No One's Afraid of Inflation Now, It's Recession

Sydney, Aug 15, 2008 (ABN Newswire) - Suddenly the spectre of inflation no longer hangs over the world: it's gone, banished by the reversal in sentiment in commodity and financial markets.

Banished by fears of recession, which were confirmed overnight with Europe contracting in the second quarter, with Germany and France following Italy into a slump.

Oil, copper and gold down, and wheat, corn and soybeans as well it's been a sea change in sentiment in the past month.

Slowing Europe and Japan suddenly mean the US is not alone, so it's off into the greenback because you'll be more protected there.



Europe moved into a real slowdown in the June quarter,with growth contracting by 0.2%, Germany's economy contracted by 0.5%. France slowed as well, with the economy falling a surprising 0.3% in the quarter.

Growth is still up for the first half after the March quarter saw growth of 0.7%, but the size and speed of the slump was surprising, and emphasised why commodity prices are weakening, along with the euro.



Inflation is supposed to have peaked, or is close to peaking; growth is slowing, and so will price pressures as recession bites.

That's why the surge in consumer inflation last month in the US came as a complete shock to the markets. Despite the slump in oil and petrol prices from mid-month onwards, and the rise in the value of the US dollar, the CPI surged by a rather large 5.6%, the highest rate since January, 1991 when the first Gulf War was raging.

That compares to an annual 5.1% in the year to June.

The CPI rose 0.8% in July, compared to June when it jumped 1.1%, so there was a small slowing.

But the surprising news had no impact on interest rates, shares or sentiment. Oil was still easier, gold fell sharply, losing the gains of the day before and copper was lower.

Higher food, petrol and energy costs were responsible, despite the drop in oil and petrol prices. Those falls are continuing, that's why economists believe the CPI will drop sharply this month.

Now the older and wiser of those in the market wonder if there's something more dangerous approaching, along with the slumping global economy: deflation. More of that shortly.

All year long, the debate has raged over whether the world faces a greater risk from resurgent inflation or from a deflation, caused by the credit crunch, to match Japan in the 1990s.

The fall in commodity prices has, for now, convinced the market that we need not worry about inflation.

In the US, the market for government inflation protected bonds (called TIPS) now implies that inflation will average 2.16% over the next decade.

That's the lowest in five years, but is it just as much an overshoot as the upward drive in commodity prices when they peaked midway through last month?

What is still clear is that inflation is still with us: from the United States, through Europe and Asia, prices are still rising.

Wholesale price inflation is double digit in China (but consumer prices are easing); in the US, Europe and the UK wholesale and consumer price inflation are at levels not seen for more than a decade in some cases. 

In Japan this week's report of a 7.1% jump in wholesale inflation was the steepest rise in 27 years

In the eurozone, the consumer inflation hit 4.0% in July; more than double the European Central Bank's inflation target of 1%-2%.

Inflation stands at 3.6% in France, at 4.4% in Britain (its highest level for 16 years) and at its highest level for 12 years in Italy at 4.1% and 11 years in Spain where its running at 5.3%.

In Germany inflation hit 3.3%, the highest rate since 1993 and enough to get the old anti-inflationist Bundesbank rolling in its grave.

Inflation hit 4.3% in Norway, Eastern Europe it's 6.7%, while in India it's running at nearly 12% and in Japan at 1.9%, the highest for more than a decade.

In some countries such as Argentina there's doubt about the declared rate (9.3% there) because of changes to the way the government accounts for and reports inflation. In Thailand it's running at 27% and higher in Egypt

This week China reported a slowing in consumer inflation to 6.3% from 7.1% in June. But core measures which discount food and energy have risen past 2%.

Now the point of this international roll call is to make a point: normally it would be enough to see interest rates rising everywhere: in India, the central bank is tightening policy, but apart from the increase at the start of July by the European Central Bank, central banks are holding back, transfixed in the case of the Fed and with the Bank of England by fears of a downturn and fears about inflation.

So why then are financial markets (even bond markets) suddenly more relaxed about price pressures and galloping into equities and out of oil and commodities?

Relative growth differences between the US, Asia and Europe is the one reason already stated, but the Merrill Lynch's August fund managers survey provides a second reason.

