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World faces third deflationary wave
Dominic Rossi
EM crisis means further fall in potential global output is unavoidable
A Chinese investor walks past an investment map showing suitable property markets for wealthy Chinese to invest in at the International Property Expo in Beijing on April 11, 2014. Wealthy Chinese will pour AUD$44 billion (US$39.4 billion) into Australian real estate over the next seven years, potentially pushing prices in one of the world's most expensive housing markets even higher. Chinese property investors have been on a international spending spree since the global financial crisis hit most of the world's economies.
The world economy is bearing the brunt of a third deflationary wave in less than a decade. The first was the US-led housing and financial crisis of 2008-9, the second wave was the eurozone crisis of 2011-12, and now a third, an emerging markets crisis.
This emerging markets crisis bears many of the hallmarks of previous episodes. All emerging market crises start in the foreign exchange markets before making their way through others: commodities, debt, equity and finally the real economy. This one is no different.
In the next few months we may reach a bottom in absolute price terms for emerging market securities, but past experience teaches us that it takes years of capital scarcity to restore capital and cost discipline after years of over investment. A new bull market in emerging markets is still some way off, and the 2002-7 period will be archived as a golden era.
The impact of this emerging market crisis on the developed world will be a little different this time. In 1997 it created a price shock that raised real income and real consumption levels in the developed world. Today an emerging crisis will create both a price and volume shock due to its greater relevance to world GDP and to global companies than in the past.
The net effect on developed nations will not be positive. Hopefully the Federal Open Market Committee will acknowledge these risks when it sits to deliberate monetary policy in September. We will see.
Whichever, the impact of this third deflationary wave has yet to reach the shores of Lake Michigan, irrespective of the tight labour markets in the US. Lower gasoline prices may now be being felt, but the fall in manufactured goods prices from Asia is still ahead of us. Tighter US monetary policy, and a strong dollar, would only intensify these oncoming deflationary forces.
The volume shock from the deflationary wave will become visible in trade data between developed and developing nations. The Financial Times recently noted that currency devaluations had failed to stimulate exports while limiting imports. In aggregate they had diminished world trade.
So it is critical that the US trade deficit now be allowed to expand and fill the aggregate demand gap that must arise from the fall in purchasing power from the developing world. Tighter US monetary policy will not help here either.
In sum, this third deflationary wave will mean that world GDP will continue to operate at a level below potential output. Downward pressure on prices will persist and a supply-side contraction in developing nations will be required before prices stabilise. A further fall in potential global output is now unavoidable. The adjustments to GDP forecasts are still ahead of us.
Those who hoped the secular opportunities of developing nations would insulate them from these woes will need to rethink
Consequently an economic landscape, formed of low nominal growth and low interest rates, will shape the developing world as it has shaped the developed world for some time. Those who hoped the secular opportunities of developing nations would insulate them from these woes will need to rethink.
Nor will a fresh round of competitive devaluations offer an escape route from these supply side adjustments. On the contrary, this would only intensify these price and volume shocks. A tightening of US monetary policy, and a stronger dollar, comes to the same thing. Either of these policy options would lower aggregate demand at a time it is already too low. Why make the adjustment unnecessarily painful?
At the beginning of this year I feared the secular stagnation hypothesis, but hoped as the year progressed it would be in full retreat, on the back of a US consumer recovery. In truth it has spread, capturing the developing world in its wake. This ice age of low nominal growth and interest rates looks more permanent than ever.
So the conundrum for investors continues. Negative real interest rates on bank deposits cannot be the road to prosperity, yet the promise of low nominal returns on traded securities looks risky.
My answer to this is to bet on innovation rather than hope policymakers get it right. Whatever you may read to the contrary, companies are investing and innovating. It is only by investing in innovation that we can escape this otherwise humdrum nominal world. The rest really is up to policymakers.
