John Pattullo looks at the deflationary impact of globalisation and the world's balance sheet recession, and asks what this means for fixed income investors.
We have been saying for some time now that a disinflationary pulse is rippling across the world. The implications are important for fixed income because low inflation should permit interest rates and bond yields to stay lower for longer.
The great recession has been an important factor in this phenomenon. Although households and companies have gone some way to repairing their balance sheets, when government debt is included overall debt levels are still very high. In fact, balance sheet repair is misleading. In many cases, it is the asset side of the accounting ledger that has risen as house prices and stock markets have inflated. Liabilities remain high.
Once bitten, twice shy is the refrain of many economic participants. European companies are holding mountains of cash, which a decade ago would have burnt a hole in the pocket of any chief executive, yet investment and acquisition activity is muted. Similarly, the recent uptake of Targeted Longer-Term Refinancing Operation cash from the European Central Bank was dismal. Despite the ultra-cheap money, banks had little reason to participate when their clients were in no mood to borrow. As the adage goes: you can take a horse to water but you can't make it drink.
The deflation of globalisation
All of this might seem shocking, if it were not already flagged. Richard Koo, the economist at Nomura has spoken at length about the long-term fallout from a balance sheet recession. Hailing from Japan, which is still struggling with the deflationary forces of the last 25 years, you could argue he is qualified to comment.
He notes that, when the household and corporate sectors are engaged in balance sheet repair, only fiscal stimulus can properly invigorate an economy, monetary stimulus merely leads to mini bubbles in asset-prices. Witness the US stock market hitting an all-time high or UK house prices near record levels, yet consumer price inflation today is below 2 per cent in both countries.
This view was propounded even earlier by Roger Bootle, the former chief economist of HSBC, in his book The Death of Inflation, published in 1996. In it, he predicted that the forces of globalisation would crimp the inflationary pressures seen in the late 20th century. Pay growth would be constrained by competitive forces as collective bargaining declined, labour-saving technology undermined workers' power and emerging markets added billions of ambitious low-paid workers to the global workforce.
For companies, he claimed globalisation was a double-edged sword, both creating new markets for goods and services but also unleashing additional competitive forces that would narrow profit margins.
Technology and more price-sensitive consumers (a consequence of competition on pay) would create a feedback loop. Moreover, he postulated that a build-up of debt would exacerbate the deflationary problems. His views begin to look remarkably prescient, and would appear to support the view by Larry Summers, the former US Treasury Secretary, that we are experiencing a period of secular stagnation.
Impact on yield
For fixed income investors the speed with which globalisation's competitive forces wash through the global economy and the length of time the economy takes to recover from the balance sheet recession can help form our opinion on whether yields are at appropriate levels.
To some extent, globalisation's downward impact on goods prices may already have peaked. As developing economies become richer, their own domestic consumption and higher pay levels diminish the downward pressure they exert on prices.
Similarly, global trade may be reaching saturation point. Much of the developed world is already plugged in to the global economy and lots of the service industry, such as restaurants, is by its nature localised. As banks have retrenched, even cross-border capital flows have slowed.
It is still unclear whether we are yet over the hill in terms of recovery from the balance sheet recession. In 2010, markets were debating when interest rates would rise from their lows. Five years on and we are still having that debate, even if the US and the UK appear closer to monetary tightening – or rather making it less loose.
In contrast, Europe's economy remains anaemic and is skirting close to deflation (see chart) so fresh urgency surrounds quantitative easing (QE) and whether the ECB will engage in US-style purchases of sovereign debt. This would be tacit acceptance of fiscal burden sharing across the eurozone, something to which Germany is not yet ready to commit.
QE is portrayed as a tool to anchor low financing costs and help to spur the economy, but it is also a currency weapon. While denying it, each of the main developed economies has sought to depreciate their currency and boost their exports. First, it was the US and the UK, then Japan and now the eurozone looks on the verge of joining the game.
The balance sheet recession landscape painted by Koo, Bootle and Summers appears convincing and subscribing to its thinking has served us well the past couple of years. If we have learnt one thing from the financial crisis, however, it is to keep an open mind. For that reason, we remain alert to signs of inflation, looking at wage indicators and demand for credit as reflected in major bank lending surveys.
Yet perhaps this is symptomatic of a world that is struggling to shake off the mindset of the last few decades, convinced that inflation is around the corner. The reality may be that we are all turning Japanese and may have to get used to a low growth, low inflation world. Not a bad environment for a fixed income investor.