Should we be worrying about inflation? Deflation? Reflation?
Or, perhaps, as CLSA’s Asian equity strategist Christopher Wood suggests further down, none of the above?
But first, the FT’s John Authers kicks off the debate with his Short View column on Wednesday, noting that the market “has its story straight”:
“The world is reflating, led by commodity exporters; equities are still in a “sweet spot” of low rates; and the concern for the future is inflation, not deflation”.
That, at least, takes into account events of the past few days, he says, starting with the recovery of US and other key stock markets from the dampening effect of recent poor economic data, and Tuesday’s surprise decision by Australia to raise its key interest rate by 25bp to 3.25 per cent. (Higher rates are not usually good for markets, adds Authers, “but yesterday they were seen as a central bank validating the reflation story”). That was followed by the record rise in gold – “seen as an inflation hedge”.
Yet inflation does not yet show up in economic data or in markets that most directly try to predict it, notes Authers. While core inflation is falling in the US and elsewhere, implicit 10-year inflation expectations in the bond market are lower than earlier this year.
Either, he concludes, “the ‘sweet spot” of low rates and strong emerging market demand will persist, the interpretation du jour, or markets are premature to put such weight on the reflation story”.
In Wood’s view, detailed in his latest Greed & Fear newsletter, the direction of markets is — and will remain — closely intertwined in a “classic reflexive process” with the direction of policy, for example, pending new bank capital rules from the Basel Committee. But, he warns:
If a renewed deflationary wave hits world markets this quarter, then the massive power of the financial lobby will ensure that the regulators cannot do what they should do which is to move banking capital guidelines back onto a tangible equity basis ending the ludicrous charade where various forms of debt are categorised as “capital”. This would clearly imply the need for the global banking industry to raise a lot of equity, as BNP Paribas smartly did this week.
It is, therefore, “impossible to make market predictions without considering the policy cycle, and the two at this juncture are more closely linked than ever”, he says, noting that the inflation/deflation debate and the focus on inflation all seems “rather pointless”.
That said, “the end game may well be hyperinflationary when the market finally loses confidence in US federal government guarantees,” concedes Wood.
In the short term, though, the big risk is “not an inflation scare but rather another deflation scare, when it dawns on the stock market that the recovery is not really healthy”. He concludes:At that point the market action, namely falling stocks and rising bonds, will give the authorities the perceived room for manoeuvre for another wave of fiscal and monetary stimulus.
Anyway, adds Wood:
The lead indicator of any potential sudden violent swing from deflation to hyperinflation is still more likely to be in Japan than the US – because Japan has been in a deflationary cycle for far longer; its domestic institutions are already (unlike in the West) massively overweight government bonds and its public sector debt to GDP is already at 200% of GDP and rising.
Related links:
Inflation - Lex
Reading the news flow – FT Alphaville