Déjà vu

Last August, and again earlier this year, Chinese devaluation and the threat of a more serious decline in the Yuan (combined with USD strength) sowed the seeds of brief periods of significant drawdown in Global equity markets: the Global Index fell 12% in the month after last August’s trivial devaluation, and almost 14% in the weeks leading up to mid-February, when Yuan devaluation fears again re-surfaced.

Despite net outflows continuing apace through the first quarter – almost matching the entire outflow in the first 11 months of last year – and heavy Central Bank intervention, together with some tightening of controls at the margin, the Yuan actually strengthened in a move (vindictive, some speculators might say!) designed to head off speculative pressures and provide reassurance that all is well in the East. Another $1trillion in loans helped, but that’s neither here nor there in China these days. Move along, nothing to see here…

But we know differently. We know that you simply cannot grow credit $2.5 trillion annually with no corresponding nominal income growth; we know you cannot add capacity where there is already too much capacity; and that you cannot grow bank balance sheets at a rate annually equivalent to 40% of nominal GDP. Not if you want to keep your exchange rate fixed, you can’t.

And that’s where recent developments are interesting, the Chinese officially target the Yuan against the CFETs index – against a basket of 13 currencies (about one quarter USD weighted) and the Yuan has depreciated 1.3% since the end of March (5.9% year to date). From the mid-January low, the Yuan appreciated 2.1% against the USD through the end of March but has depreciated 1.2% versus the USD subsequently. They’ve unwound half the appreciation of the prior weeks.

Quietly, and under the radar, the Chinese have been letting the Yuan slide against the CFETs basket and, probably more importantly for the market, against USD.

Graph 1

This USD strength is seen in the broad USD appreciation in recent weeks: the next chart shows the percentage of currencies in the US effective exchange rate basket that the US has appreciated against in the last 20 days: the USD has appreciated against 80% of the currencies in its own basket.

Graph 2

We are seeing broad USD strength, broad Yuan weakness and, significantly, the Chinese quietly letting the Yuan slide against the USD.

This feels like déjà vu from our standpoint.

The global economy is already at low altitude, the median annual growth rate in our broad national sample is just 1.9% with over half growing less than 2% annually, and appears to be losing speed, again over half have growth slowing. Another round of Yuan/USD weakness into that mix is likely to precipitate just the same reaction as we saw last summer and earlier this year. Perhaps it’s time to seek out that tin hat again…

Japan responds

As we have noted in our written material several times since the Chinese authorities buckled last August under the weight of enormous domestic capital outflows, when China accounts for approximately 20% of your exports and 25% of your imports you have to respond… and respond the Bank of Japan did. Initially by suggesting the imposition of capital controls in China and now with firm action by a shift to negative interest rates.

The Bank of Japan has set itself the target of 2% inflation – despite QE amounting to 15% of GDP annually that has left them holding 26% of the stock of outstanding Japanese government debt (up from just 7% in early 2013). Japanese core inflation (Inflation excluding food and tax effects) still stands at a meagre 0.1%.

What’s going wrong?

Well, quite simply, that QE doesn’t work in Japan in the way you might argue it works elsewhere.

Here’s the picture:

Firstly, injections of monetary liquidity – through asset purchases – are offset entirely by a decline in the velocity of circulation of money – in short, more money does less, leaving you where you started.

2016.1.29.JapanResponds

Secondly, the liquidity injected simply ends up in the “current account” at the Bank of Japan – that is to say, banks hold the cash in the form of mountainous reserves at the central bank.

The level of current account deposits at the Bank of Japan stands at a mind-boggling Yen 253 trillion (up 42% y/y) – that is approximately half of GDP.

2016.1.29.JapanResponds2

The Japanese system is incomparably awash with liquidity and one strong product of that has been a sharply weaker yen (the effect on equity prices and subsequent wealth effect on consumption – the transmission channel for QE in the USA – is negligible when Japanese households have just 10% of their assets in equities versus 53% in cash). The channel through which Japanese QE works – and Japanese QE is on a scale that dwarves that in any other country besides China (where state-approved bank balance sheet expansion effectively replicates QE) – is through an explicit policy to drive the yen down and thereby import some inflation whilst giving Japanese exporters a bit of a boost.

However, along come the Chinese in the middle of the largest credit bubble in history and throw a “spanner in the works” with a weaker yuan.

The yen has appreciated approximately 12% against the yuan since last August. That hurts. It hurts a lot and is a substantial headwind for Japanese QE.

