The onset and persistence of deflation can reflect a variety of factors, and the resulting deflation can be ‘good’ or ‘bad’. Consider an economy initially at a full-employment equilibrium (π*, Y*), given by the intersection of aggregate demand (AD) and aggregate supply (AS). A sufficiently large negative demand shock that shifts the aggregate demand from AD to AD’ can push the economy to a deflationary region (π**, Y**) with declining prices and lower output. This type of deflation is ‘bad’, because it could reflect a severe cyclical downturn, the bursting of an asset price bubble or excessively tight policies. The effects of the shock could be amplified through deterioration in confidence and expectations of declining prices, exacerbating the initial deflationary impact. The alternative to a demand shock is a positive supply shock that shifts the aggregate supply curve downwards to AS’, where output is higher, even while prices are declining (π’, Y’). This type of deflation is ‘good’ and can arise from a variety of factors, including technological innovation and productivity growth, gains from an improvement in the terms of trade as a result of a large decline in the prices of imported goods, or heightened expectations of long-term political and economic stability. It should be pointed out, however, that once prices start declining, the risk of adverse dynamics of deflation is heightened, even if it were initially triggered by positive supply shocks. A Confluence of Deflationary Forces: Supply Shocks From the supply side, the bursting of the international commodity price bubble triggered by intensification of the global financial deleveraging since September has caused the prices of raw materials (e.g., crude oil, iron ore, metals) imported by China to decline sharply, representing a powerful positive terms-of-trade shock. Moreover, there has been a strong supply response over time to high pork prices, which has been the key driver for China’s food price inflation since 2007. These positive supply shocks will likely result in headline deflation in 1H09, in our view. As a heavy user and net importer of raw industrial materials, China’s domestic producer prices tend to be closely correlated with the relevant international prices. The recent near-freefall in the CRB Index for raw industrials suggests that China’s PPI inflation will drop rather sharply from its current relatively high levels (e.g., 6.6%Y in October) into negative territory over the coming months. The decline in PPI inflation will likely put downward pressure on non-food CPI inflation. Given the enormous production capacity in China’s manufacturing sector and fierce competition pressures among firms, cost savings as a result of low input prices tend to be passed through to end users. The recent round of CPI inflation has been primarily caused by a sharp rise in food price inflation, which in turn was due to a surge in the prices of meat (especially pork). The high prices of pork, together with policy measures to subsidize production, have over time induced a strong supply response. Meat prices have stabilized and edged down since summer 2008. Given the high base, as long as the price levels stop rising, meat price inflation (i.e., the year-on-year change of price levels) should start to decline rather sharply. And now even the level of pork prices has started to decline. Given the current trends, we estimate that food price inflation will slide into negative territory by 1Q09, unless there is a substantial increase in grain prices. However, we do not expect a meaningful rise in grain prices anytime soon, given: i) the significant decline in international grain prices; and ii) the bumper grain harvest in China in 2008. A Confluence of Deflationary Forces: Demand Shocks From the demand side, the impact of policy tightening implemented since late 2007 – featuring the austere administrative credit control – has helped to rein in the rapid expansion of money and credit. The attendant disinflationary impact will likely become more pronounced in the coming months, given the usual lag effect. Further weakening in exports represents a negative external demand shock that could also be deflationary. China’s past experiences suggest that a significant decline in export growth should have a meaningful disinflationary/deflationary impact on the economy. China has suffered two episodes of deflation in recent history: one during the Asian Financial Crisis and the other in the aftermath of the NASDAQ stock bubble burst. The deflation either coincided with or occurred in the immediate aftermath of a collapse in export growth. Deflation in 2009: ‘Good’ or ‘Bad’? Despite still relatively high CPI and PPI inflation at the current juncture, we believe that a perfect storm for deflation is gathering strength under the surface and is expected