Deflation is Back... (but)

Callum Thomas

Topdown Charts

It's that D-word again. Deflation is knocking at the door of the global economy, as predicted back in February. But who is going to answer, and who is really at the door? (and so what??)

In the following charts and paragraphs I will provide my take on the key drivers, the response, the ripple effects, and a base case scenario for how it plays out heading into 2020.

First up is a trusty chart I came up with a few years ago. It shows the proportion of countries experiencing "deflation" (i.e. negative growth year over year) across consumer price inflation, corporate earnings, and industrial production. After the deflation dissipation of 2017-18, a new deflationary wave is sweeping the globe.

Consumer price deflation is one thing, but economic deflation is another. Consumer price deflation is typically driven by falling commodity prices, that is unless there is an accompanying economic deflationary impulse.

From a cyclical standpoint, the considerable monetary policy tightening across the globe in 2018 and effective trade policy tightening from the trade wars have really been the major elements behind this economic deflation, and it is in understanding how we got here that we can begin to understand the key drivers, what to watch for, and the next steps.

Deflation Drivers: Monetary Policy Tightening

The first and most overlooked aspect is how significant the monetary tightening of 2018 was. You can see in the chart below a 9-month period where there were exclusively rate hikes. At the same time the ECB was tapering QE, the BOJ did stealth taper, and the Fed was doing quantitative tightening. The patient was taken off life support...

Coming out of a world that had gotten used to ultra low interest rates and super easy money, this tightening of policy (and if you recall, a surge in bond yields) really took a bite out of the global economic cycle. And now central banks are furiously backpedaling.

Deflation Drivers: Trade Policy Tightening

The other key policy act was effectively a tightening of trade policy across the globe as Trump made good on election promises to stir up the global trade order... and stir up he did.

The China-US trade war (which is not the only game in town, multiple tit-for-tat trade disputes have followed across regions, and not just with the US). Anyway, the chart below provides a good gauge of the impact of the China-US trade war, where Chinese manufacturing trade orders have stagnated, and more recently have likewise collapsed for US manufacturers.

We can probably go around in circles pointing the finger at what the main driver is, but it's fair to say the headline shock and uncertainty aspect, along with tariff hikes and renegotiations have only compounded and added to the headwinds of monetary policy tightening last year.

US Economic Slowdown and the Powell Policy Pivot

The US economy has been far from immune to the global slowdown, and you can see the US manufacturing PMI swiftly catching down to global ex-US. Both the ISM and Markit PMIs are pointing to a significant slowdown in US GDP growth. So what we have here is the US economy clearly exposed to global risks, and likely softer growth ahead.

Tasked with counter-cyclical macroeconomic policy, it would be either a dumb, dishonest, or irresponsible central banker to not take action in the face of these facts. Preemption and precaution are words that come to mind, but so too does that D-word from before.

Deflation. Clearly there is an economic deflation impulse in progress, and if you think of some of the structural trends driving deflation e.g. automation, Moore's law, gig economy, falling search costs, internet and globalization, etc... it's fair to say that the risk of a deflation overshoot is higher and with greater consequences, than the risk of an inflation overshoot.

Indeed, the last time people were talking about runaway inflation was back when QE was first launched, and those alarmists came up well short on that thesis.

But anyway a policy pivot is indeed underway.

The Fed is one of a growing number of central banks who have opted to take the preemptive path and cut interest rates. An open question remains: what next for the US dollar...

There's a lot of moving parts with this, but I will say that when you have a currency that is overbought, a crowded long, overvalued, and then you throw in a turn in monetary policy direction, it doesn't usually work out too well for the bulls.

Where to from here?

There's still a little bit of water to go under the bridge, but I am very optimistic on the global economic outlook in 2020. The chart below shows how the global policy pivot should flow through into a stronger global manufacturing PMI in the months and quarters ahead. And that's without any possible upside from trade-truces (albeit also without downside from trade-tantrums).

It's always going to be hard trying to predict what happens next with trade policy and whether we get a resolution to the trade war (remember, it's a 2-way risk), but monetary policy is at least playing to some familiar rules of the game. And the global monetary policy pivot is setting a path to a cyclical upturn in the global economy in 2020. So the tides may soon turn on this global deflationary wave...

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Callum Thomas
Head of Research
Topdown Charts

Callum is Head of Research at Topdown Charts. Topdown Charts is a chart-driven macro research house covering global Asset Allocation and Economics.

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