The only thing to do, according to the Bank of Japan right now, is make interest rates negative and force that Yen 253 trillion of liquidity out into the economy via bank lending.

Why? Because the appreciation of the yen is pushing inflation the wrong way, if left unchallenged Japan will slip back into core deflation very quickly.

Core inflation responds with about a ten month lag to the exchange rate.

2016.1.29.JapanResponds3

Moreover, the exchange rate impacts the output gap (gap between actual and potential output) and that also drives inflation.

An appreciating exchange rate turns the output gap negative and that pushes down on inflation.

2016.1.29.JapanResponds4

So, easy to see why the Bank of Japan responded. They said it was to encourage banks to lend those reserves, but we know better.

It’s just the first little warning shot in an open currency fight with the Chinese.

With the yuan under severe pressure as a consequence of persistent and ongoing domestic capital flight, and a devaluation of 20%+ extremely likely, it’s just the start. The Bank of Japan will, in due course, be stepping up its bond purchases and pushing rates further into negative territory in a determined – and ultimately successful – effort to drive the yen down sharply.

More fuel to the global deflationary fire.

 

MONOGRAM CAPITAL MANAGEMENT

Severe Stress

We have written at length, and in great detail, over the last nine months about the stresses in the Chinese banking system and the threat to both Chinese and global stability.

As if more proof were needed the following chart, showing the volume of interbank lending in China, illustrates the extent of the pressure on a banking system that is enormously over-extended in an economy that is overleveraged and with extreme overvaluation in equities, real estate, and increasingly, government bonds (10 year government bonds currently yielding less than one percentage point more than US 10 year government bonds).

Yes, in November 2015 (latest data) Chinese interbank lending hit Yuan 8769 billion (or Yuan 8.8 trillion, about $1.4 trillion)

2016.1.07.severestress

In year on year terms the level of lending has exploded.

2016.1.07.severestress2

Now, interbank lending has typically been a way for Chinese banks to get around PBOC (People’s Bank of China) restrictions on balance sheet growth and leverage (loans can be made via other banks and are off balance sheet and circumvent loan/deposit ratio limits and capital requirements). The PBOC has tried on several occasions to address this loophole in the structure of regulations to little or no effect.

The enormous increase in interbank lending can only mean the following: the banking system is creaking under the strain of capital flight and tightening domestic liquidity conditions and that bad loans must be piling up at an alarming rate.

How should banks respond to this sort of scenario? Well, look at US banks after the subprime crisis. US banks reduced their credit market debt outstanding by approximately $3 trillion between the end of 2008 and the end of 2015. They reduced debt to add approximately $1 trillion in equity. Eminently sensible – swap debt for equity and deleverage.

What have Chinese banks actually done? Well, step forward anyone who wants Chinese bank equity… I don’t see a crowd. So, the Chinese response has been to increase bank leverage (when they are talking about deleveraging the system). Extremely worrying.

Consider that the balance sheet of Chinese depository corporations (“banks”) is $31 trillion, or three times Chinese GDP, and has quadrupled since the global credit crisis began in 2008. There you begin to see just how important Chinese banks are – they have a balance sheet equivalent to 30% of global GDP. Moreover, they are very inefficient lenders. In the last four quarters alone they expanded their balance sheets by $4.3 trillion when Chinese GDP grew just $0.5 trillion… which means just one thing, lots and lots of bad/non-performing loans in the pipeline.

And, for all those who think the Chinese can use their $3.3 trillion in foreign reserves to bail out the banks, perhaps the following information might be helpful. Assuming just 20% of Chinese bank assets are non-performing at peak (and that number is very, very modest by historical Chinese standards) and with a 50% recovery rate, you write off $3 trillion for the banks (0.2 * $31 trillion = $6.2 trillion and 0.5 * $6.2 trillion = $3.1 trillion). A relatively benign credit event cleans out PBOC reserves (assuming there is no further flight). If you think those FX reserves give the PBOC ample firepower to hold up their banking system then you are possibly guilty of wishful thinking and blind optimism.

Keeping to the USD peg, keeping real rates high enough to stem the capital outflow, deleveraging the financial system and keeping the economy motoring? These are impossibly incompatible objectives. Only one way out (as we highlighted many months back) – a significant decline in the Yuan (20% plus) that exports all of China’s problems to Japan and the West in a deflationary tsunami.

 

MONOGRAM CAPITAL MANAGEMENT

China’s threat in two charts

If, in fact, China is growing at the reported 7% target rate, it certainly is not evident in these charts.