to bring about a deflationary impulse in 1H09, which may morph into persistent deflation in 2H09 and beyond, barring an aggressive policy response up front. Deflation is not always a bad thing. However, it is very difficult to make a distinction between ‘good’ and ‘bad’ deflation in practice, given the entwining supply and demand shocks. Our best judgment is that the potential deflation that we envisage to emerge in 1H09 will be a mixture of ‘good’ and ‘bad’ deflation, with the former likely dominating the latter. Here’s why: First, the potential deflation, or drop in price level on a year-on-year basis, in 1H09 will likely reflect the high base in 1H08. The surge in prices for both international commodities and domestic raw materials in 1H08 has been largely driven by speculative demand, stemming from investors’ need to hedge against a weak US dollar and expectations of further price increases, in our view. By the same token, the subsequent sharp correction of these prices in a near-freefall fashion since 3Q08 has reflected a massive unwinding of these speculative positions (by commodity investors) and destocking (by commodity users), as the global financial market leveraging intensified suddenly in the aftermath of the bankruptcy of a major financial institution in the US. This is more of a financial market event than a real economic one. From China’s perspective, this is a positive supply shock, in our view. Second, the bulk of China’s food price increase took place between 2H07-1H08, mainly reflecting a tight supply of pork. The high pork prices have since induced a strong supply response over time and, as a result, food prices have stabilized and started to decline since mid-year. The resulting year-on-year decline in food prices should therefore be treated as ‘good’ deflation. Third, the ‘bad’ deflation stemming from the two types of negative demand shocks – tight monetary policy in 1H08 and weak external demand – will take a bit longer to show, as suggested by the historical relationship. Entering 2H09, deflationary pressures may ease, as the positive supply effect will likely phase out. The negative demand shocks will instead become the primary deflationary forces. In this context, whether the headline deflation in 1H09 will persist into 2H09 hinges on policy responses, in our view. Like inflation, deflation is also ultimately a monetary phenomenon. The policy tasks are twofold: i) to undo the previous tightening effect and stimulate real domestic demand with a view to offsetting the external weakness; and ii) to prevent deflationary expectations from getting entrenched, which may set off a deflationary spiral and turn ‘good’ inflation into ‘bad’ inflation. This would entail strong, pre-emptive policy responses, in our view. Inflation Forecasts We revise our CPI forecast for 2009 to -0.8% from 1.5%. We forecast headline CPI deflation at -0.9%Y in 1H09 and -0.7%Y in 2H09. The key driver of headline deflation is food prices, and we forecast that food price deflation will average -2.8%Y in 1H09 and -0.75%Y in 2H09. Non-food CPI inflation will decline in 1H09, averaging 0.5%Y, and slide into negative territory in 2H09, averaging -0.6%Y. We expect headline CPI deflation could drop to as low as -1.8%Y in February 2009, mainly reflecting the high base effect due to a temporary jump in food prices in the aftermath of the snowstorm in early 2008. The easing in deflationary pressures envisaged for 2H09 in our forecasts reflects the effect of policy stimulus that will likely be able to arrest the decline in the price levels. This highlights the risks to our forecasts. If policy responses are weaker or later than expected, deflation could become more serious, in our view. Implications The initial deflationary impulse due to positive supply shocks should bring about cost savings, especially to the energy- and raw materials-intensive sectors. However, with sticky nominal wages, we believe that persistent deflation will cause real wages to rise, profit margins to fall and employment to be cut back, which may set off a deflationary cycle with far more serious consequences. A deflationary environment generally favors bond holders (or creditors) over equity investors (or debtors). The key is to prevent deflationary expectations from getting entrenched. We expect further aggressive policy responses in the coming months. Specifically, we forecast at least a 108bp cut in the benchmark interest rate by mid-2009 (see China Economics: 108bps Rate Cut and More to Come, November 26, 2008). An additional fiscal stimulus package is also a distinct possibility. While we expect a broadly stable USD/CNY exchange rate throughout 2009, we could not rule out renminbi devaluation were a severe deflation (e.g., more than -2.0%) to persist (see China Economics: A New Renminbi Regime? November 24, 2008).
