Gold News

New Japanese Import! Deflation

Expect China to compete for importing deflation to you very soon...
THREE years ago central bankers had well and truly commandeered the printing presses, with the express purpose of creating inflation, writes Vern Gowdie in Greg Canavan's Daily Reckoning Australia.
Every other period in history, when governments have resorted to this strategy, hyper-inflation was the unintended consequence.
So my 2012 prediction of "a deflationary influence on the global economy" was not orthodox economic thinking.
But we are not living in orthodox times. The world is transitioning (ever so slowly) from an economic dreamland to a much harsher reality.
In dreamland, courtesy of ever-expanding levels of debt, economic growth was pretty much a given outcome. Prolificacy replaced productivity. Several decades of this 'cake and eat it too' mentality completely altered economic thinking. What was once considered reckless – encouraging excessive indebtedness – now passes for responsible.
In late 2014 the 'spin' was about how the lower oil price would spark consumer demand. Lagarde extolled "'s good news for the global economy."
The theory goes like this: the less you spend at the bowser means the more you'll spend on something else. A consumer boom in the making.
What utter rubbish. Let's say a person earns $1000 per week and spends the lot. The $20 saved at the bowser is used to buy $20 worth of other 'stuff'. The economy still only receives $1000 that week – it didn't get any extra input. The $1000 was just redistributed a little differently.
As I pointed out in December 2014, without wage growth, the official line peddled by Lagarde – and the rest of the central banker cohort – is a complete furphy. Yet it passes for rational economic commentary.
To validate the view I expressed in the December 2014 issue of Gowdie Family Wealth, in May 2015 the Associated Press headline was: 'Experts Erred: Cheap Oil Hurts US Economy'. To quote from the article: 'Consumers slowed rather than increased their spending.'
The US economic contraction in first quarter 2015 and the Atlanta Fed GDP data are now predicting a similar soft outcome this quarter, indicating Lagarde's theory is nothing more than a Dreamland theory. In reality a debt-laden consumer is using any savings to pay down debt or buy 'something' but they are not spending more.
The long held theme underpinning the Gowdie Family Wealth investment strategy has been 'The Great Credit Contraction'. The process that is transporting us from economic la la land to a much harsher economic reality. The impact of this contracting force would be roughly the equal and opposite of the credit expansion phase.
  • Deflation replaces inflation;
  • Ultra low interest rates replace medium to high rates;
  • Real economic activity declines;
  • Asset (share, property and commodity) values fall.
One by one these criteria are being met.
Deflation – not seen since The Great Depression – is certainly on the radar screen these days.
Kroll Bond Rating Agency (established in 2010 to bring some credibility back into the ratings business) released their end of year of report titled: 'Outlook 2015: Deflation Remains the Dominant Theme'. The following is an extract from the report:
"One key indicator of deflation that seems to be even more worrisome to investors, however, is global commodity prices and what commodity price weakness suggests for demand. Copper fell over 12% in 2014, largely due to slumping demand in China and other industrial economies.
"Natural gas prices have fallen more than 12% this year. And oil prices have fallen by over 40% due to a glut of new supply and weak demand growth in many developing economies. The International Energy Agency has cut its estimates for demand for crude five times in the past six months, The Wall Street Journal reports."
The world is awash with supply – squillions of factories were built to satisfy the demand from the credit binge era. To stave off bankruptcy, the owners of these factories will be forced into a price war to generate cash flow – a deflationary outcome. Not all factories will survive, some will have more debt and higher wages costs than others. Lay-offs are certain to ensue. Rising unemployment depresses social mood. The cycle of deflation, once started, is hard to reverse.
Currencies are being deliberately lowered in an effort to make each country more price competitive than their neighbour. At present the world is engaged in a currency skirmish (the war is yet to begin).
Domestically, the RBA has joined the currency battle with its efforts to lower our Dollar to make our largest export – resources – cheaper.
In the early rounds of the currency battle, Japan is leading the charge.
In 2012, US$1 bought 80 Yen. Today, US$1 buys ¥125. So in practical terms, where an ¥800 item cost a US consumer $10 three years ago, with the current exchange rate, the US consumer now pays $6.40 for the same product.
This is price deflation at work.
With the USD/JPY exchange rate at ¥125, the trend is for further weakness in the Yen – meaning the US consumer will pay even less for imported Japanese goods.
Fantastic if you are a US consumer. Not so good for US manufacturers. But that is not the big deflation story with the Yen devaluation.
China is the big story.
China's currency (Renminbi) has remained closely pegged to the US Dollar for the past four years. The depreciating Yen is therefore making Chinese products more expensive in the US.
China (with factories as far as the eye can see and further) is not going to sit idly by and watch Japan 'eats its lunch'. But so far Japan's devaluation strategy is working. Japan's GDP reportedly grew by 3.9% (annualised) in the first three months of this year. Although, domestic consumption was much weaker at 1.5% (annualised).
Whereas, according to the 2 June edition of Society Generale's Global Strategy Weekly by Albert Edwards:
"China has big deflationary problems and cannot tolerate any further rise in the Renminbi. Indeed, on one key measure, China is already in outright deflation."
That key measure is the GDP deflator – the difference between Nominal GDP and inflation adjusted GDP. According to Societe Generale:
"...the incredibly important fact [is] China's GDP deflator had lurched into deep deflation, declining 1.2% year on year..."
China's decision to recently lower interest rates (the third such reduction in six months) is most likely in response to the weaker GDP data.
The further the USD/JPY rate moves away from ¥125, the greater the pressure on China to uncouple from the US Dollar.
Deflation is coming from domestic cost competition and international currency devaluation.
The US is going to be caught in the crossfire as the Euro, Aussie, Yen, Pound, Renminbi and Canadian all try to work their way lower to gain an edge over each other.
The tighter the deflationary grip, the more likely the current skirmish will escalate into an all-out war.
The 'winner' of a currency war is the one that 'rips the heart' out their currency the most. What sort of victory is this? But then again this sort of stupidity passes for rational economic theory in dreamland.
Yes there will be moments when it appears this madness is working, but they will be fleeting.
Deflation is coming to all of us courtesy of the most indebted country in the world – Japan.
Watch the USD/JPY exchange rate for the sign on how severe the descent into deflation is going to be.

Greg Canavan is editorial director of Fat Tail Investment Research and has been a regular guest on CNBC, ABC and BoardRoomRadio, as well as a contributor to publications as diverse as and the Sydney Morning Herald.

See the full archive of Greg Canavan.

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