Credit Suisse is out with an excellent piece of research in response to the fears over deflation. CS believes deflation fears are a bit overdone. This research is particularly interesting to me because it contrasts many of my own conclusions. They cite 6 different reasons why they deflation is not a realistic threat:
We do not believe in deflation for the following reasons:
(1) We note that in most developed economies (Euro-area, US and UK) wages are not falling. If wages fall, house prices tend to fall – and falling asset values tend to limit banks’ lending ability because of collateral deterioration as well as pushing up the household savings ratio. Wages account for about two thirds of total costs.
(2) To get falling wages and deflation, we calculate that domestic demand would have to fall 5% in the US and that is very unlikely;
(3) In the emerging markets, which account for 47% of global GDP on a PPP basis, there are concerns about inflation, not deflation.
China is now beginning to export inflation (not deflation, with prices for US imports from China rising for the first time in five years in May) as the labour market tightens. We note that the latest survey on labour demand/supply by the Ministry of Human Resources and Social Security shows a net shortage of labour for the first time in nine years.
(4) Admittedly, wide monetary aggregate growth is decelerating. Yet, importantly, this measure lags the economic cycle, while narrow money growth, which leads the economic cycle, is still rising.
(5) Unlike in the 1930s, policy makers know what to do to avoid deflation. The policy mistakes that sent Japan into deflation seem unlikely to be repeated.
Deflation has often been the result of policy mistakes. Yet, central bankers/politicians know what to do to avoid deflation and would risk inflation, not deflation. If there is a political unwillingness to spend, then central bankers can just buy assets (initially government bonds, then other private sector assets). It worked last time around, therefore it is likely to work again.
The best measure of monetary policy, we believe, is global real rates. This measure is in negative territory for the first time ever and the monetary base is now 14% of GDP in both the US and in the Euro-area (compared to 6% and 9% in 2007). We also highlight that the Fed balance sheet as a proportion of GDP is now at the highest level since 1960, the first year for which we have data.
Indeed on the subject of policy mistakes: in the 1930s there was the mistaken belief in balanced budgets (motivated by the assumption of neoclassical theory that increased public savings would lead to higher investment), with the result that US tax rates were raised in mid-1932, with the rate on top incomes rising from 25% to 63% and the doubling of the real estate tax.
(6) Assets prices (housing) are not as overvalued as they were prior to historical deflationary events (e.g. Japan in the early 1990s) The only countries likely to enter deflation are those with significant output gaps and overvalued currencies, which they cannot devalue either because of the increased risk of default as loans are foreign-currency denominated or because they are within the Euro area (peripheral Europe).
In terms of regions that are most at risk of deflation CS cites nations with little or no monetary control. As I’ve previously noted, Europe’s lack of monetary sovereignty places their various economies at substantial risk of deflation and economic malaise in the coming years.
We think there will be deflation in countries which have very little monetary control. This highlights parts of peripheral Europe or EMEA.
In peripheral Europe there are three problems:
a) The loss of competitiveness as proxied by the rise in unit labour costs and real effective exchange rates versus Germany since 2000.
b) The degree of fiscal tightening needed to stabilise government debt to GDP: Greece, Ireland and Spain require fiscal tightening of around 17%, 12% and 11%, respectively (see our analysis on page 13), even assuming a normal recovery. In the case of Spain, we have adjusted the figures for the cost of the private-sector bail-out of the banking sector (in particular, the cajas) as estimated by our Spanish banks analyst Santiago Lopez Diaz.
c) There is still over-valuation of housing in Spain. In Eastern Europe, there is a problem for those countries which have a very high level of external debt denominated in foreign currency and have overvalued currencies. As a consequence, they cannot afford devaluation – and their only option apart from default is deflation. Hungary looks one of the most vulnerable to deflation with net foreign liabilities of 123% of GDP.
But what if they are wrong? CS notes that equity values could decline substantially from current levels if a sustained deflation did occur here in the US:
We believe that in sustained deflation, equity multiples would fall to previous trough levels, e.g. 12X on trend EPS, 11.4x on forward PE, 1.8x on price to book, 0.78 on Tobin’s Q and 0.57 on market cap to GDP. On average, this would be consistent with an average S&P index level of 822 – 26% below current levels.
Bonds and gold would likely outperform:
Bonds should do well, but we believe that sustained deflation would put pressure on public finances, thus increasing the risk of sovereign default.
In case of significant and structural deflation, gold would also perform well, as in this case sovereign risk would escalate and gold likely become the only trusted store of value. In a recent note (Gold bugs!, June 1, 2010) we highlighted the reasons we continue to be bullish on gold.