(This story was originally published on March 10, 2009. It has now been republished to make it available to non-paying members at FNArena and readers elsewhere.)
By Greg Peel
"Current fears are that the crisis in the real economy could continue to interact negatively with the financial crisis it has grafted onto, plunging the global economy into a depressionary spiral in which recession and deflation are mutually reinforcing."
This comment from economists at Credit Agricole deftly sums up the global financial crisis, past and present. Recall that in mid-2007 the US experienced a "subprime crisis", which soon morphed into a more worrying "credit crunch", which then took root as a full-blown "credit crisis" which began to impact on the entire global economy, sending us spiralling into the "global financial crisis". At the outset, the subprime crisis was dismissed as trivial, and even the credit crisis was seen to be something contained within the financial sector and not overly threatening to the real economy.
But now that the real economy has "grafted onto" the financial crisis, as Credit Agricole puts it, global recession is at hand and, more ominously, global deflation is looming. A recession is simply a contraction of economic growth, and while usually causing "disinflation" (inflation growth slows) a recession rarely causes actual "deflation" (inflation turns negative). Says CA:
"The stakes are high: deflation is a rare economic phenomenon - rare but sufficiently devastating as to be avoided at all costs."
In simple terms, deflation occurs when general prices fall for a prolonged period of time. This leads to reduced margins and profits, reduced wages, and a resulting effective increase in debt. Nominal debt does not change over time, but the capacity to repay it reduces in a deflationary period. This offers the spectre of working hard week in, week out, to simply be looking at an even more onerous debt burden down the track. It is thus no surprise that deflationary periods are "depressing" in a psychological sense, let alone potentially in an economic sense. The problem is that deflation, like high inflation on the opposite hand, can be self-fulfilling. Consumers and businesses put off buying of all but essential items and shy away from any borrowing. The economy does not just contract, it contracts at a pace.
The economic term "depression" refers not to the psychological state of the same name, but to what is best illustrated on a graph of economic activity over time. A recession means negative growth and a depression supposedly requires negative growth of 10% or more, but it also requires a length of time of contraction and a long period before recovery. Such a period would appear as a depression of a line of economic growth. Or perhaps if you think about travelling across the countryside towards a distant peak, a recession might equate to have to drop down briefly to cross a river bed but a depression would be having to drop down into and cross a giant crater. The irony is that depressions are more likely to occur if everyone gets depressed.
The most famous deflationary episode was the Great Depression of the 1930s, over which the US economy contracted by a total of 26.5%, consumer prices fell 24.4%, and unemployment reached 25% in an era before unemployment pensions were available (which obviously exacerbated the situation). President Roosevelt was slow to react with stimulatory measures including monetary easing, and a shift to protectionism ensured the Depression became a deep-set global phenomenon. Also slow to react to financial crisis was Japan in the early 1990s, and failure to ease monetary policy rapidly and rationalise a failed banking system led to the second most famous deflationary episode which lasted over a decade.
[See the FNArena special report "Deflation, Hyperinflation and Depression: Where is America Headed?" available to paying subscribers.]
The last time deflation posed a real threat was the bursting of the internet bubble in 2000. Here we had a stock market bubble based on heavy debt but little or no earnings to speak of. The tech-wreck led to recession, but the US Federal Reserve acted quickly to cut interest rates, and monetary easing became even more earnest in the wake of 9/11 in 2001. The recession ultimately proved short-lived because easy monetary policy allowed banks to fuel credit markets through both traditional lending and, growing in popularity, financial intermediation (such as packaging mortgages for on-sale).
The current recession might also have been a brief one if banks had a similar capacity to pull the system back onto its feet. Certainly the monetary policy response is there. But this time the crisis began in the banks, and therein lies the problem. There has been no cheap credit-led recovery. It is now all down to the public sector. And one can clearly argue that the response to the tech-wreck only served to exacerbate what we are now experiencing, such that the brevity of the 2002 recession is now being paid for in multiples. That time deflation was a risk but never materialised for more than a very brief period. The world was not plunged into a recession-deflation-depression spiral. The longer it takes for banks to be back up and lending this time around, the greater risk of a spiral beginning.