Things which are produced have to be moved to market. The first chart shows Chinese Rail Freight Volumes (% year/year).

2015.11.02.ChinasThreat

The second chart shows the Volume of Freight per Kilometre Travelled.

2015.11.02.ChinasThreat2

Rail freight in China is falling at the fastest rate (year/year) in over twenty-five years.

This certainly does not look like an economy hitting its targets and running at an enviable (even within emerging markets) 7% growth rate.

It looks like an economy that has slowed alarmingly since the second half of 2014. In fact, it looks like an economy going off the rails (excuse the pun).

 

MONOGRAM CAPITAL MANAGEMENT

Less than meets the eye…

When is policy easing not much of policy easing? In China.

The Chinese cut the prime rate and the reserve requirement for banks last week by 0.25% and 0.5% respectively.

That brings the rate cut to 1.25% for the year and the reserves requirement cut to 2.5%.

On face value, this is quite an aggressive move after a 2% devaluation in the exchange rate a few months ago.

However, in our view, there is far less to the easing than meets the eye.

Here’s why:

The deposit base of Chinese financial institutions is approximately $20 trillion. Up to the end of September, the reserve ratio (RR) cut will have released about $407 billion of liquidity into the system. This combined with an incremental $105 billion coming from last week’s cut gives a year-to-date injection of approximately $512 billion.

However, as the following chart (October’s reserve data is not yet available, this data only goes through end of September and thus does not include the impact of last week’s RR cut) shows, in the period through the end of September the central bank lost $329 billion of foreign exchange reserves as capital flowed out of the country.

2015.29.10.Lessthanmeetstheeye

A loss of reserves represents a loss of domestic liquidity that must be offset against the RR cut to see the proper extent of liquidity injections from the central bank. Quite clearly, in the first nine months of the year 80% of the People’s Bank of China’s (PBOC) liquidity injections from RR cuts flowed straight out of the door; just about $80 billion of liquidity appears to have been injected net from a relatively swift policy easing. That amount is actually irrelevant in a $10 trillion economy under such banking system stress. It is almost certain that reserves declined again in October, probably offsetting more than half of that month’s RR liquidity release.

Moreover, with the GDP deflator and the negative producer price inflation, the nominal prime lending rate has not declined at a pace to even match the price deflation, leaving real lending rates higher than they were at the start of the year.

In addition, despite the devaluation, the real effective exchange rate is also higher over the last twelve months and since the beginning of the year.

All in all, less than meets the eye when you look at the true nature of Chinese monetary policy. Higher real rates, a higher effective exchange rate and a trivial increase in domestic liquidity. Why might that be so?

Well one reason, perhaps, is that the PBOC is trying to fight two fires with one extinguisher. The capital outflow puts downward pressure on the yuan such that the PBOC must defend it if it is to maintain the dollar currency peg. It needs high real interest rates to hold capital in, but the consequence of higher real interest rates for horribly leveraged domestic corporates on wafer thin (if any) margins are painful. It appears that the rate cuts and the RR cuts are intended to show willingness to support the economy under stress without also compromising the peg.

As always, something must give. Will the Chinese allow the system to fail for the sake of the peg? No, we don’t think so. It reinforces our view that the yuan will be devalued significantly in coming quarters. The paradox is that the more they cut rates… the faster capital flows away, the greater the pressure on the peg and the greater the stress in the system that necessitates even more RR cuts. It’s a vicious cycle where cuts necessitate more cuts; easier to let the yuan weaken.

Of course, when you get almost 30% of your imports from China, and their currency weakens, the Japanese will come under increasing pressure for an even more aggressive QE stance to show that they are doing something, anything, to address a deflation storm heading their way. A weaker yuan also implies a weaker yen.

MONOGRAM CAPITAL MANAGEMENT

Why China really matters

Chinese nominal USD-denominated imports dropped 14% in the three months to September year/year (and 14% in the six months to September year/year) – the median growth rate since the end of 2008 has been +6% year/year in both cases.

  • In short, Chinese import growth has been strong since the onset of the financial crisis in 2008/9, reflecting a period of exceptional local policy stimulus.

To put this in to context, the chart below shows the proportion of the growth in world merchandise trade accounted for by various countries/regions since 2008:

  • China, an economy of approximately $10 trillion – about 12% of Global GDP – accounts for 32% of the growth in goods imports over the five years from 2008 – 13. China has been punching well above its weight.
  • The Asia region as a whole, so dependent on China, accounts for almost 70% of the growth in global Imports.
  • China and Asia accounted for 54% and 27% of the growth in exports over the same period.

