Geopolitical Update : Can ECB’s QE avert Deflation in Europe?
The ECB has lowered its deposit rate further to minus 0.5% and announced it will start “printing” money again to buy EURO 20 Bn of Euro-Bonds a month. QE is back.
I expect the really decisive steps from the next ECB chief Madame Lagarde though.
Markets focus on the short term and they are celebrating the move. But as Japan learnt over the past 30 years: lowering interest rates and printing money may postpone deflation, but it enlarges the role of the state (socialisation), weakens the economy and strengthens the very deflationary forces it tries to fight. Japan learnt to embrace deflation by facing the truth: it is ageing and her labor force is shrinking. Europe is still in denial and Mrs. Lagarde is aware of that. The Old Age Dependency Ratios (see chart below) will explode just as asset & house prices shrink, both squeezing disposable incomes.
I have managed money in Japan during its worst deflationary decades and I can tell that Europe is headed for a bigger fallout than Japan’s. It is trying to avert deflation by weakening her banks, fostering mass immigration, manipulating asset prices and over-regulating her sickly markets (creating millions of unproductive jobs). The EU is weakening her social & political fibre at it. Along the way, Japan chose instead to preserve social and political stability, and that shows. It boasts by far the safest cities among the G7. What is paper money worth if security and trust are gone?
European central banks have been in a flurry of activity – bracing for the possibility that the looming recession could finally thrust Europe into deflation. Central bankers have reasons to be concerned. Europeans have NOT seen yet what deflation really is.
Just in case the ECB’s fears should be confirmed, let us talk about deflation today. Kindly bear with me.
1 – DEFLATION at the doors of Europe
For years now people in the West are using the term deflation loosely. We may have been fighting deflationary forces, but our economies have not been in outright deflation yet. We have been hovering mostly in a “zero to low inflation space”. Deflation is different and central bankers know that.
The best characterisation of outright deflation is not when CPI becomes negative. It is when BALANCE SHEETS shrink. CPI is a highly political and somewhat manageable figure; calculated by the same government that sets the target. There are no audits.
Only Japan has faced the sustained implosion of balance sheets. That happens when all households do the right thing at the same time and they reduce their debt exposure.
The rational behaviour of individuals reinforces deflation. I managed funds in Japan and Asia during those “brutal” years and saw first hand what deflation does. And yet, economies find an equilibrium and some businesses even thrived. While Japan is a warning of what Europe could face, Japan is also a reminder that there is life after deflation – if embraced.
Experts talk about the Two Lost Decades in Japan. That is not entirely true. Japanese people learnt a lot during those two decades. It made the country leaner and better. Japan is currently not only a somewhat undervalued equity market, it is most of all a resilient society. Something we can’t say of other G7 economies in a time when so many Systemic Risks loom in the horizon. I dare to say that boosting the resilience of a society is at least as important as maximising her GDP.
2 – A lesson from Japan
During those decades of hardship in Japan I saw countless company executives cutting their own salaries by 50% before asking the workforce to take a 25% pay cut. Rather than firing 25% of the workforce, many companies cut salaries by 25%. This is not what we (fund managers) wanted to see, so we “punished” Japanese companies. They kept companies running at the expense of shareholders.
But, low margins aside, the collective “we are in this together” set off amazing creativity, hard work and sacrifice to overcome hardship. This collective trust and civility was exposed when Japan was hit by the triple catastrophe of 2011. There were no looting scenes, rather remarkable cohesion. Sure, Japanese GDP per capita didn’t grow robustly, but neither did Western Europe’s over the past 4 decades despite migration of a massive scale. Japanese people are no longer maximising “okane” (money) as they used to, it is a broader set of goals nowadays. One thing I see is this: They seem to be far more content and trusting in their institutions than their Western peers.
Deflation is natural just as downsizing is when you reach retirement age, but reinforced deflation is a systemic collective phenomenon – investors, governments, businesses, consumers and media are part of it. We investors sometimes maximise short term profits by destroying the very fibre of society: collective trust, the backbone of security. Once that is gone, the basis for organic economic growth is gone. Governments have to step in .. creating jobs via regulation, manipulating supply, demand, yield curves, prices etc. And if your government also owns the TV and media that feeds your daily news, you may being fed only 95% of the facts. A small but systematic bias can create an illusion over time. In Europe the dominant state-owned media calls itself independent, and nobody is bothered by that kind of daily claim. Tell that to people in North and South America and they’d tell you “you must be kidding”.
Central Bankers’ biggest problem
Armed with a sense of duty and a price stability mandate, a number of central bank officials are working on alternative digital currencies. Some are doing it in sync with their national governments, others are in defiance of their own governments. Can their independence shield them? Maybe not for long. Some in the latter group are being deemed as more loyal to a supranational agenda than their national interests. The key word here is lack of trust.
Digital currencies have many advantages. They would allow central banks to phase out cash, assume complete control & full oversight of peoples’ finances, enforce negative interest rates more efficiently, reduce money laundering, reduce tax evasion etc. I see no shortage of good currency ideas, the problem is the following: The trust between central banks and their respective governments has faded away, just as nations don’t trust each other anymore. There are as a result more political and military alliances than competing nations. The Cold War was a safer place than planet earth in this transition.
3 – Gold, uncomfortable friend and foe
It is against this backdrop of distrust, that I see GOLD playing an important role in the transition to a partial Currency Realignment or a new Monetary System. I stick to my positive strategic view on Gold. But you should hold gold only to the extent that you can stomach the possible raids against it – its price and ownership.
