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)

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

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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

Deflation and the Fed… what would Greenspan say?

September 24, 2015

For those of us that have been around a while, and can remember, back in May 2003 (in the aftermath of the burst of the greatest equity market bubble since 1929) Alan Greenspan, then Federal Reserve Board Chairman said the following:

  • “We at the Federal Reserve recognize that deflation is a possibility. Even though we perceive the risks as minor, the potential consequences are very substantial and could be quite negative”  (Alan Greenspan, Congressional Testimony, May 2003)

At the time, this came as something of a bombshell, for the Chairman of the Fed even to entertain the possibility of deflation was quite a surprise to markets.

We thought it might be interesting to look at the parallels between today’s US inflation picture and that of the Spring of 2003. The comparison is quite striking.

We looked at 180 individual line items in the total Consumer Price Index (CPI) and the 106 line items that pretty much make up the Core CPI:

  • The chart shows that currently 43% of the individual core inflation items are in annual deflation, that compares to 48% in the Spring of 2003 and 45% in late 2010
  • The annual core inflation rate is currently 1.8% versus 1.5% in 2003
  • We are currently seeing the same breadth of core deflation that we saw at the bottom of the cycles post 2000 and 2009 bear market crashes

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We then looked at how annual core inflation for the 106 sub-components had changed over the last 6 and 12 months to see if there was any clear trend:

  • In the Spring of 2003 about 60% of the components had seen year/year inflation decline in the previous 6 and 12 months (a clear downward trend) compared to about 50% today

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Interestingly, in 2003 we saw:

  • 48% of core inflation components in deflation and 60% with a clear downward trend

In 2015 we see:

  • 43% in annual deflation and 53% with a clear downward trend

Our thought is then, “What is so different?”

Greenspan was worried about deflation and yet now Janet Yellen appears to be itching to tighten. (Growth was strongly accelerating in 2003/4 and has been stuck at 2.5 – 3.0% in the last year or more, so that can’t be the reason).

Could it be the fabled “tightness of labour markets” argument, the so-called “Phillips curve” fed to generations of economics students purporting to link labour markets to inflation? (Along the way, countless economists seem to have lost sight of the fact that A. W. Phillips’ famous 1958 paper was titled “The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957” and said nothing about unemployment and consumer price inflation).

Well, here is the relationship between the US unemployment rate level and US average hourly earnings over the last 50 years:

  • Clearly, even to an untrained eye, there isn’t one. A lower unemployment rate does not push up wage inflation…
  • There is, truly, nothing in the historical data to show that a lower unemployment rate (a “tighter labour market”) implies faster wage inflation (or, for that matter, faster price inflation)
  • Look at it with lags, as changes, whatever way you like, the “tight labour market/higher inflation” thesis cannot be substantiated… another case, to paraphrase our hero Thomas Huxley, of “a beautiful theory and ugly facts colliding”

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Conclusion:

  • If Greenspan was worried about deflation in 2003, why does Yellen not share the same concern (especially with the Chinese banking system in the state it is in and a Yuan devaluation on the way)? Would Greenspan be considering another round of QE here? We are inclined to think it would be foremost in his mind if he were still Fed Chairman.
  • Tight labour markets/faster inflation concerns just cannot be substantiated by the data; that is no reason to tighten.
  • US consumer inflation is determined exogenously (outside the control of the Fed) by the vast global overhang of global supply. Inflation in assets, inflation in balance sheets and surging debt are endogenous (inside the control of the Fed). They should tighten to address the latter and lay to rest old ghosts of Phillips curves. God forbid we get more QE, the consequences will be even worse when the rebalancing and re-pricing of risk takes place…
  • Because Central bankers are raised to believe that consumer price inflation is the target variable, they completely missed the consequences of inflation in asset prices and balance sheets in the last two cycles (confusing a positive supply shock from Chinese over-investment and low shop inflation with a miraculous surge in underlying productivity growth and hence trend GDP growth) and risk making the same mistake again…

 

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.

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

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

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

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  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.

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  • 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

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.

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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.

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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).

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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

UK inflation… widespread disinflation

August 18, 2015

While people generally focus on the headline number, the more useful information, as always, is contained in the detail of the index. We look at the 80 main sub-components of the index to see if there is any uniformity in the trend for inflation seen at the headline level. Any reversal in trend will be evident at the sub-index level first:

  • Of the 80 components, 50% have deflation over the last 12 months, looking back over the last decade (and more) that is an extraordinary degree of price deflation.

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  • Of the 80 components, 65% have inflation below 1% over the last 12 months and 78% have inflation below the 2% level in the last 12 months.