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Changing My Call on the Chinese RMB
December 04, 2008
By Stephen L. Jen | Stockholm
Bottom line: I am changing my call on the CNY: I now believe that Beijing could very well permit modest and temporary (5-10%) depreciation of the CNY. That Beijing would hold the line on the USD/CNY parity was too demanding a call, given the economic reality China faces. A flexible CNY will help validate the depreciating trend in AXJ. Until now, I have had the view that, despite the intense pressures from the slowing economy, the rapidly rising manufacturing unemployment, and the sharp rate cuts, China will most likely resist devaluing the RMB. I had two main reasons behind this subjective view: (1) a CNY devaluation would run the risk of triggering a protectionist reaction from other countries, and (2) a maxi-devaluation would have very unpredictable consequences for general confidence, particularly when property prices are on the verge of falling sharply. After the fixing on Tuesday morning and President Hu's comments over the weekend, I have thought a lot about this call, and I am no longer convinced that Beijing will hold the line on the RMB. Here are several new thoughts I have: 1. Sharp economic slowdown in China. In my previous comments, I explained my view of the Chinese economy. The super-sized fiscal stimulus, the dramatic interest rate cuts and the export tax rebates are all aimed at offsetting the rapidly deteriorating economic conditions. As the world slows further, which is likely, it would be quite unnatural for Beijing to not let its currency, which is supposed to be flexible, move in the direction it wants to go. Capital flows into China could also dwindle. 2. Depreciation, not devaluation. Previously, I had compared the dilemma China currently faces to that in 1997. But this comparison is not quite a valid one, as back then the RMB was de facto pegged to the dollar, and China was pressured to have a one-off large devaluation. This time around, we have a currency that is supposed to be flexible, one that reflects market forces, including capital flows, interest rate policies, and relative economic performances. China could in principle defend letting the CNY weaken with the economic fundamentals. In other words, if China indeed adopted a flexible currency regime back in July 2005, then the CNY should weaken against the dollar now. 3. Introduce two-way risks to the RMB. Until recently, the one-way trade in CNY had been a major problem. This is the best opportunity to introduce two-way risks in the CNY, in my view. Letting the CNY weaken now could reduce the intensity of the one-way trade mentality when the CNY resumes its appreciating path. 4. 'Competitive depreciation' in AXJ? While I don’t believe that AXJ economies will engage in competitive ‘devaluation’, if market pressures persist, central banks may be more tolerant of permitting further currency weakness. A more flexible CNY would facilitate this process. I am not saying that there will be a maxi-devaluation. Rather, I am highlighting the risk that China could allow the CNY to weaken modestly against the dollar in the weeks ahead. Not doing so would be inconsistent with the flexible currency regime. In the long run, I still see the RMB as a currency that should appreciate against most other currencies. But during this global recession, it could very well weaken.
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Testing Times
December 04, 2008
By Elga Bartsch | London
Showing the Euro’s Macro Mettle The present global downturn is historic in many of its dimensions. For Europe, an additional dimension is that the downturn marks the first recession since the start of monetary union. While the euro-zone has seen phases of stagnation in the first ten years of its existence, it has yet to endure a full-blown recession. And it’s in these testing times that the euro area’s mettle is likely to be shown. Clearly, there are some unique pressure points in the euro area, as the currency union is not matched by a political union and most economic policy decisions, other than monetary policy, are still taken at the national level. Note that this heterogeneous policy approach could also be beneficial in an environment of a high level of uncertainty about the outlook and of divergent opinions about what policy options are best to follow. In addition, the pros and cons of E(M)U membership will likely be debated both inside and outside the euro area. The current consensus seems to be that the chances of EMU break-up have increased on the back of the current turmoil. We disagree. In fact, we think that the opposite might be the case and some countries could be fast-tracked towards EMU membership. Here we discuss the challenges facing Europe in 2009 and conclude that EMU will likely pass this first real test of its macroeconomic policy framework. As a result, we expect the economy to recover from mid-year onwards. Dramatic Cut in Production Lies Ahead The first challenge lies in the nature of the recession itself, notably the sharp fall in profits and the rise in unemployment and insolvencies it will bring. One of the standout features of the current downturn is the forceful reaction of the corporate sector, notably the reduction in production schedules which is the sharpest ever recorded. Manufacturers are already prepared for a full-blown recession, even though order books still remain in mid-cycle dip territory. Many companies have already cut back investment spending, started to scale back hiring intentions or announced lay-offs. Contrary to the US, the euro area unemployment rate has barely budged yet. Since the start of the year, about 222,000 job cuts have been announced across the region, most of them in recent weeks. The increased role of temporary agencies and fixed-term contracts suggests that these layoffs could happen quickly. The share of temporary employment ranges from 9% in Belgium to 32% in Spain, compared to an EU-15 average of 14.8%. Yet, temp jobs accounted for 47% of the new jobs since 2000 in Germany, compared to about 30% in the EU-15. France saw a 9.4% shift from temporary into permanent jobs, potentially limiting its ability to scale back payrolls. Getting the Policy Response Right The second