copied in its entirety...

To Deflation
by Andy Xie
Morgan Stanley
http://www.morganstanley.com/GEFdata/digests/20050610-fri.html#anchor
4June 10, 2005

The current business cycle is inching towards a deflationary ending. Excessive increases in leverage and capacity in this cycle could turn disinflation into deflation during the coming downturn.Property speculation has been at the heart of demand creation in both Anglo-Saxon consumption and Chinese investment — the two drivers of the current business cycle. While commodity prices are still high, the excess capacities downstream are already causing the first wave of deflation. The vanishing profits among downstream industries would take down upstream commodity prices. These forces are likely to bring down inflation and increase the cost of money for speculators. Excess capacity in property itself is also closing in on property speculation. Declining rents and rising property prices are frequently observed among Anglo-Saxon and Chinese cities. This trend also increases the cost of speculation and makes it more difficult to continue. Global property speculation is nearing its end, I believe. The US housing market is in its final frenzy. Other markets have already peaked out. When speculation cools, demand will also slow, which could bring down prices and reinforce the deflationary forces from excessive leverage and overcapacity. The risk for deflation is highest in East Asia where most economies have current account surpluses and most overlap with China’s capacities. The risk is lowest among Anglo-Saxon economies that have large current deficits that allow deflationary pressure to vent through currency depreciation.The Speculation-led BoomGlobalization and technological progress have given birth to a low inflation world; the average inflation rate has averaged about 2% over the past 10 years among China, Europe, Japan and the US, which together account for two thirds of the global economy. The average bond yield in these economies has declined by over half during the same period. The low interest rate environment has given birth to the age of speculation, I believe.Speculation has played a dominant role in the current business cycle. It began in 1998 when the US Federal Reserve lowered interest rates and the BoJ increased money supply in response to the Asian Financial Crisis (see Who Wants Asia’s Surplus Savings and Goods, 4 June, 1998). The deflation shock from the Asian Financial Crisis turned into a tech bubble. The tech bubble led to excessive investment. When it burst, it was another deflation shock and the Fed and other central banks responded by cutting interest rates and increasing liquidity again (see Think Before You Stimulate, 1 October, 2001). The stimulus led to a property boom with a weak dollar trade and an Rmb revaluation trade along the way to increase liquidity further and prolong the boom.I call this cycle a speculation-led boom because demand creation has been based on unrealistic asset prices. Anglo-Saxon consumption has been dependent on decreasing savings or on borrowing on rising property prices, which has caused big trade deficits among these economies. Rising property prices have been driving the profit expectation that supports China’s investment boom. Speculation has been the most important force behind the rising property prices, I believe.This cycle resemble those in the 19th rather than 20th century. The foundation for a speculation-led cycle is lack of inflationary pressure due to either surplus labor or technological progress. The world has experienced plenty of both. After the high inflation period in 1970s, the central banks around the world believe that their main job is to balance inflation and growth, not to fight speculation. In the 19th century when insufficient demand was the main challenge, speculation was the main constraint on liquidity expansion. What has occurred in this cycle is that the major central banks in the world did not see the structural change in the monetary environment.Cyclical Deflation AheadThe Anglo-Saxon consumer debt and Chinese overcapacity will likely become the main factors in causing cyclical deflation as the current cycle turns down. Ironically, Anglo-Saxon consumer debt would mainly exert deflationary pressure on its trading partners. Because these economies have huge current account deficits, they could export deflation through currency depreciation. Cutting interest rates is effective in pushing down currencies for economies with current account deficits, as foreign investors are less willing to buy their assets.The economies with big current account surpluses and export exposure to these Anglo-Saxon economies would be at more risk of experiencing some cyclical deflation. Most Asian economies fall into this category. In addition, they compete against China. As China’s overcapacities push down its domestic prices, their export prices could follow.China may be most vulnerable to cyclical deflation. It faces overcapacity in manufacturing, infrastructure, and property in addition to the risk of declining property prices. It is still too early to calculate accurately China’s overcapacity. What we know is that China’s fixed investment has risen from US$343 billion in 1998 to an estimated US$1 trillion in 2005.Liquidity Will Remain StrongAs the cycle is reaching a deflationary ending, interest rates are likely to remain quite low. In a ‘normal’ business cycle, it ends when central banks fight inflation with aggressive rate hikes. Hence, a downturn would be associated with rapidly contracting liquidity. The demand downturn in this current cycle stems from declining profitability and asset prices due to overcapacity. The central banks are not under pressure to raise interest rates quickly.This is why liquidity is still so strong so late in the cycle. Financial markets have been resilient despite deteriorating business prospects. The situation could change when corporate earnings turn shockingly bad and the demand for risk assets drop as a result.One justification for strong markets is that money has to go somewhere. But it doesn’t have to. In a speculation-led cycle, asset prices tend to move together. Hence, diversification does not work well. The right strategy should be ‘buy low, sell high’. The most important investment decision is to hold cash when the cycle turns down and to decrease it when the cycle turns up, I believe.From a macro perspective, the above investment strategy would imply changing money velocity. Indeed, in a low inflation and interest rate environment, money velocity is unstable and depends on sentiment. Unless central banks keep liquidity tight, there is no stable equilibrium. It all depends on sentiment.The Risk of Secular Deflation RemainsIn addition to the risk of experiencing some cyclical deflation ahead, the risk of secular deflation remains (Cyclical vs. Secular Deflation, 11 October, 2002). Secular deflation could be due to: (1) rapid technological progress; (2) declining population; or (3) a competitiveness shock. The first type of deflation is of course good. The IT sector has been experiencing rapid deflation for years, benefiting consumers and producers alike. When enough industries in an economy behave like the IT industry, it will suffer secular deflation. This is why I believe that central banks should tolerate deflation during a period of rapid productivity growth. Indeed, fighting this type of deflation by increasing liquidity only leads to asset bubbles, which is what Anglo-Saxon economies have done.The second type of deflation is similar to a chronicle overcapacity challenge. For example, property prices are likely to drop when population decreases, ceteris paribus. In general, the capital stock per capita rises with a declining population, which translates into chronicle price weakness. Both Europe and Japan seem to fall in this category.The third type of deflation could be solved through restructuring. When a labor market is flexible, an economy could adjust against a competitiveness shock by redistributing resources to where there is still competitiveness. The adjustment may involve some currency weakness also. However, if the labor market is not flexible, the competitiveness shock would be born by decreasing prices and lowering returns on capital. This did occur in Japan and it may spread to other Asian economies.In summary, the risk in the global economy still tilts towards deflation rather than inflation. Central banks should change their policy objectives and view containing speculation as a central task.