2015.13.10.WhyChinareallymatters

Why is this so important? Well, the following chart shows domestic demand growth in the major regions/countries on a rolling five year annualised basis:

  • Real domestic demand growth barely hit 2% annualised at its peak over the period in Japan, the UK and the US and has not grown at all in the Eurozone.
  • When you have little or no demand growth you rely on foreign demand; in the case of the developed economies you rely on Chinese import demand to hold global growth up.

2015.13.10.WhyChinareallymatters2

Collapsing import demand, as we have argued previously, is reflective of an alarming slowdown in Chinese manufacturing sector investment growth (as Chinese companies race to bring capacity growth more in line with the rate of growth in demand in the West):

2015.13.10.WhyChinareallymatters3

This is not a cyclical but a structural adjustment – weak global growth, disinflation/deflation follow.

With the exhaustion of the effects of monetary policy, how long will it be before we hear arguments of the kind below from policymakers?

  • “look, government bond yields are near record low levels, we can borrow for ten years at rates of 2% or less (or thirty years at negligible rates), I think we should be issuing lots more debt to take advantage and invest that money in real, tangible things (like infrastructure) where surely we can find some projects with long run returns above the nominal/real cost of borrowing.”

Or

  • “Bond yields are so low, let’s borrow money, build a ‘National Recovery Fund’ and invest all the proceeds in the equity market directly, the risk premium is positive and surely equity returns will exceed bond returns over the next ten to thirty years.”

 

MONOGRAM CAPITAL MANAGEMENT

 

UK inflation… where?

September 15, 2015

Although Annual Core Inflation slipped to 1% in August and Headline Inflation to zero, the devil, as always, remains hidden in the detail…

Look at the diffusion index of UK inflation – It looks at 80 individual sub-components of the UK inflation headline number and looks at what proportion are inflating (and at what rate) versus what proportion are disinflating (and at what rate).

If inflation rises sharply because, let’s argue, just 3 components surge higher while 77 plunge, that is less indicative of an underlying inflation problem than a broad-based/widespread increase in prices. The breadth of inflation/disinflation is as important, if not more so, than the level:

  • 52% of the index components have actually experienced deflation in the last 12 months.

2015.15.09.UKInflationWhere

  • 66% of the index components have an annual inflation rate below 1%.

2015.15.09.UKInflationWhere2

  • 77% of the index components have an inflation rate below 2%.

2015.15.09.UKInflationWhere3

  • And finally, 70% of the index components have seen annual inflation decline over the last 12 months.

2015.15.09.UKInflationWhere4

  1. So, UK inflation is exceptionally low. The breadth of low inflation is unprecedented and the overwhelming majority of index components have seen inflation decline in the last 12 months. Nothing particularly concerning here for the Bank of England.
  1. As we have argued many times, UK inflation has “Made in China” stamped on it. In a world of increasingly open markets, where trade grows faster than production, where investment in fixed capital as a proportion of Global GDP is at the highest level in 30 years and where the world’s largest exporter, China, is still growing its manufacturing fixed capital stock at a rate almost 6% points faster annually than demand growth in the developed world, you get disinflation. In addition, with inevitable Chinese devaluation you get deflation. In this world, UK companies are price-takers and not price-setters. The price-setter is the marginal supplier of capacity and that is unquestionably China… whose main export will soon be deflation. Any company trying to fight that tide to be a price-setter will lose market share, profitability, employment and its business.
  1. UK real economy inflation, as measured by the CPI and RPI, really is out of the control of the Bank of England. The Bank should raise interest rates to reign in monetary sector runaway inflation (houses and financial assets) to arrest the dire consequences of QE sooner rather than later. If a price has to be paid, it is better paid today than tomorrow. The same is true for the Fed in the United States. The longer the delay, the worse the consequences.

 

MONOGRAM CAPITAL MANAGEMENT

China’s problem… easy to see

September 8, 2015

Amidst all the furore around China’s market weakness and market declines, here is China’s problem in a nutshell:

  • China lost $94 billion in Foreign Exchange Reserves in August, taking the decline to $436 billion since June 2004.
  • Foreign Exchange Reserves have fallen 11% from the June 2014 peak level.

2015.08.09.ChinasProblem

2015.08.09.ChinasProblem2

  • Global Foreign Exchange Reserves are down 4.9% y/y – the fastest decline since 1982.