And we are clearly no closer to bank revival. However, this time around the world's governments and central bankers are doing the right thing as far as economists are concerned, by fighting disinflation with "reflation" - the twin stimulus packages of fiscal handouts and easy credit (low interest rates). If reflation can match disinflation, then deflation is avoided. So far we have seen rapid disinflation as the price of oil and other commodities have crashed overnight. But an affect on general prices is yet to manifest itself in the data. Central banks look at "core" inflation rates (ex energy and food) and those are falling in growth at the moment, but not so quickly as to assume deflation is at the door.
However, battling disinflation and winning is currently a big ask.
"All financial crises," notes Credit Agricole, "originate with an excess accumulation of aggregate liabilities, against the backdrop of a collective error in assessing risk. The current crisis conforms to the rule in that it follows a long period of excessive, imprudent credit expansion".
The collapse of this major credit bubble contains the "seeds" of the debt-deflation mechanism, the CA economists suggest. As asset values fall, the relative value of a corporation's debt tends to increase, which may require a reduction in debt leverage (take any property trust in Australia as an example). Debt can be reduced through income (cashflow), raising new funds, and/or asset disposals.
Take your choice of Australian resource companies in difficulty at present (or any sector for that matter). Debt levels are too high and commodity prices have fallen, drying up income. The cost of refinancing has become prohibitive and as share prices have collapsed, equity raisings are out of the question given massive dilution. The remaining option is to sell assets. And that is what a very large number of corporations in every sector in the economy in every economy on the planet is trying to do right now, simultaneously. And the lower asset prices fall, the greater debt to asset value measures rise, forcing more debt reduction, forcing more asset sales.
This is a deflationary spiral before you even start moving into the consumer economy.
Banks are not only the source of the crisis, they remain an ongoing part of the crisis. As asset values fall, collateral values against loans fall, causing banks to restrict lending. That's why debt refinancing for corporations is either expensive or unattainable. This leads to an increase in loan defaults, and the subsequent impact on bank balance sheets leads to credit rationing, despite lower credit demand, and despite low interest rates.
So the question remains: Will the reflationary efforts of governments and central banks across the globe, fuelled by money printing (particularly in the US but elsewhere as well) be enough to ward off the deflationary avalanche of snowballing forced asset sales? Can monetary reflation overcome the overwhelming rush of credit deflation - so-called global deleveraging?
Credit Agricole believes, with respect to the US, that it will. "Indeed we are betting on the effectiveness of the measures," the economists note, "albeit without any proof so far. Still the measures taken as a whole augur well for fighting the risk of deflation".
Despite Europe appearing to be potentially an even bigger basket case than the US at present, Credit Agricole does not believe the risks of deflation are greater in Europe than in the US, but actually less so. Consider this observation:
"It is true that Member States [of the EU] found themselves in a relatively favourable situation before the economic cycle went into a downswing. Until the summer 2008, they were facing inflation, not deflation pressures. After two years of above-potential growth, industrial capacity utilisation rates were running at record highs. The labour market had become tighter, with a steady fall in the number of unemployed, which began in 2005. At the same time, the sharp rise in commodity prices threatened to put pressure on input prices, wages, and spread to all consumer prices by a contagion effect."
One might easily substitute "Australia" for "Member States" in this quote, except that Australia had come off the back of more than a decade of solid economic growth rather than just a couple of years. The common argument is that Australia was in a much better position than most economies going into the GFC, so it should thus not suffer as much.
Macquarie economists note that the first fall in the Australian inflation growth in the cycle occurred in the December quarter just passed, when the headline CPI dropped 0.3% to an annualised rate of growth of 3.7%. It is a long way from plus 3.7% to minus, and Macquarie considers Australian deflation a "low-probability event".
From a global perspective, Macquarie has taken a look at nominal long bond yields in different economies compared to real yields (adjusted for inflation). Inflation levels across the globe are falling but, like Australia, remain positive for now. When inflation prevails, real bond yields are lower than nominal yields because inflation erodes the value of the payout. But if the market is anticipating deflation, then nominal yields (at which you buy a bond now) will fall towards real yields. The lower the differential along the bond curve, the longer the period of deflation is being expected.
At present the UK is looking at deflation until 2011 on this measure, while Japan and the US have settled in for a decade's worth. (Australia not analysed). Now, market prices do not reflect future certainties, and as such opinions will change, but remember that deflationary spirals begin when the constituents within an economy begin to believe in deflation setting in for some time.
The International Monetary Fund suggests the risk of global deflation is currently the highest it's been for a decade (and the World Bank has just decided the global economy will recede in 2009, for the first time since the War) and that deflationary risk will remain elevated throughout 2009, but nevertheless the IMF believes "the most likely outcome is that sustained deflation will be avoided".