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  • Most importantly, 70% of the sub components in the UK inflation index have seen their rate of inflation decline in the last 12 months.

There is simply no sign, at this point, of any latent inflationary pressure. Indeed, the Chinese devaluation (the beginning of a trend), persistent global oversupply (compounded by ongoing over investment in China and the Emerging Markets) and the weak global growth environment all suggest disinflation and deflation are the greatest risk.

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There is little evidence here for the Bank of England to justify a rise in interest rates. However, there is more justification elsewhere should the Bank be keen to press ahead:

  1. The private sector in the UK is running a financial deficit of 1.5% of GDP (i.e. its Gross Investment > its Gross Savings) meaning that the private sector, like the public sector, is accumulating net liabilities. This is the first time we have seen this in the private sector since 2002. The economy is accumulating debt at a rapid pace.
  1. The average house price/income ratio now stands at 5.3x and is at 6.5x in the Southeast and a record 7.8x in London. In fact, of the 9 UK regions, all have a price/income ratio above 4 (and 44% above 5).
  1. The UK is running a record current account deficit of 6.2% of GDP (this is not a consequence of a peculiarly British ability to hold very low yielding foreign assets, as some have suggested). With only modest Fiscal Tightening in recent years and the private sector going into deficit, the UK has provided the deficit that, from an accounting position, is the counterpart to the improved deficits/surpluses now being run in many of its trading partners. The final chart shows the change (as a % of GDP) in the UK Current Account since mid-2009 compared with that of the major blocs/countries around the world:

Both China and Japan have seen their surpluses decline sharply as the global economy has corrected. The UK has seen its deficit widen sharply as the Eurozone and US have improved their external positions materially.

You could say the UK, and the UK consumer, has helped hold the world up in this difficult period.

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All told, overvalued housing markets/large current account deficits (private and government sector deficits) have been a warning sign in many a crisis around the world and especially in the UK. The Bank of England will find more justification here than in the inflation data.

Do you tighten to have an impact on something you can influence i.e. domestic credit conditions or tighten to have an impact on something you cannot influence i.e. the massive overhang of global productive capacity and easier Chinese monetary conditions?

 

MONOGRAM CAPITAL MANAGEMENT

The Problem of China…

August 12, 2015

(with apologies to Bertrand Russell, “The Problem of China” published in 1922)

When Bertrand Russell published his fascinating observations of China, its role in the world, relationships with its neighbours and prospects for growth, little did he know that almost a century later China would still represent an enormous challenge for the West.

While the devaluation of the Yuan in recent days has been surprising in its timing, it is a policy shift that we have expected and written about for quite some time and reflects the big problem that is China. Here are 4 reasons to expect a sizable Yuan devaluation over the next year or two:

1.  Major Chinese financial institutions are expanding their balance sheet at a rate equivalent to 35% of GDP annually. If we, conservatively, expect half of those assets to be non-performing (perfectly prudent by historical standards) and apply a 50% recovery rate to the losses then the financial system is writing off an amount annually equivalent to 9% of GDP (that is approximately estimated as  (0.5 * 35%) * 0.5 = 8.75%). Think about that number carefully, if you believe (and we don’t for a second) Chinese GDP growth numbers, then the economy is actually contracting: 7% GDP growth less 9% write-offs.

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Summary of Point 1 = The Chinese economy is,  and has been for some time, in outright contraction/recession.

 

2.  The capital stock of the Chinese manufacturing sector is expanding at a 10% year/year rate. That contrasts with a 31% median annual growth rate in the ten years through 2013.  Unfortunately, domestic demand in the USA + Euro area+ Japan + UK is growing just 2.5% year/year.

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Summary of Point 2 = China is adding capacity to supply goods way faster than demand is growing. That means increasing amounts of idle and costly capacity in China. When supply growth rapidly outpaces demand growth it means only one thing… deflation. China is slowing capacity expansion, which is slowing growth, but the gap remains enormous and suggests a huge deflationary pulse is headed west as the capacity finds sales. The impact of much, much slower investment growth has to be cushioned… by devaluation.

 

3.  The Chinese Yuan has appreciated in real, effective terms by 11-15% in the last year (depending on whether you apply a consumer price or producer price deflator). For an economy in contraction/flat at best, with rapid capacity expansion, a corporate sector that is grotesquely leveraged by international standards and sits atop wafer thin/non-existent profit margins… that’s a big problem.

Yuan appreciation on this scale is almost unprecedented and Chinese industry just does not have the ability to withstand it…

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Summary of Point 3 = The Chinese Yuan has appreciated on an almost unprecedented scale and the strength of the USD, with a policy tailwind behind it as the Fed presses to normalize interest rates, makes it unbearable. Lower interest rates in China, changes to Reserve requirements in China or any other monetary policy changes in the Western style are ineffective. Devaluation is the only way out.