Why is this important?

Historically, foreign currency has flowed to China and the PBOC has purchased those currencies (acquiring an asset) to stop the Yuan from appreciating. They exchanged Yuan for the foreign currencies (creating a domestic currency liability). The PBOC’s balance sheet grew with foreign exchange assets and their domestic currency liability counterpart.

Left unchecked, that explosion of domestic currency liabilities into the system fuelled speculation and credit expansion – foreign exchange reserve growth reflected extremely accommodative domestic monetary policy.

Now the whole cycle has gone into reverse.

Capital is flooding out of China as the PBOC exchanges Yuan back into foreign currency for investors to flee.

The decline in foreign exchange assets, therefore, represents a substantial tightening in domestic monetary conditions as the PBOC buys Yuan (reducing the liability on its balance sheet) and hands back Dollars/Euros/Pounds etc. (reducing the assets on its balance sheet). This is why the PBOC has cut rates and cut reserve requirements for banks – they are trying desperately to fight a huge monetary policy tightening.

What more can be done?

Our view remains that meaningful Yuan devaluation over the next few years is the only real solution here for the Chinese, leading to substantial global disinflation/deflation pressure at a time of extremely low starting inflation.

Japan and Germany are particularly vulnerable given their trade overlap, some Asian banking systems (e.g. Singapore and Hong Kong) are particularly vulnerable given their extreme debt growth.

 

MONOGRAM CAPITAL MANAGEMENT

Structural headwinds for Emerging Markets

August 26, 2015

A common misbelief among investors is that economic growth and equity market returns are positively correlated. Faster growing economies generate faster earnings growth and that must be good for investors… right? Wrong.

It ignores 3 important factors (1) companies typically issue large amounts of new equity to finance the growth such that earnings per share growth (not earnings growth) suffers badly (2) the benefits of company growth can accrue to three alternative agents: investors, managers and/or employees. Often, once managers have paid themselves, employees have received pay rises and the company goes on an investment spree, there is little or nothing left for the poor old investor standing patiently at the back of the line and (3) investors often overestimate growth and overestimate the durability of growth, extrapolating rapid growth into the horizon when we know that mean reversion is an important feature of all economic activity.

Nevertheless, for as long as investors suffer the cognitive dissonance of believing in growth miracles (China has been the best, delivering miserable returns to “apparently” rampant economic growth over the last two decades) it is important to look at the structural underpinnings of Emerging Market growth.

Two simple charts illustrate the huge structural headwinds facing Emerging Markets in the next five years or more that will, over the course of the cycle, overwhelm any benefit that might accrue from near term currency devaluation:

  • Firstly, we can see that the “Growth Gap” between Emerging and Developed Countries is very highly correlated with the scale of deficits run in the Developed World. The rapid acceleration of EM growth versus the West in the period 2000 – 2008 (that gave rise to endless stories about the sclerotic Developed World giving way to China and Emerging Economies, that Emerging Economies would dominate economically and politically within a few years, that investors need only follow the path to the East to find riches) was driven purely and simply by unprecedented Developed Country deficits.
  • The EM growth boom was “Made in the Developed World”

2015.26.08.StructuralHeadwinds

  • Secondly, this ballooning Western deficit promised eternal reward and investment surged in the Emerging Markets to build capacity to meet the promise of endless demand:
    • Investment as a % of GDP in the Emerging World exploded from 25% to 31% in just about a decade.

 

    • Sadly, just as investment reached levels unprecedented in the last century, demand evaporated as the Developed World deficits evaporated (a $650 billion swing since 2008).

 

  • This means Emerging Markets have been left out on a limb – unprecedented investment with no apparent demand… Mind the Gap.

2015.26.08.StructuralHeadwinds2

What does it mean?

  • Investment/GDP ratios in the Emerging Markets must fall sharply in the next 5 – 10 years, back to levels prevailing prior to the run up after 2000. That means much slower growth structurally. To think that the fabled “Emerging Consumer” can step in is without justification.
  • The disappearance of the Developed Country deficits means a disappearance of US Dollars and that implies tighter conditions domestically, compounding the adjustment in investment. In other words, the growth rate in International Foreign Exchange Reserves (the counterpart on the Central Bank balance sheet to the growth in domestic currency liquidity) will slow rapidly and in due course, as in China, reserves will flow away rapidly. Rising reserves imply easier domestic policy conditions, falling reserves imply tighter domestic policy conditions.
  • Weaker currencies and, in some cases, lower interest rates can cushion the blow but the headwinds are far too strong to be resisted domestically. Emerging Market growth will go back to levels little different from the Developed Countries, as was the case prior to 2000. If “growth is your thing” that’s not an appealing prospect.
  • Having been out of EM Equities for the last two years we would not anticipate re-entering anytime soon.

