A Precarious Financial Environment
Looking for inflation, perceiving deflation
By Jean-Luc Burlone, M.Sc. Ecn., FCSI (1996)
In 2008, the USA was the epicentre of the financial crisis and the credit crunch almost paralyzed the economy. Luckily, the Federal Reserve (FED) printed several trillion dollars and pushed them into the market by purchasing treasury bills and mortgage-backed securities. This was imitated by major central banks around the World (Japan, Britain and Europe), and it was expected that readily available no-cost credit, combined with businesses’ and investors’ renewed confidence in the financial system, would secure liquidity and drive investments into capital expenditures and new business activities. These investments would stimulate the economy, create jobs, reduce unemployment and increase demand for goods and services. More money chasing goods and services would raise the level of inflation to the two percent level, where the FED is justified in raising interest rates and thus, a return to normalcy.
But demand remained flat while supply increased. Instead of financing new businesses, free money went to finance acquisitions, leverage stock buybacks, expand capacity and build large inventories of products and commodities. As a result, financial markets remain far away from normalcy: abundant money and resources are latent, news of slow economic growth are now news of oft-recurring low rates since central banks keep chasing inflation with official rates at near zero while real rates, in Europe and Japan, are negative, setting conditions for a lack of liquidity and volatility.
Instead of financing new businesses, free money went to finance acquisitions, leverage stock buybacks, expand capacity and build large inventories of products and commodities. As a result, financial markets remain far away from normalcy…
In 2015, China is the epicentre of the current crisis. While building its gigantic infrastructure projects, the country was the largest buyer of commodities in the past several years: it poured more concrete than the US did in the entire 20th century and it used more steel than the US and Europe combined. Currently, it still burns as much coal as the rest of the world, buys an eighth of the world oil output and half the production of metals and minerals. Clearly, China was the major engine of recent global growth and it still drives global trade (which represents 60% of global growth). But the country’s $11.4 trillion economy has slowed from double-digit growth in 2010 to 6.9% this year and some key indicators suggest the slowdown may actually be much steeper (lower than 5%) than stated officially.
To mitigate its economic woes and avoid a crash landing, while managing its transition from an investment to a consumer economy, China cut interest rate several times, lowered the reserve requirements for bank loans to private businesses and devalued the renminbi by 10%. An additional devaluation of the currency seems probable as the economy suffers from a large sum of capital outflows ($500 billion in recent months). Currency devaluation means lower prices for a fourth consecutive year for Chinese manufacturers and necessarily implies lower prices for competitors in Asia and around the world. A debt problem also looms over the situation and non-performing loans are rising. Since total Chinese debt reached 240% of the GDP, authorities cannot bail out every sector and must let some default as the Sino Steel Enterprise did in late October, the first State Enterprise to do so. Manufacturers in Asia directly affected have fully loaded inventories, financed by credit to the worrisome level of $18 trillion and some find themselves in a tight financial spot because $1.6 trillion of their debts are in dollars while their currencies are devalued and their sales are low. Around the world as well, manufacturers face deflated price for their products and commodities remain in a slump.
Manufacturers in Asia directly affected have fully loaded inventories, financed by credit to the worrisome level of $18 trillion…
An overall deflationary environment — fuelled by currency devaluation, commodity slump and a looming credit crunch — may swash economies in the foreseeable future. As the price of globally traded goods fall, profit margins and earnings will come under pressure, eroding tepid economic growth. We are moving from the final stage of an expansion phase to the early stage of an economic contraction. Financial markets will react accordingly.
Jean-Luc Burlone, M.Sc. Ecn., FCSI (1996)
Economist – Financier
The text above is my personal view and should not be viewed as promoting an investment action of any sort. It is solely my opinion on the current financial context based on reports and data from the financial press.