That's good news, other than no one can remember the last time the IMF actually got anything right. And if it is at all a measure of Macquarie's own confidence in its "low-probability call", the equity team has nevertheless decided to examine the effects of deflation on each of the Australian stock market sectors.
How does deflation affect the various sectors?
As already noted, deflation is not goods for banks. Falling asset values mean higher debt to asset values and falling incomes mean less capacity to service growing debt. This leads to an increase in defaults. The Big Four Australian banks have enjoyed a spurt in margins and revenues as they regain market share from foreign and small banks and non-bank lenders, but this is still in a climate of falling credit demand. Banks need to generate enough revenue growth to overcome growing loan defaults and delinquencies in order to stop their balance sheets contracting. And to use a now hackneyed expression, the elephant in the room is commercial property. We are yet to see the sort of collapse in commercial property prices we did in the 1992 recession, but there's not a lot to suggest we won't.
While many believe Australian banks will still be forced to cut dividends and raise capital ahead, Macquarie believes "the structural integrity of the major banks today leaves them in a relatively strong position, regardless of falling asset prices and low interest rates". Note that Macquarie suggests "relative" strength, which can imply "bad, but not as bad as others" as opposed to "good".
Deflation + banks = not good.
The property question provides a segue into the listed property sector. Clearly deflation is very bad for this sector as it relies heavily on property assets funded by debt, the income from which pays distributions. As asset values fall, debt ratios are greater, and that debt needs to either be refinanced in a market little willing to lend or reduced through asset sales. At the same time, (commercial) occupancy rates will likely fall, leading to lower rent income, and rents themselves may need to fall to avoid more vacancies. Asset sales are forced to occur at the same time everyone else in the sector is doing the same thing, and willing buyers are limited.
Macquarie sees the Australian listed property sector divided clearly into two camps - those with manageable debt levels and reliable income streams and those with critical debt levels and tenuous income streams. In the former case, such trusts would be defensive, and may even outperform in a deflationary climate given their yields. In the latter case, the ten foot pole comes out, before being put away again.
Deflation + property = bad.
The listed infrastructure trust space can be grouped in with property trusts given the nature of the investment model. This is separate from infrastructure construction which is more your basic materials and construction sectors - your Borals and Leightons. The two most popular infra trust investment targets are roads and airports. Within all the infra trust space, however, the same rules apply with regard to too much debt.
Macquarie suggests toll road takings have shown to "remarkably resilient". (Is this the point where we proffer the Sydney public transport system as one reason?) However, while numbers of cars on the road clearly rise with time the spanner in the works is unemployment. Regular toll road users do so to get to work, so if there's less work to go to there will be less cars on the road.
Airports are vulnerable in a deflationary environment given most flights are discretionary, unlike trips to work. And watch for a surge in cross-ocean internet meetings now that the technology is readily available and reliable.
Deflation + infra trusts = not good.
Turning to Australia's "other sector" (outside of banks), being resources, we can again put forward a simple dichotomy. Clearly all commodity prices have materially reduced, thus reducing mining company income. The resource sector has always undergone lengthy cycles and one day it will turn around again. But for now, Macquarie suggests "it is increasingly difficult to get positive on the resource sector".
In a deflationary climate, there will be no let up for weak commodity prices. The best a mining company can do is to go into a hibernation of sorts and await the spring. Core production will continue but marginal production will cease. Revenue will be greatly reduced (although raw material costs will also reduce, providing a dampener), which thus brings us to the dichotomy. Those companies with little or no debt, or at least sufficient core cashflow to cover debt, will slumber peacefully. Those with overhanging debt problems will need to sell assets. In selling assets, a mining company reduces the capacity for cashflow generation in the future. Some mining companies will not survive.
The perfect example of this dichotomy is BHP and Rio.
Deflation + resources = not good.
Gold, while considered a commodity, is more effectively a currency, and thus its fate in a deflationary environment is a different kettle of fish. In theory, gold is the universal hedge against inflation, so logic would suggest that a period of deflation would weigh on the price of gold. However, gold is most importantly a store of wealth.
