates – is out of order.
The end of excess
A Chinese PPI reading may seem like a relatively trivial economic indicator, but it feeds into global inflation via export prices and China has been a powerful supporter of global consumers through its lowering of import prices.
Now this trend is reversing to higher inflation, creating a need for further CNY devaluation and reigniting inflation expectations while central banks are about to reduce their endless QE support.
This means higher prices, lower growth, and stronger US dollar which is as close as you get to a perfect mixture for a recession.
Recessions are the economic equivalent of “clearing away the excess”. I would argue, in fact, that what the world needs is to adjust itself to reality, and a recession will do just that. It will also, of course, come with massive political shifts, further social contract issues, and increased volatility.
Given the need to clear away excesses and perceive reality, I will let Lao Tzu have the final word: “Life is a series of natural and spontaneous changes. Don’t resist them – that only creates sorrow. Let reality be reality. Let things flow naturally forward in whatever way they like”
Markets have certainly created their share of both resistance and sorrow of late... Photo: iStock
— Edited by Michael McKenna
Steen Jakobsen is chief economist and CIO at Saxo Bank