 

MONOGRAM CAPITAL MANAGEMENT

Implications of the China Crisis…

August 24, 2015

While in many cases a 38% decline in Equities from their mid-June peak, wiping out 16 months of gains in just 8 weeks, might have had substantial domestic economic effects – not least through the wealth loss in the Private Sector – the consequences of the decline in the Chinese market are slightly more subtle and global in nature.

A little background data might prove helpful; according to the China Household Survey of Finances, about 9% of Households participate in the Equity Market and Equities account for just 1% of Total Household Financial Assets. In comparison, Japanese, Euro and US Households have 10%, 18% and 33% of their Financial Assets in Equities. The loss of wealth and the direct effect on consumption in an economy of approximately $10 trillion and where Household Consumption is just 38% of GDP (versus 52% back in 1990) is, by any measure, modest. Moreover, the top quintile of Households by Income own over 90% of the Equities held by all Households and they have the lowest propensity, by far, to consume. China is just a little bit different.

So, what is the most worrying element of this whole affair?

As we have shown previously, the real problem of China lies in the fact that Manufacturing Productive Capacity Growth still substantially exceeds the rate of growth in demand globally. Domestic demand in the Euro area, UK, Japan and US is growing at just about 2.5% when Chinese Manufacturing Capacity is growing at almost four times that pace.

The gap is narrowing rapidly, and that is the source of the rapid slowing in Chinese growth, reflected in commodity prices, global growth and global inflation. However, it is still substantial and the excess that has been accumulated will take years to run-off.

2015.24.08.ImplicationsoftheChinaCrisis

The consequence of this huge overhang in potential supply is very clear when you look at the growth rate of Global Merchandise Trade in the last decade:

  • China accounts for a fifth of the growth in Global Merchandise Trade in the 10 years through 2013, with the Asian bloc as a whole at 43% (22% if we strip away Japan and China).
  • At the margin, China (and Asia) have made a hugely disproportionate contribution to the growth in World Trade in the last decade. In that period, global production rose 2.7% annually when trade grew 4.7% annually.
  • In the 5 years up to 2013, China accounted for 27% of the growth in Global Merchandise Trade.

2015.24.08.ImplicationsoftheChinaCrisis2

In short, World Trade Growth has substantially outpaced production growth in the last decade and China has been a disproportionate contributor to that trade growth. China is the marginal provider of cheap goods – it is, in effect, the price setter in the global market for merchandise.

Now, if we add a devaluation to a massive overhang in capacity and the role of China as the marginal price setter globally, what do we get? Disinflation and Deflation.

China’s “out” from this slowdown – driven by years of debt accumulation, bank balance sheet expansion and grotesque over investment – is devaluation. The implication for the West is clear – deflation. This makes an exit from QE and a normalization of monetary policy almost impossible.

What is the impact of deflation on Equity markets?

Well, take a look at the following chart. We took one of the most reliable and commonly used valuation ratios – the Price/Trailing 10 Year Earnings – and looked at it over the last century and more versus US Consumer Price Inflation. You see something very interesting:

  • Over the whole period there is, as some have noted, a “sweet spot” for valuation – the blue bars have a distinct “hump” at the 5th and 6th inflation decile, which is when consumer price inflation is in the range 2.0 – 3.3%.  Note that valuation falls away quite appreciably when we get down into zero inflation and below that in the lower two deciles.
  • There is, however, some relief when we exclude the extraordinary period of the last 20 years and the bubble of 2000. Then we see that the “sweet spot” is, in fact, a consequence of a small number of observations around the 2000 bubble peak. Nevertheless, valuations do fall away noticeably at very low inflation/deflation periods (and at very high inflation levels).

2015.24.08.ImplicationsoftheChinaCrisis3

So, if our analysis is correct and we face a period of intense disinflation/deflation, then a lower valuation for Equities would appear entirely appropriate. In the meantime, reluctant to pin all hopes on a forecast, we continue to “observe and infer” i.e. to respond to changing market conditions rather than try, frustratingly, to anticipate them.

 

MONOGRAM CAPITAL MANAGEMENT