We buy gold in times of inflation because inflation erodes the value of otherwise positive returns on, for example, the stock market. But we will also buy gold in periods of deflation to avoid losing any more money on the stock market, or elsewhere. Macquarie draws on the favoured example of gold in the Great Depression - a period of lengthy deflation. The actual US dollar gold price was fixed at the time, but gold miner Homestake saw its shares (a rough proxy for gold) rally from US$70 to US$300 between 1929 and 1933 - a period when the S&P 500 lost 60%.
The gold price can also hold up in a deflationary period in anticipation of high inflation ahead. The US, for example, is printing big time to reflate its economy. If the world stops buying US bonds on the other side of the ledger, the US dollar will collapse and the gold price will soar.
Deflation + gold = not bad.
If the resources sector follows lengthy cycles, so does the basic materials sector. As a proxy for problems in basic materials one need only look at the US housing market, to which many Australian companies are exposed. No one can see the end of the downward price spiral (deflation) at this stage. New construction has dried up. The Australian housing market is better placed, but there is little reason to suggest new home building is about to surge again - government grant or no government grant. In the non-residential sector, government spending on infrastructure is a boost but commercial property is clearly a drag.
Once again, material sector companies will live or die on debt levels, given income will be greatly reduced.
Deflation + basic materials = bad.
The energy sector is currently offering up a tale of two fossil fuels - oil and gas. While the prices of both are clearly depressed, oil is seen as the old way and gas (cleaner liquid natural gas) is seen as the new. The energy sector, again, lopes through extended cycles. The world's big oil companies have been around for decades and have seen it all before. They know that the bottom of a cycle is the time to invest for the future, and that's exactly what's going on at present in the LNG space.
The alternative energy space should be seeing the same interest, but alternative energy investment requires a greater level of venture foresight from lenders or investors at a time when debt is being rationed and risk aversion is the name of the game. Moreover, alternative energy will either surge or stutter depending on whether carbon cap-and-trade markets ever get off in the ground in Australia and the US.
So energy companies should be investing at the bottom of the cycle and never at the top, but as the Macquarie analysts note, many energy companies can't help themselves investing when oil prices are high, and are now paying the price. The oil price has collapsed a long way but the market is pricing energy companies as if this is an "oversold" condition, with expectations for a bounce in the not too distant future. Macquarie notes that the share prices of energy companies are currently materially higher than they were in 2004 when the oil price was last in the US$40s.
Deflation will thus reduce the attraction of energy companies, particularly those which have overstretched their balance sheets (the common theme). But those with healthy balance sheets and acquisitive capacity will stand to benefit in the long run. Macquarie suggests "given the capital-intensive nature of the upstream industry, the potential cost deflation clearly provides a huge opportunity for those participants with balance sheets large enough to exploit it before the oil price rises and drags activity levels and costs up with it".
Energy production is a very cost-intensive industry, requiring not only simple inputs such as steel, but also service costs. Service costs have collapsed as production and exploration has slowed, leading to a severe strain on the energy service sector. The service space (your Boart Longyears for example) became very crowded in the oil price boom and is now suffering from competition and price wars. Deflation is very bad for energy servicing, with the exception, at present, of those companies with secure maintenance cashflows and exposure to LNG development.
Deflation + energy = bad for some but not all.
Moving downstream to the utility sector, we enter the grounds of what is consumer discretionary and what is a consumer staple. While deflation causes consumers to postpone spending on discretionary items, one has to eat, so staples such as food are not much affected. Therefore prices are not much affected either (which is one reason why food is not considered part of "core" inflation). The same can be said for electricity and gas. Maybe a recession might prompt Dad to run around turning lights off after teenagers and scold them for spending too long in the shower, but conservation considerations have already prompted such activity anyway. In short, we still need as much electricity and gas whether we are in a boom or a bust.
Hence utility prices are unlikely to deflate meaningfully and utility companies should still provide relatively secure returns.
Deflation + utilities = not bad.
We now segue nicely into the retail sector. Retail is divided into the two camps of discretionary and staple.
For discretionary retail, there is probably nothing worse than deflation. For deflation implies that consumers are not buying, or putting off what they might otherwise have bought. At one end, small ticket items such as restaurant meals become an expensive and unnecessary indulgence, while at the other, big ticket items like a new car become just too much of a risk, particularly when debt is involved. The option is available to eat at home and to stick with the old clunker for another year.
