One of the things I have been trying to get my head around is how the assumed association between inflation and growth has become so strong that many seem to believe that they are one. As a dog is likely to experience fleas finding a flea does not mean there is a dog attached to it. Growth is likely to experience inflation and recession experience deflation. But inflation does not lead to growth and deflation does not need to lead to recession.
Oil and energy prices are the main cause of the deflation we are currently seeing but that in itself is stimulatory. Central banks are responding to their deflation gauges by erring on the side of further stimulation. So rather than one countering the other we are seeing Dr.Aghi and his clan administering double the dose. Which is all very well and rather pleasant as long as any growth doesn’t see inflation, or rather any rapid inflation.
Central banks respond to historic data and could be considered to be driving down the economic highway with their windscreens covered up using the rearview mirror and the instruments to navigate by. Which is fine as long as the curves in the road are gentle but fatal if sharp bends are ahead. My concern is that the stimulation due to deflation caused by stimulatory effects will heighten the chances of a sharp bend ahead. If energy prices were to rise suddenly we would have inflationary effects occurring just as CB policy has adjusted for the reverse.
Which brings the risk down to a spike in oil. One just has to sum all the commentary and forecasts for oil prices to see that the bias is hugely to the down side which would suggest that the risk of an oil spike is all the more likely.
Oh look. Oil is rallying hard and is up 12% in less than 24 trading hours. The news event this is being pinned on is friday's data of rig closures and the price move has so far been explained as short covering. Which to your author’s ears normally is a dismissive statement of hope and denial that prices could go higher for other reasons. The risk is therefore for this to run and with it a further risk to sharpening that bend ahead of the policy makers.
Let’s take a look at the rest of the deflation trade. The most obvious has been the bond markets. The size of the market is gigantically monstrous and yields are pretty close to zero across many of the key ones. My concern is what happens should opinion on the outlook of inflation suddenly shift due to growth from CB stimulatory policies combined with rising energy prices. Coming from such a low yield base and with such huge consensus any exiting of positions could be messy as it is unlikely that there are many people left looking to buy. This could very easily look like 1994 again.
If we do get a 1994 the effect this time could be much more dramatic and would derail central bank policy and place huge burdens on the
elephant diplodocus in the cupboard. All the bonds that central banks and funds hold.
As I have regularly remarked, equity prices are not expensive when measured against alternative yields and as such I have been dismissive of traditional measures of earnings and dividends versus price suggesting that equities are toppy. However if we get a serious tip in bonds then that argument vanishes. In which case equities would get caught up in the sell off.
So where as we saw equity and bond price inflation in the deflationary QE era, we could well see equity and bond price deflation in response to a shift to perceived inflation. Of course whilst this in itself will act as a brake on inflation, it does make one ask where one wants to have ones money parked in a bond AND equity selloff.
Which brings us back to cash and a safe haven currency that isn’t going to be sold off like mad in this panicky scenario. Take your pick, but a low debt issuing country running twin surpluses would be sensible. There is an alternative and though this goes against my grain, I guess as most of what I have written above could be considered Zero Hedge fodder, let's go the whole hog and suggest buying gold. There I've said it.