challenge for the next 12 months is to calibrate the policy stimulus correctly for the euro area as whole. This will involve the use of monetary, fiscal and regulatory policy. While the ECB’s monetary policy – including its liquidity provision to the banking system – is by definition one-size-fits-all, fiscal policies and bank rescue operations are still decided at the national level. This ‘patchwork’ approach for economic policy clearly sets continental Europe apart from the US. In general, we believe that competition between EU governments in the policy arena is desirable, even more so at the current juncture where uncertainty is high. With governments opting for different approaches, the relative merits of these become evident quickly. This holds for the bank rescue packages as well as the fiscal stimulus packages. Thus far, we find very little evidence of beggar-thy-neighbour policies being adopted. Possibility of Reduced Policy Effectiveness In addition to multi-faceted policy approaches, there is a possibility that the policy measures taken could be less effective than usual. For starters, the transmission of monetary policy could be limited, possibly severely, by the ongoing turmoil in the financial industry. Clearly, ECB easing should be (and is) front-loaded. In addition, it is not limited to interest rate cuts. It also extends to generous liquidity provision and, more recently, to quantitative easing. Still, getting the total amount of easing right is a tall order in the best of times due to long and varying time-lags. It is even harder with a highly uncertain outlook, the presence of negative supply shocks and persistent structural impediments to higher trend growth. We expect a trough in the refi rate of 1.5% to be reached in early 2009, slightly below the 2% we had pencilled in before. But the uncertainty around our main scenario is considerably higher than usual. We would therefore not rule out that the ECB will need to push policy rates to a new low. In any case, the ECB will likely aim to maintain a medium-term perspective and thus keep a firm eye on its exit strategy, given that the current trouble partly has its roots in the ECB allowing a major bubble to develop by leaving interest rates too low for too long during the last easing cycle. Hence, if the ECB deems that additional interest rate cuts are needed, it could well be keen to reverse them again as soon as possible. Similarly, the effectiveness of any expansionary fiscal policy stance depends on the reaction of the private sector, notably the saving behaviour of private households and, to a lesser extent, non-financial corporates. Next year, fiscal policy should turn expansionary for the first time since 2001, we estimate. Currently, we count around €65 billion of discretionary measures, equivalent to 0.7% of GDP. More is on the way as we write. Thus, we would not be surprised if the deficit eventually reached, or even exceeded, the 3% mark in 2009. Bigger budget deficits, however, do not automatically guarantee stronger domestic demand. Higher spending by the government could be offset by lower private sector spending and higher savings. For a region historically plagued by big government budgets, it is thus essential to ensure that the fiscal measures remain temporary in order to avoid that the private sector becomes concerned about the long-term sustainability of government debt levels. Ideally, the measures would therefore come with a sell-by date. Alternatively, they could involve a front-loading of long-term spending plans on items such as infrastructure, research and development. Mind the Coming Country Rotation within the Euro Area As such, the recession should not cause a rising divergence in economic performances across the area. But it will likely cause a rotation between which countries out- and underperform the region. Countries such as Spain and Ireland, for instance, where domestic demand powered ahead on the back of booming house prices and rising household debt over the last ten years, will need to regain the price and cost-competitiveness they lost when consumer price, wage and unit labour cost inflation outpaced the rest of the euro area by a considerable margin. This adjustment process will probably require painful structural reforms, corporate restructuring and wage moderation. In our view, investors should get ready for turnaround and restructuring plays in these countries, which will eventually follow the current downturn. Additional risks stem from chunky current account deficits, which helped to fund domestic demand growth through capital imports. A fall-off in these capital inflows could imply additional headwinds for domestic demand growth. Postcards from the Edge of EMU Recent events have underscored that euro membership can provide some shelter against financial market (notably currency) turbulence. Countries like Denmark, which maintain an exchange-rate peg against the euro, have found themselves in an uncomfortable position where the central bank was forced to hike interest rates to fend off currency weakness. Hence, the spread over the ECB policy rate reached a new historical high of 175bp, adding to the pressure on a highly leveraged economy already in recession. Similar pressures were also felt further afield in Central and Eastern Europe. In many respects, it reminds of the tensions felt in the European Exchange Rate Mechanism (ERM), in particular in the early 1990s. Dislocations at the fringe of the euro area also have important repercussions on the euro area itself. Not only is the euro area much more open than the US – with exports of goods and services accounting for 22% of GDP, compared to 12% – but more than a third of these exports are destined for other European countries, of which Central and Eastern Europe account for a further third. In addition to direct exports being dented by the global recession, foreign affiliate sales of euro area multi-national companies will likely also feel the pinch. Unfortunately, there aren’t any data available at the euro area level. But as a rough guide, foreign affiliate sales can total as much as 210% of exports in the case of Germany, 98% in the case of France and as little as 38% in the case of Italy. Investment Spending Will Likely Take the Hardest Hit