Some have predictably set their Chicken Little meters ticking again where global deflation is concerned. Our opinion is that a world recession may be in the offing, but another global financial crisis is definitely not in the cards.
Here’s Asia Unhedged’s view of how deflationary spiral works: monetary conditions push down commodity prices, and falling prices affect sovereign as well as corporate balance sheets, making the problem even worse.
The collapse of commodity prices now reflects shrinking world demand and poses a significant danger of a global recession in 2016, with declining world trade and sharp declines in demand, especially from the commodity-producing countries or countries with a high degree of external leverage (e.g., Turkey).
The term “global recession,” though, hardly captures the lopsidedness of the present situation. Lower oil and commodity prices are an ill wind that does some good, especially in Asia. Asian countries import commodities and export manufactures, so the impact on the continent will be mixed. We see both tendencies at work in China, where declining manufacturing exports have hurt the industrial economy’s output and profitability, but where the service sector and household consumption have continued to expand at a buoyant pace.
The patterns become clear when we go into fine focus. On the commodities side, the collapse of the oil price was mainly a monetary phenomenon: the Fed’s expected tightening forced up the value of the dollar and commodity prices were dragged along by the deflationary tide. Oil, though, has taken on a dynamic of their own. Too many producers, Middle Eastern as well as US, need cash badly and will not cut production to stabilize prices. The last leg of the oil price crash, which pushed crude to a hair’s breadth of its 2009 low, is a “real” rather than a monetary event.
For the most part oil has fallen as the dollar has risen, but there are notable exceptions—for example in late August (after China’s mini-devaluation of the yuan) or after last week’s OPEC meeting, when they moved together. That is how a deflationary spiral works: monetary conditions push down commodity prices, and falling prices affect sovereign as well as corporate balance sheets, making the problem even worse.
The real effects of commodity price decline are clear from the chart below, showing the y-o-y change in imports among the world’s largest importers by dollar volume. The collapse of oil and commodity prices has reduced the dollar volume of imports for many countries, and it is hard to separate real volume from price effects with the data presently available. But it is noteworthy that two of the so-called BRICs, Russia and Brazil, have the largest import declines in the group, with Indonesia and Thailand just behind them: they are commodity exporters, and the fall in their dollar import volume by more than 35% y-o-y reflects recessionary conditions brought on by the collapse of their export prices. That shows clearly how the monetary effect turns into a real effect: commodity exporters are squeezed by falling prices and are forced to reduce imports, provoking a downward spiral in world trade volumes. That is why the danger of world recession is substantial – somewhat above 50%, in our view.
Commodity prices, to be sure, are only one symptom of tightened world monetary conditions. Levered countries and levered companies around the world are in or close to distress. To an extent we have never seen in previous monetary cycles, the mere threat of future Fed tightening has tightened credit conditions in the major industrial economies well in advance of Federal Reserve action. Although energy sector spreads have widened to distress levels in the US high-yield market, all sectors of the market have widened dramatically, including health care, where most high-yield issuance financed past leveraged buyouts.
With the Atlanta Fed’s GDPNow model showing US Q4 growth at just 1.5%, it is easy to see how straitened credit conditions in the US would translate into a technical recession during 2016, with lower exports and CapEx leading the way down. CapEx in the US oil sector is projected to fall by 50% in the analysts’ consensus between 2015 and 2016; the recent drop in the oil prices indicates a far steeper decline.
Asia Unhedged think it more likely that the US will get by with 1.0% to 1.5% growth, but there is substantial risk of recession.
On the other hand, Commodity prices may have fallen to 2008-2009 lows, but nothing else in the financial landscape resembles the circumstances of the financial crisis and the Great Recession. First of all, the financial system is much stronger. Bank capital to total assets stood at just 9% in 2008 vs. 12% today. The eurozone has some catching up to do in improving bank capital, and that is something to monitor. But overall the world financial system is stronger.
Second, US consumers are in far stronger shape than in 2008. The US consumer stood at the epicenter of the financial crisis, with the collapse of the subprime mortgage market. Before the crisis, consumer debt service payments had risen to a record 13.2% of disposal personal income; since then the ratio has fallen to a record low of 10%.
Third, although dollar credit to emerging market borrowers has doubled since 2009 to more than US$3 trn (as the BIS reported last week), the lion’s share of the debt is held by mutual funds rather than banks—by cash investors rather than levered investors. Some emerging markets already show extreme distress. Brazil is in a recession deeper than that of 2008. But the systemic implications of financial problems in emerging markets are far lower today than they were when levered investors (banks and hedge funds) did most of the lending. Brazil’s sovereign bond due in 2041 is trading at a dollar price in the mid-70s, and Brazilian corporate borrowers are subject to a deluge of downgrades. That will be painful for households and pension funds who own the bonds, but it will not have knock-on effects. Fourth, there is no contagion among emerging markets, in sharp contrast to 2008-2009, when volatility soared simultaneously in all markets. We see this clearly in the implied volatility of emerging-market currency exchange rates vs. the US dollar.
Brazil’s currency volatility has soared, for example, but Indian and Philippine volatility remains subdued; in fact, it fell slightly between August and December of this year. The market is assigning risk premia to specific assets based on their exposure to deflationary trends, but there is no evidence of a generalized increase in risk (as measured by option-implied volatility) across the board. We continue to view the US equity market with caution. The past two sessions have shown that deflation headwinds were powerful enough to overcome optimism about the tech-and-consumer side, which buoyed the major indices after Friday’s employment report.