Dominic Rossi is global chief investment officer, equities, at Fidelity Worldwide Investment
World faces third deflationary wave
Dominic Rossi
EM crisis means further fall in potential global output is unavoidable
A Chinese investor walks past an investment map showing suitable property markets for wealthy Chinese to invest in at the International Property Expo in Beijing on April 11, 2014. Wealthy Chinese will pour AUD$44 billion (US$39.4 billion) into Australian real estate over the next seven years, potentially pushing prices in one of the world's most expensive housing markets even higher. Chinese property investors have been on a international spending spree since the global financial crisis hit most of the world's economies.
The world economy is bearing the brunt of a third deflationary wave in less than a decade. The first was the US-led housing and financial crisis of 2008-9, the second wave was the eurozone crisis of 2011-12, and now a third, an emerging markets crisis.
This emerging markets crisis bears many of the hallmarks of previous episodes. All emerging market crises start in the foreign exchange markets before making their way through others: commodities, debt, equity and finally the real economy. This one is no different.
In the next few months we may reach a bottom in absolute price terms for emerging market securities, but past experience teaches us that it takes years of capital scarcity to restore capital and cost discipline after years of over investment. A new bull market in emerging markets is still some way off, and the 2002-7 period will be archived as a golden era.
The impact of this emerging market crisis on the developed world will be a little different this time. In 1997 it created a price shock that raised real income and real consumption levels in the developed world. Today an emerging crisis will create both a price and volume shock due to its greater relevance to world GDP and to global companies than in the past.
The net effect on developed nations will not be positive. Hopefully the Federal Open Market Committee will acknowledge these risks when it sits to deliberate monetary policy in September. We will see.
Whichever, the impact of this third deflationary wave has yet to reach the shores of Lake Michigan, irrespective of the tight labour markets in the US. Lower gasoline prices may now be being felt, but the fall in manufactured goods prices from Asia is still ahead of us. Tighter US monetary policy, and a strong dollar, would only intensify these oncoming deflationary forces.
The volume shock from the deflationary wave will become visible in trade data between developed and developing nations. The Financial Times recently noted that currency devaluations had failed to stimulate exports while limiting imports. In aggregate they had diminished world trade.
So it is critical that the US trade deficit now be allowed to expand and fill the aggregate demand gap that must arise from the fall in purchasing power from the developing world. Tighter US monetary policy will not help here either.
In sum, this third deflationary wave will mean that world GDP will continue to operate at a level below potential output. Downward pressure on prices will persist and a supply-side contraction in developing nations will be required before prices stabilise. A further fall in potential global output is now unavoidable. The adjustments to GDP forecasts are still ahead of us.
Those who hoped the secular opportunities of developing nations would insulate them from these woes will need to rethink
Consequently an economic landscape, formed of low nominal growth and low interest rates, will shape the developing world as it has shaped the developed world for some time. Those who hoped the secular opportunities of developing nations would insulate them from these woes will need to rethink.
Nor will a fresh round of competitive devaluations offer an escape route from these supply side adjustments. On the contrary, this would only intensify these price and volume shocks. A tightening of US monetary policy, and a stronger dollar, comes to the same thing. Either of these policy options would lower aggregate demand at a time it is already too low. Why make the adjustment unnecessarily painful?
At the beginning of this year I feared the secular stagnation hypothesis, but hoped as the year progressed it would be in full retreat, on the back of a US consumer recovery. In truth it has spread, capturing the developing world in its wake. This ice age of low nominal growth and interest rates looks more permanent than ever.
So the conundrum for investors continues. Negative real interest rates on bank deposits cannot be the road to prosperity, yet the promise of low nominal returns on traded securities looks risky.
My answer to this is to bet on innovation rather than hope policymakers get it right. Whatever you may read to the contrary, companies are investing and innovating. It is only by investing in innovation that we can escape this otherwise humdrum nominal world. The rest really is up to policymakers.
Dominic Rossi is global chief investment officer, equities, at Fidelity Worldwide Investment
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