Big international investors no longer fear inflation.They worry more about recession, which they believe will take care of cost pressures.So does that indeed signal a deflationary period of rapidly falling growth and prices?

Here's what Merrill Lynch concluded this week:

Fund managers' fears of inflation have all but evaporated to reach their lowest level since the downturn of late 2001, according to Merrill Lynch's Survey of Fund Managers for August.

Merrills said a total of 193 fund managers participated in the global survey from 1 August to 7 August, managing a total of $US611 billion. A total of 161 managers participated in the regional surveys, managing $US432 billion.

The survey captures an extraordinary reversal in investors' attitude towards inflation. A net 18% of the 193 respondents expect global core inflation to fall in the coming 12 months.

In June's survey, a net 33% thought inflation would rise.

A falling oil price and growing evidence of recession have prompted this rethink.

More investors believe that the global economy has already entered recession - 24% of the panel take that view this month compared with 20% in July and 16% in June. During the credit boom, investors urged companies to borrow more, but with the credit crunch biting, they are now concerned about leverage.

The net percentage of investors who believe corporates are under leveraged has tumbled to 9%, down from nearly 40% at the end of 2007.

"The message from investors to corporates is that if we are headed for a recession, they should clean up their balance sheets and prepare a financial buffer," said Karen Olney, chief European equities strategist at Merrill Lynch.

"As banks de-lever, non-financial corporates will have to wake up to far less flexible world of credit."

Merrill Lynch found that US assets are indeed back in favour (as it seemed in the Mat survey).

"With the economic downturn spreading to the eurozone and certain emerging markets, investors are starting to view U.S. assets as attractive.

"The net balance of asset allocators overweight U.S. equities stands at 12 percent, its highest level in more than six years.

"Supporting this view is the widely-held belief that the U.S. dollar is undervalued.

"A record net 58 percent say this month that the dollar is undervalued, while a net 71 percent say the euro is overvalued. Investors believe that the U.S. has a better corporate profit outlook and higher quality earnings than the eurozone."

In Europe, investors are moving from oil to consumer stocks.

"European investors have responded to the fall in the oil price by selling oil producers and buying into discretionary consumer stocks.

"The percentage of European investors overweight oil & gas stocks collapsed to 11 percent in August from 52 percent in July.

"Investors have also significantly scaled back large underweight positions in travel & leisure, personal & household goods and retail companies.

"Technology and media sectors, both with significant exposure to consumer demand, also swung back in favour.

"At the same time, inflation fears among the European panel have fallen to levels even lower than in the Global Survey.

"A net 45 percent of European fund managers expect the region's core inflation to fall over the next 12 months. In June, 32 percent of the European panel were predicting rising inflation.

"The market appears to have overreacted to a fall in the oil price, and investors have turned a blind eye to second round effects of inflation, such as rising wages," said Karen Olney. "It will take several months of slowing global growth to be sure that the inflationary dragon has been slain."

But the Merrill Lynch survey contains a cautionary note.

"One consequence of the recent fall in the oil price has been a rapid unwinding of what the survey has highlighted as a highly-crowded trade: Investors have reduced 'long' or overweight positions in energy and started closing underweight positions in financials.

"But have they lost sight of the fundamentals in unwinding this position?"

Merrill Lynch says it believes that the energy sector will continue to be supported by a strong oil price.

The firm forecasts oil at $US119 in the fourth quarter, underpinned by low, real global interest rates.

Francisco Blanch, Merrill's head of global commodities research, said in a statement with the survey results: 

"While we have started to see some demand for oil curtailed in OECD economies, the economic fundamentals in China and other emerging markets support oil at more than $US$100 a barrel into 2009."

"Investors have moved to close underweight positions in European financials after second quarter results suggested banks are on the road to improvement."

But, according to ML's Stuart Graham, head of European bank equity research, toxic write-downs are coming to an end and banks have completed more than half of their capital raising.

However, although earnings downgrades for banks are well under way, doubts remain about the sector's ability to bounce back quickly.

"Banks are highly unlikely to see a V-shaped recovery in their share price given the uncertainties in the market," said Stuart Graham. "Apart from the economic outlook, a key question is how stringent regulators will be in setting new rules to govern banks' capital ratios. No one yet knows what the appropriate capital structure of the future is."


 

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