For several years now, investors have been scratching their heads over what comes next for the world economy: inflation, or deflation?
The inflationist argument derives from the trillions of dollars, pounds, euros and yen printed out of thin air by the world’s major central banks, in a desperate attempt to reflate their economies, devalue their currencies, and depreciate their governments’ debt loads.
The deflationist argument derives from the behaviour of free markets themselves, which have a natural tendency to “cleanse” bad investments, and of commercial banks whose deleverage following their lending excesses prior to 2007 equates to a destruction of the money supply.
We now appear to have an answer. Deflation it is. China’s decision last week to devalue the renminbi amounted to a seismic shock for world markets. Fund manager Crispin Odey, in a report to investors composed just before the announcement, wrote: “The day that China understands that it must devalue, is the day that deflation really breaks out across the world”. Well, now they’ve gone and done it. The Chinese have opened Pandora’s box. Now we have to live with the consequences.
The Chinese decision to devalue is, to many, puzzling. Having long pegged their currency to the US dollar, the move simply to relax the tradable boundaries of the peg in small increments amounts to a fudge. It adds to market uncertainty and price volatility. Will the People’s Bank of China step in to defend certain exchange rates, or not?
It might have sent a more dramatic and convincing signal to have cut the rate in one fell swoop, rather than tinker on the periphery. Now nobody knows whether to trust China’s financial authorities, and their motives, or not.
Inopportune
China’s shock move has certainly come at an inopportune time. In mid-August many fund managers are on the beach, either literally or mentally. More to the point, the devaluation comes amid a horrible sell-off in the prices of all commodities, and not unrelatedly during an equally horrible decline in the currencies of many emerging market economies.
Long-time markets watcher Russell Napier suggests that “a sudden cessation of capital flows to emerging markets, many already reeling from falling commodity prices and declining exchange rates, could push some
highly leveraged countries into default”. His advice? “Get long cash in general and get long US dollars in particular.”
So events in China are clearly a big deal. But they are also a sign of schizophrenic policy on the part of Chinese officialdom. The International Monetary Fund guardedly welcomed China’s embrace of an apparently more free market, less interventionist approach to currency management. But this is coming from the same administration that has been threatening to throw sellers of Chinese stocks into prison. Consistency is evidently not highly valued in China.
This on-again, off-again relationship with laissez-faire economics has been a feature of Western monetary policy too. Having thrown Lehman Brothers to the wolves in the darkest days of 2008, the US authorities were quick to underwrite the rest of Wall Street before itdisintegrated. The UK authorities performed the same type of volte-face with Northern Rock, and then Lloyds and RBS.
Teething pains
But the teething pains of the new capitalist ‘hybrid’ Chinese economy reflect another, more pressing, question that remains to be answered everywhere. Has the overarching monetary experiment that is quantitative easing (QE) had any real impact on the productive economy, or has it merely been an exercise in boosting the prices of financial assets, leaving the real economy floundering in a dry tinder forest of latent inflation?
Societe Generale analyst Albert Edwards, like Napier, was early to warn of the perils of deflation. Until recently he has been pretty much a lone voice in the wilderness. Now his deflationist warnings are being treated with more respect.
“I have not one scintilla of doubt,” he commented recently, “that the Western central banks have set us up for an even bigger version of the 2008 Great Financial Crisis. QE will be stepped up to such a pace that you will hear the roar of the printing presses from Mars.”
If Edwards is correct, and I fear he is, that may end up being of some solace for those of us who’ve clung on grimly to precious metals during their recent travails – because if we get hyper-QE in response to broad deflation, gold is an essential asset in that environment. The other strategies that make sense? De-risk, diversify, and favour defensive stocks, particularly versus leveraged growth stocks that will be savaged in any deflationary downturn.
• Tim Price is director of investment at PFP Wealth Management and writer of The Price Report. Read more from Tim in our free Capital & Conflict email.
Category: Investing in Gold