All major central banks are aggressively devaluing their currencies, but exchange rates are kind of stable, because they are all devaluing in tandem. They are boosting their gold reserves, but they don’t want the official price to go up. No problem – they don’t need to accumulate that much gold, because wealthy investors are doing it for the government. Those holding large sums of Gold in bunkers will see them confiscated one day. It makes sense. Governments have the duty to seize them under extraordinary circumstances. It is a bit like diversification and structured products. They are likely to fail you when you most need them.
Gold has become de facto the most needed and uncomfortable asset in the modern state. Nothing else could expose the Money Illusion among investors and consumers like Gold does, if allowed to. Ultimately gold will overcome all schemes set against it. Why? Eroded trust. You can’t hack, print or clone gold. Any paper or digital currency is inherently vulnerable to the schemes of men. Reason why they may all coexist.
4 – Debt, does it matter at the edge of the abyss?
Economists will see that at the edge of the abyss, investors will accept a higher Debt/GDP ratio. Simply, the conventional alternatives are worse – barring a new monetary system. While households and corporations reduce their balance sheets, the role of the government is likely to increase dramatically, along with debt and liabilities. Those that can think ahead will be able to take advantage of the switch into a deflation investment mode. In deflation, the weight of mortgages and debt will be so heavy, foreclosures and repossessions are likely to accelerate the monetary reset. It will be a good time to stop blaming the government for what is a collective failure. Barely 900 people across Europe took to the streets when people’s assets were seized in a EU member state.
There are good economic reasons why most investors miss those big bond rallies.
5 – Demographics leads the way
There are multiple forces driving deflation, but demographics is the most powerful one. Governments simply reinforce those forces. Politicians and economists cannot influence demographics in the short term.
With the labor force peaking, immigration controls in the pipeline and deflation looming … the squeeze in disposable incomes will test the real estate bubbles. Once prices begin to drift lower and balance sheets begin to shrink, it will be hard for house prices to continue their current 10 to 30 year rallies. Deflation will not only punish those that took on debt (mortgages) lured by low interest rates. It will also destroy wealth and lead to wealth transfers.
Many economists advised companies and investors to take on debt, because interest rates would remain near zero for years to come. What they overlooked is that those zero rates exacerbate the deflationary pressures that one day could push the prices of real assets, tangibles and houses into a negative downward spiral. Central bankers know this, and that is why they are working towards a new solution. Not all governments want a digital currency though.
Resisting the temptation of Mass Migration to stem deflation: Japan
Many Western nations are keeping prices steady thanks to a steady large flow of immigrants – While the latter keep their populations and GDP’s from shrinking, this is not really boosting GDP per capita. Japan decided not to be lured into allowing Mass Immigration to postpone the Deflation Process. The collective thinking was that mass migration would create a host of new problems, new costs and take away security. In fact 20 years later, Japan boasts by far the safest big cities in the world. I am a third generation migrant, so I am not against immigration. I am rather saying that government-induced migration in a massive scale will not solve the problem. In fact it is becoming politically less and less feasible. Not only, because the far right is taking advantage of the issue.
My father told me as a child “it is we Japanese migrants that have to adapt and embrace this foreign culture & language. Not vice-versa”. Indeed, nobody in North or South America bent backwards for the Japanese migrants, and that helped them integrate faster and better. I think there was a lot of wisdom in what my dad said. My dad would thus see some dangers in Europe’s government-enforced Willkommenskultur (a culture that aims at welcoming the foreigner).
Can Europe postpone the inevitable? I doubt it. Fewer families need fewer cars and fewer houses. This leads to shrinking Balance Sheets. If you see that solely as a policy failure, you may create a far greater problem. The earlier we see the facts the better we allocate our limited resources and time.
Outright deflation could be tough on many large ageing economies (not just the USA and China) where total debt, liabilities & entitlements over all households have run out of control and are reaching way over 200% of GDP. Debt barely matters .. until you hit deflation. It is ironic that some small & mid-sized emerging economies along Russia have been more cautious with debt than the industrialised rich nations.
A reader in Germany told me his bank wouldn’t sell him Peruvian government bonds. The same bank would sell him Greek government bonds though. How remarkable: Peru has a Debt to GDP ratio of 27% and its foreign reserves exceed the outstanding debt. Many local businesses are even switching from USD debt to local debt. Yes, Peru has done a remarkable job with fiscal discipline, but it has a major advantage: it is in a demographic sweet spot.
6 – Investing in the times of deflation – not so bad
Should we enter a period of declining asset prices and shrinking balance sheets, there could be multiple effects on investment strategy – not all devastating. At least during the initial period: less diversified and selectively diversified portfolios win, long dated bonds of healthy states & militarily powers outperform, new technologies become even more valuable, lower-cost status symbol discretionary goods win, cost cutting services win, domestic small caps, Gold, possibly the USD etc. There is no perfect static forecast for what is coming. There are many potential scenarios that favour some of these assets more than others, so these assets need to be monitored continually.
More important could still be what not to be over-exposed to as deflation sets in across Europe and later across most of the Northern Hemisphere: banks,
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This is the current state of my research. My main scenarios are continually tested and updated if necessary.
By Christian Takushi MA UZH, Independent Macro Economist & Geopolitical Strategist. 12 Sep 2019.
Disclaimer: None of our comments should be interpreted or construed as an investment recommendation
A distinct broad approach to geopolitical research
(a) All nations & groups advance their geostrategic interests with all the means at their disposal
(b) A balance between Western linear-logical and Oriental circular-historical-religious thinking is crucial given the rise of Oriental powers
(c) As a geopolitical analyst with an economic mindset Takushi does research with little regard for political ideology and conspiracy theories
(d) Independent time series data aggregation & propriety risk models
(e) He only writes when his analysis deviates from Consensus