At the wholesale level there is some respite in the form of lower input costs (materials and labour), but wholesalers also have large amounts of sunk capital to fund. Retailers have little sunk capital (they tend to just lease a shop) but are clearly exposed to falling demand and subsequent discounting price wars. Familiar brands tend to fair better than unknown brands, but a brand name won't ward off deflation.
Deflation + consumer discretionary = bad to very bad.
Consumer staples, like utilities, are largely immune from deflation. While we might shy away from the Wagyu beef and go for the cheap mince in a recession, we will still eat. And we will still drink Coke and plenty of beer - maybe even more so if we're down in the dumps. We will still buy pills and go to hospital, so you can just about lump the entire healthcare sector in with consumer staples. We just won't spend up big, so while consumer staple companies (such as Woolies) will likely outperform, they won't necessarily rise in value. You can also consider telcos to be in the staple camp to a large extent, for we will still make phone calls.
Deflation + consumer staples = not bad.
There was a survey the other day, I think in the Sunday paper, which suggested beer, fast food and pokies were havens for the recession-hit Aussie. We've discussed the first two, which thus brings us to the gaming industry.
So far gaming revenues have held up well. This is no surprise, given it provides cheap entertainment for some, and for the more desperate a hope to win some money to ward off trouble. But lower interest rates and petrol prices have also had an immediate impact on household budgets to date, freeing up funds to be blown on the pokies. This will not, however, last in a deflationary environment, because rising unemployment will force less participation.
Deflation + gaming = not good.
If consumer discretionary is one sector hit hard by deflation, there is a flow on effect into the media sector. Advertising revenues from goods and services have collapsed. As unemployment rises, advertising for jobs crashes. The only saving grace for the media sector in a period of deflation is the split between old and new media.
While new media companies such as Seek have seen revenues fall as unemployment rises, this has occurred as a pullback in a longer term trend of new media growing at the expense of old media. Thus companies exploiting new media and subsequent advertising revenue will at least have some dampening effect at work. The opposite is true for free to air television and newspapers and magazines. Old media is now losing revenue from both recession and lost market share. Radio remains relatively immune from market share erosion as radio is a "staple" in the sense that we will always listen around the breakfast table and in the car, and to sporting events. Radio will still lose revenue in a deflationary environment, nevertheless.
Deflation + media = bad to very bad.
That brings us to the end of our sector discussion. If there is one thing that stands out, I have used the labels of "not bad", "not good", "bad" and "very bad" in relation to a deflationary climate, but never "good". This sums up what deflation does to stock markets.
The question thus is: Is anything good?
Over the past twelve months investors in government bonds have done very well. Government bond investment is considered the antithesis of stock market investment. When inflation is strong, stocks rally and bond prices fall with rising yields. Under deflation, stock prices fall and bond prices rally with falling yields. Under deflation, real yields can be higher than nominal yields (they are always lower under inflation). It is thus no surprise, therefore, that government bonds are considered a "safe haven". This is clearly the case at present in the US.
Should we thus all rush out and buy bonds, particularly given the Australian government is now issuing them by the truckload?
The problem with bonds is that they are undermined by government attempts to reflate the economy. Taking the US example, the government is relying on exporter countries buying the constant issues of bonds as a means of investing their surpluses and thus funding the US deficit. At the moment, all global economies are in strife but the world is preferring the "haven" of the reserve currency. This is all well and good, until it stops.
We learned yesterday that the world's second biggest economy - Japan - has gone into current account deficit for the first time in 13 years. Before China arrived on the scene, Japan was the greatest exporter of manufactured goods on earth. To this day it still relies on selling Toyotas and Sony products. But so extraordinary has been the turnaround in Japan's export fortunes (exacerbated by a rising yen) that its current account has swung wildly into deficit - much more wildly than anyone ever imagined.
Japan owns a very big chunk of US bonds. If it begins to sell bonds (as a deficit suggests it should) then the floodgates could open. Germany and China are also big owners of US bonds and their fortunes are not exactly rosy at the moment either. If the US bond market collapses, so will the US dollar, because all that will be left will be printed greenbacks with no economic value.
While Australia's situation is not nearly as tenuous, deflationary environments are not necessarily a safe one for government bonds. Disinflation - yes. Deflation - dodgy, because deflation can rapidly turn into high inflation if governments over stimulate.
That only leaves gold.
There are no two ways about it: deflation is bad for investors. We can only hope, as Credit Agricole, the IMF and Macquarie (to name three) do, that government and central bank reflationary strategies across the globe will work.
