Central bankers worldwide have emphasised the importance of bringing down runaway inflation by hiking interest rates and using other measures even if it means slowing the economies. But what if the central bankers get it all wrong and overkill?
If the aim of the central bankers is to return the G7 consumer price index to the trend line from March 1997 to December 2020 (the onset of the coronavirus), it means that the G7 consumer price index will fall by about 2.5 percent by the end of 2024 from recent levels. The G7 countries consist of Canada, France, Germany, Italy, Japan, the UK and the US. Yes, the developed economies could face deflation – when general price levels in a country falls.
In the 77 years from 1938 to 2015, five periods of deflation occurred in the US: 1938-1939, 1949-1950, 1954-1955, 2009 and 2015. The three periods of deflation coming off relatively high levels of inflation were in 1938-1939, 1949-1950 and 2009. The year-on-year US CPI inflation rate hit highs of 5.1 percent in 1937, 19.7 percent in 1947 and 5.6 percent in 2008. Inflation was relatively subdued in 1953 and 2014, with highs of 1.5 percent and 2.1 percent respectively.
The current environment is reminiscent of the period preceding deflation in 1949 to 1950 when backlogs that were built up during World War II led to sharp inflationary developments. Once the post-war demand was satisfied, supply exceeded demand and resulted in falling prices of goods and services.
In the current situation, backlogs were built up with the outbreak of the coronavirus as well as the precarious geopolitical situation in light of the current Ukrainian conflict. We are fast approaching the post-coronavirus stage where demand will be satisfied while Europe’s gas woes as a result of the Ukrainian conflict will hurt economic growth and demand. Steady or even falling prices in developed economies are already on the radar screen as in 1949-1950.
Nobody knows exactly how things will pan out over the next year or two. Perhaps history could guide us. I compared the trends 1938 to 1939, 1949 to 1950 and 2009 based on the 12 months before deflation set in and the 10 months after deflation set in.
It is the trends that count rather than the actual levels due to changes in macro-economic policies, new industries and the opening up of previously illiquid markets.
On a year-on-year basis, US industrial production started to fall 12 months before deflation set in in 2009. Contraction during the other periods began five months before deflation set in. The downward momentum began to slow after about four months after deflation set in and turned positive between eight and 11 months after deflation set in.
The US consumer price index in 2009 bottomed five months after deflation set in compared to six months in the 1948-1950 period and eight months in 1938-1939 period.
The average US unemployment rate during the 1948-1950 and 2009 periods climbed to more than 7 percent from 4 percent until deflation set in and remained at the high levels during the 10 months after deflation set in.
In the 1938-1939 and 2009 periods, secondary market rates on US 3-Month Treasury Bills dropped sharply in the first t10 months of the 12 months before deflation set in and remained close to zero in the 10 months after deflation set in. The 1948-1950 period followed a different trajectory but rates were cut three months after deflation set in.
Governments were effectively in charge of bond markets in the early 20th century and frequently issued bonds. Since the 1970s the bond market has become larger, more diverse and liquid. That explains the virtual zero volatility during the periods 1938-39 and 1948-50.
In the 2009 period, the yield on US 10-year government bonds plunged in the first 10 months of the 12 months before deflation set in and increased sharply in the four months after deflation set in. In the 1938-39 period the yield on the then relatively illiquid bonds decreased gradually over the entire 22 months. In the 1948-50 period the yield on the US 10-year government bonds decreased gradually in the first 10 months of the 12 months before deflation set in and remained unchanged in the 10 months after deflation set in.
The behaviour of the US stock market as measured by the S&P 500 Composite Index during the 1938-1939 and 2009 periods were remarkably similar. In both cases the stock market fell by about 40 percent until deflation set in. In the 2009 period the stock market bottomed a month after deflation set in, while in the 1938-1939 and 1948-1950 periods it bottomed a month later.
The trends of the said periods of S&P 500 Composite market valuations based on the Shiller PE10 Ratio (price earnings ratio is based on average inflation-adjusted earnings from the previous 10 years) are remarkably similar. In the 2009 period the PE10 bottomed a month after deflation set in, while in the 1938-1939 and 1948-1950 periods it bottomed a month later. The gaps between the ratings throughout the 22 months can be ascribed to the development of new industries and other factors such as globalisation.
I agree that quite a few other scenarios and views exist and developments, specifically on the geopolitical front, may upset the apple cart. The unanswered question is whether the historical deflation trends caused by overkills by central banks will repeat itself.
Yes, stocks will rally from time to time as soon as some “good” news such as lower-than-expected inflation numbers or signs of weaker economic growth become evident, pointing to a more dovish stance by central bankers. But developed market stocks are in trouble as the prospects of deflation and recession will chip off lavish valuations.
In my opinion, a “risk off” strategy is more prudent than taking high risk bets as some signs of deflation and approaching recession are already surfacing. The Freightos Global Container Index is already down by more than 40 percent compared to a year ago. The Goldman Sachs Commodity Index, which tends to lead the G7 CPI inflation rate by about six to seven months, also points to the G7 inflation rate falling to about 4 percent from the current 8 percent sooner than later.
I think that investors in developed markets should look past the current runaway inflation stage and start to focus on the ensuing possible deflation and recession stages. G7 bonds could offer you solid protection against a deflationary cycle in developed economies. Developed market equities may face further downside pressure in coming months while a long uphill battle lies ahead before previous highs will be tested again.
Unfortunately, poorer nations’ economies will bear the brunt through lower commodity prices, weaker currencies and possible social disobedience due to higher wage demands on the back of higher inflation.
Ryk de Klerk is analyst-at-large. Contact [email protected]. He is not a registered financial adviser and his views expressed above are his own. You should consult your broker and/or investment adviser for advice. Past performance is no guarantee of future results.
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