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Macquarie Research: Deflators of the world unite

[stockguru1982]

According to Macquarie Research:

Deflators of the world unite

Impact on the US & Global PPIs

Pressure to export overcapacity in flat trade=devaluations

- US wholesale inflation could get worse over the next twelve months. PPI ex Food & Energy stands at only ~0.5% YoY, although it slightly accelerated in July. It is likely that regions with the greatest need to export domestic over-capacity (China, Euro, Japan and Korea) will accelerate export of deflation.

- As discussed (here), China is between a rock and a hard place and unless global cyclicality and trade recovers (an unlikely occurrence, in our view), the pressure to devalue Rmb will remain unrelenting. China’s US$ import prices into the US are already falling at ~1.2% and have been negative for six months. Given latest Rmb devaluation, it is quite likely that the index of China import prices (US$) will fall by ~2% or more.

- At the same time, the Eurozone and Japan are also increasingly exporting their domestic over-capacity and deflation into the US. Germany’s import prices into the US are currently falling by ~2% and have been negative for seven months whilst Japan’s import prices are falling by ~3%.

Low supply of US$ adds further pressure

- Inability of the US to improve its velocity of money (i.e. encourage consumers and businesses to accelerate spending and investment) and associated slow growth in global trade (volumes rising by less than 2% vs. historic average of ~6%), implies that supply of US$ remains exceptionally low (close to zero vs. average growth between 2001 and 2013 of ~15%, refer here and here).

- This in turn has a tendency to push US$ exchange rates up (DXY and US TWI), causing further expansion of deflationary pressures and erosion of commodity indices, feeding through global supply chains. Apart from an outside chance of much faster than expected nominal GDP growth rates leading to higher US Current Account deficits, supply of US$ can only expand via QE4.

Challenging choice for the Fed

- As the latest revisions of the US GDP shows, not only was this recovery the most muted on record but perhaps most importantly the US has a challenge accelerating nominal GDP growth rates above the 3%-3.5% range (here). Given the US’ overall leverage of ~3.5x GDP and need to continue leveraging in a more sustainable fashion, it is nominal rather than real GDP growth rates that matter. The objective is to keep nominal GDP as high as possible and real interest rates low. Deflationary pressures are therefore not constructive.

- Whilst the Fed seems desperate to get out of zero range-bound policies of the last seven years and is constantly shifting its public decision goalposts (first it was unemployment, and then it was broad measure of under-employment, followed by wages and inflation etc), it is just as much between a rock and a hard place as China is. It is the classic case of damned if you do and damned if you don’t. As long as it is accepted that deleveraging is no longer possible, then what is needed is QE4, not a rate rise, but currently the hurdle for QE4 is higher than doing nothing or raising rates and then walking them down again.

- The above implies that deflationary winds could get stronger and volatility rates higher. We continue to prefer commodity consumers and markets with significant domestic liquidity (i.e. India, China, Taiwan & Philippines).