 

4.  China is haemorrhaging foreign exchange reserves. Over the years capital flowed into China, chasing the “miracle”, and the Chinese central bank purchased those foreign currency inflows and in return provided Yuan liquidity – the central bank increased its assets and had a corresponding increase in its liabilities in the form of Yuan liquidity. The growth in reserves fuelled the economy.

With a former Trading Manager responsible for the UK Foreign Exchange Reserves at our firm, this is an issue close to our heart.

Now, in the last 4 quarters, China has lost $299 billion in reserves. This represents an effective tightening in domestic monetary conditions on an enormous scale. As if Yuan appreciation were not enough, this makes policy conditions much, much more restrictive just when the economy is floundering.

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Summary of Point 4 = A huge loss of international reserves represents a substantial tightening in monetary conditions, on top of the real appreciation in the Yuan.

 

What are the implications for the West?

Well, just take a look at the UK Consumer Price Index to see what looms.

Over half of the index components have already deflated over the last year, and that is before the Chinese devaluation trend kicks in.

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Fully 83% of the index components have inflation in the last 12 months below 2%.

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Moreover,  75% of the index components individually have lower inflation rates today than a year ago.

A Chinese devaluation cycle is only going to compound the existing trend.

The Bank of England might want to normalize interest rates to deal with the record current account deficit. Private sector financial deficit and grossly overvalued housing market will face a challenge in coming months/quarters.

Do you deal with monetary sector inflation or do you deal with real economy deflation/disinflation… ?

Either way, a desire on the part of the Chinese to devalue (and they need significant devaluation) probably means less of a desire in the UK and US to tighten policy. Monetary liquidity conditions are likely to remain more accommodative for longer and there is a non-negligible risk that another round of QE might be necessary to counter the Chinese move. Monetary policy competition between the Bank of England, the ECB, the Fed and the Chinese.

This is what the world looks like when you have one tool – QE – and you use it to abandon… “The Problem of China”!

 

MONOGRAM CAPITAL MANAGEMENT

UK Inflation: Long Term Structural Pressure from China, but Recent Falls are Driven by Oil Price

  • 8% fall in energy CPI; excluding food and energy CPI is 1.3%, down from 1.8% in January 2014
  • Structural mismatch between Chinese manufacturing investment and Western demand means China is “exporting” deflation into the Eurozone

London, 13 January 2015. Paul Marson, Chief Investment Officer of Monogram, comments on today’s inflation figures and the root causes:

“Today’s figures reflect a sharp 5.8% fall in energy CPI over the past year.  Without the impact of oil prices on food and energy, underlying CPI remains a more plausible 1.3% year on year, up from 1.2% year on year in November.

“In the long term, the UK faces the structural pressure of Chinese “exported deflation”. China’s manufacturing goods supply is growing much faster than Western and Chinese demand for manufactured goods. This means a glut of supply pushing down manufactured goods prices and western inflation in general.

China is a global price setter and its proportion of exports to the UK has grown significantly over the past decade, meaning that China will increasingly export deflation to the UK and the West.”

Graph: UK Energy CPI

 13.01.2015 UK Inflation Graph 1

Graph: Chinese manufacturing sector supply/ Western demand mismatch

13.01.2015 UK Inflation Graph 2

“Made in China”: The Hidden Cause of Euro Deflation

  • 13% of non-internal Eurozone imports are from China
  • Structural mismatch between Chinese manufacturing investment and Western demand means China is “exporting” deflation into the Eurozone

London, 8 January 2015. The Eurozone officially entered deflation this week, driven by falling oil prices. Paul Marson, Chief Investment Officer of Monogram, comments on the more concerning long-term structural driver of Eurozone deflation:

While ‘Made in China’ is a common sight on manufactured goods, China also exports deflation. Chinese manufacturing goods supply is growing much faster than Western and Chinese demand for manufactured goods. This means a glut of supply which increasingly pushes down manufactured goods prices.

According to World Trade Organisation data, China accounts for 17.1% of the total increase in world merchandise export (excluding the Eurozone) from 2002-2012, hugely disproportionate to its size. This makes China a global price setter. In the past decade, the percentage of Chinese imports into the Eurozone has doubled, meaning that China is increasingly exporting deflation into the Eurozone.

Worryingly, Chinese monetary stimulus, which looks likely, will increase Chinese manufacturing investment, further exacerbating the problem.

Graph: Chinese manufacturing sector supply/ Western demand mismatch

08.01.2015 Eurozone Deflation