12 October 2015

The Deflationary Grip

The Fed has refrained from increasing interest rates, as expected by us, till date, in spite of repeated vocalization to the contrary. The reasons attributed by the Fed are many for its inaction, depending on what is trending in the recent data.

However, we believe that the real fulcrum of the inaction is the deflationary grip on the global economy. The table below shows change in PPI for the globe as a whole, for period ending 30th June 2015.

Change in Global PPI
Period% Annualized Change
12 months ending 30 June 2015 -4.0%
24 months ending 30 June 2015 -1.3%
36 months ending 30 June 2015 -0.5%

Source: Decimal Point Analytics

The above data is weighted average for top 25 global economies, accounting for about 85% of global GDP. The national PPI is adjusted for currency movement taking into account the fact that a certain portion of GDP is tradable and hence affected by currency movements.

It can be seen clearly that the deflationary trend in the world is fast increasing. The day to day national observations get noisy due to currency movement effects. However, once we strip that out, the underlying trend is quite clear.

We at Decimal Point, have been operating since 2010 under the working premise that deleveraging in developed world, coupled with unconventional monetary policy will lead to deflationary trends in developed world, while at the same time leading to inflationary trends in developing countries due to excessive stimulus.

However, since the later part of 2014, that premise needs to be changed to deflation everywhere. The causes for this event are two. Firstly, unconventional central bank action has kept interest rates too low for many developing economies, leading to suboptimal businesses to survive or even to expand. This has led to excess capacity. There was inflation when the excess capacity was getting built. However, now that the excess capacity has been built, while aggregate demand for the globe has grown below forecasts for many years in a row, it is creating a price pressure. Second reason is that China has just switched from being a leveraging economy to a deleveraging economy, joining the ranks of many developed economies.

The policy makers have believed, for many decades now, that monetary policy can be used to smooth out kinks in demand, and later, that belief has transformed into action based on the premise that monetary policy can create long-term demand. However, the policy makers are ignoring, or giving just lip service, to the side effect of asset price bubbles that the unconventional monetary policy has helped populate.

In conclusion, we are in very interesting times in terms of price trends. In our opinion, portfolios that take this reality into account will benefit in the medium term.


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