Being weighed down by tighter financing conditions, falling corporate profits, faltering global demand and declining house prices, we expect investment spending to contract by close to 5% next year, the sharpest contraction in 15 years. On our estimates, export demand will also experience a very sharp slowdown and ease by about 1%, the first outright contraction in exports since the start of our database in the early 1990s. Meanwhile, consumer spending should prove somewhat more robust, we think. Assuming a slight fall in the saving rate, which at 13.7% is high by international standards, we expect consumer spending to expand by a modest 0.75% next year as protracted payroll reductions will likely cap the dynamism. Some support should come from falling consumer price inflation, which will likely fall markedly and should trough around the 1% mark in July, before starting to rise rapidly again in the second half on the back of flip-flopping base effects. This sharp fall in headline inflation should not be mistaken for the start of a deflationary demise à la Japonaise though. Instead, the falls in energy and food prices, which are the main drivers behind this development, should be seen as a factor supporting real demand growth. We believe that the ECB will look through these massive swings in headline inflation caused by base effects. In our view, investors should do so too. Bottom Line: Pass Mark, Could Do Better in the Future Our base case is that EMU will withstand the pressure and contracting activity will eventually give way to a muted recovery in mid-2009. For the full year, we now expect an outright contraction in GDP by 1.0%, after we had to tweak our numbers again in the light of the sharp fall in activity indicators. After contracting sharply in 4Q08, we expect the rate of decline in overall economic activity to start slowing in 1H09. In 2H, sequential GDP growth rates will likely turn positive again though, but even then growth should remain timid. Our 2010 GDP growth estimate stands at a sub-par 1.1%. The muted recovery is partly the result of the less aggressive policy stimulus compared to some Anglo-Saxon countries. It is partly due to the remaining structural rigidities, which not only limit the scope for demand-side stimulus, but also suggest that it might take longer to work through the downturn. In this sense, the pressure for further structural reforms exerted by the downturn combined with a shift in country performance could turn out to be an important long-term positive. Our Surprise: EM-Umbrella A number of market indicators, including the sharp widening in country-specific bond yield and CDS spreads, would suggest that the current consensus is that the present turmoil increases the chances of an EMU break-up. In our view, the opposite is probably the case: a number of countries in fact could find themselves being fast-tracked towards EMU membership. In cases such as Denmark, this could be due to a shift in public opinion about EMU membership potentially paving the way for a ‘yes’ vote in a referendum. In other cases such as Hungary, it could turn out that the involvement of the IMF strengthens the commitment to near-term fiscal consolidation, thus bringing forward the likely timeframe over which the convergence criteria for EMU entry will likely be fulfilled. As a result, a number of countries might find themselves under the EM-Umbrella somewhat earlier than the current market consensus would suggest. Key Macro Trade Ideas for 2009 Equities: Our European equity strategy team advises investors to stay patient in 2009 and is now neutrally weighted in equities in its asset allocation. In its view, in bear markets patience is the preferred virtue, cash the preferred asset. While equities have already reached fair value, big valuation undershoots are still a distinct possibility. The team has identified three signposts signalling the start of the next bull market: earnings, US house prices and deleveraging. A possible crisis scenario in early 2009 concerns deflation as well as the ability of governments to finance the reflation efforts. Hence, investors should stay defensive but incrementally buy cyclicals with strong financial health. For details see Euroletter: 2009: Stay Patient, December 1, 2008. Interest Rates: Rates markets face a new environment of aggressive non-traditional official intervention in financial markets, from bank capital injections to quantitative easing. These interventions can and will distort the way markets behave. At the same time, they will have to absorb unprecedented levels of government borrowing, at a time when balance sheet is at a premium. Preferred trades include: Duration: 2y1y most attractive forwards versus Morgan Stanley central bank forecasts. Curve: Tactical bull flatteners near term, but supply should steepen the curve eventually. Spreads: European government bonds seen underperforming Libor, protection on Belgium and Austria viewed as attractive buy. Inflation: Breakevens to recover as deleveraging flows subside/fade, real yields look attractive and should fall as linker curves steepen. For details, see 2009 Global Interest Rate Outlook: The Great Balancing Act, December 1, 2008. Credit: Our credit strategy team is bullish on investment grade credit on the back of the global policy response and prefers owning large, systemically important banks (see Buying Is Best When There Are Only Sellers, October 10, 2008). While a short-term risk of fund redemptions exists, the majority of investors are probably running material cash balances already. The longs focus on two areas: First, credits benefiting directly from government support. In Europe, this would include banks across France, Switzerland, the UK and the Netherlands. Second, non-cyclical credits where valuations have suffered primarily from the market deleveraging process and which now offer a combination of equity-like upside potential and a credit-like downside risk profile, e.g., non-cyclical leveraged loans. The team remains very bearish on cyclical corporate earnings though, and a bearish stance seems appropriate for cyclical corporates, especially weak investment grade credits with above-average funding needs in the next couple of years.
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