De­fla­tion: Boom or bust?

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

It has been our con­tention for a while that cap­i­tal­ism is re­turn­ing to its 19th cen­tury de­fla­tion­ary roots. In­deed, the ev­i­dence for this as­ser­tion has be­come over­whelm­ing. The con­sumer price in­dices of 13 OECD coun­tries have neg­a­tive YoY read­ings.

Another eight are be­low 1%. In the case of “goods in­fla­tion,” all Euro­pean economies are flash­ing neg­a­tive. And if the likes of Italy or Spain thought that sal­va­tion lay with an “in­ter­nal de­val­u­a­tion,” they can think again as Ger­many’s pro­ducer price in­dex is neg­a­tive. Even the US CPI ex-shel­ter is only inch­ing along at about 1% YoY (ex­clud­ing rental costs as th­ese are largely im­puted val­ues not based on ac­tu­ally trans­acted prices).

Our own lead­ing in­di­ca­tor of in­fla­tion, which is largely based on ac­tu­ally trans­acted prices, is plung­ing again. This in­di­ca­tor has tended to lead fall­ing or de­cel­er­at­ing prices by about six months. The in­dex tends to be highly cor­re­lated to world trade, and wor­ry­ingly it has bro­ken down in re­cent days. The as­sump­tion is that world trade will fall in vol­ume terms, with de­clin­ing prices to boot.

But what ex­actly is the driver of th­ese de­fla­tion­ary forces? There are three big fac­tors:

1) The ad­vent of new shale oil and gas tech­nolo­gies is lead­ing to lower en­ergy prices. This is “good de­fla­tion” which can be thought of as a tax cut. The un­known fac­tor is the amount of US dol­lar debt that has been in­curred to de­velop re­sources which may be­come un­prof­itable at much lower prices. In this case, plenty of bor­row­ers could go bank­rupt, which is hardly good news. In­deed, the af­ter­math of the 1985 oil price plunge saw bank fail­ures in Texas and the Lone Star state’s econ­omy strug­gled for years af­ter­wards.

2) Pro­duc­tiv­ity en­hance­ments tied to ac­cel­er­ated au­to­ma­tion and the spread of ro­botic tech­nol­ogy is hav­ing a pro­found im­pact. Robots used to do sim­ple and repet­i­tive tasks. Now they do smart and repet­i­tive things such as surgery. The worry for the mid­dle class in most ad­vanced economies is that their jobs mostly in­volve do­ing in­tel­li­gent and repet­i­tive tasks. The good news is that the price of surgery will go down; the bad news is that many sur­geons will be out of a job. This is clas­si­cal cre­ative de­struc­tion, but this time hit­ting pro­fes­sion­als.

3) In­tense pres­sure is also to be seen in cap­i­tal-in­ten­sive man­u­fac­tur­ing in­dus­tries that are still heav­ily rep­re­sented in ad­vanced economies, ie., mak­ers of au­to­mo­biles and house­hold white goods. Such pro­duc­ers of hard­ware tend to run high debt loads and are highly ex­posed to po­ten­tial “dis­rup­tive tech­nolo­gies.” For ex­am­ple, bat­tery tech­nol­ogy ad­vances al­low far more ef­fi­cient stor­age of elec­tric­ity, which will lead to the re­place­ment of the com­bus­tion en­gine and with it the bank­ruptcy of a big chunk of our in­dus­trial sys­tems.

In short, cap­i­tal­ism has rarely seen a time when both the forces of cre­ation and de­struc­tion have been as pow­er­ful as right now.

The ques­tion is not whether we face in­fla­tion or de­fla­tion – this one is set­tled in favour of de­fla­tion. As an in­vestor, you need a port­fo­lio that can han­dle both a de­fla­tion­ary bust and the ben­e­fits of a de­fla­tion­ary boom.

Hence, we would tend to own shares in the au­to­ma­tion cat­e­gory, hedged by US trea­suries and dim sum bonds. This set-up should pro­tect against a nasty out­come in both the en­ergy sec­tor and that part of the cap­i­tal-in­ten­sive in­dus­trial com­plex that is es­pe­cially prone to dis­rup­tion.

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