Since I was a junior analyst at JP Morgan at the dawn of international investing, inflation has been on the way down everywhere. Not only did disinflation mean lower inflation in every successive period, it also meant different countries’ inflation rates converged.
Disinflation was achieved by tight monetary policy and fiscal discipline. All that is over. Now the world is moving towards lower annual growth of 3% and medium-level inflation of 3%. This 3×3 world is flanked by the dangers of rising inflation expectations on one side and deflation on the other. That prompts more asset price volatility as outcomes are disputed.
Ranking by rising prices
In my JP Morgan days, we spent a lot of time debating relative national inflation rates and rankings. Getting it right meant getting currencies and real returns to investors right too. Of all the asset allocation tools we used, the simplest and best was the ranking of countries by relative inflation performance. All that disappeared as an investment variable during the disinflationary period. Now it will come back with a vengeance. We will see, though, widely divergent inflation, growth and currency changes.
Let’s start with the simple things the US brands and uses but doesn’t make. The falling cost of its imports from Asia has played a key role in the period of disinflation. It has held down inflation throughout the economy. This has enabled the US service industry to overpay its workers and overcharge its clients for 20 years. This didn’t damage disinflation prospects because Asia kept charging less for its goods. Finally, Asia has financed the US current account deficit by recycling its export dollars into US financial assets.
All this is ending. The reason is partly Asian and partly attributable to Alan Greenspan. The US Federal reserve chairman is trying to sustain global bubbles and excesses by printing money. And now, by devaluing the dollar, he seeks to make US excess consumption more sustainable by limiting the current account damage. What he will achieve instead is an increase in US import prices and inflation and so a rupture of the US consumer debt and housing bubbles.
Moreover, by forcing Asian currencies off their dollar pegs, Greenspan will also force them off the dollar standard. The Asians (and the Russians and so on) will repeg their currencies to non-dollar currencies and hold these as reserves. This will force up US interest rates. So Asia will help boost US inflation.
But there is an inflation problem in Asia too. Profit margins are getting murdered. Asian producers must choose between making no money and increasing prices, including those of exports to the US. The mix of dollar-dumping and dearer Asian exports will add pressure to inflation because it will help restore pricing power to US Inc.
Rising inflation will hit no other major region. Japan and Europe have strong currencies and low growth. And neither faces wage or unit labour cost pressure. Japan could well stay in deflation for another year and Europe’s inflation rate might fall below 2%.
Currencies will adjust accordingly, as in the old days, when Germany always had 4% inflation and France 10% and the franc’s value fell 6% every year. That will now become the dollar’s fate. In those days, French assets never outperformed Germany’s in common currency. That will hold for the US.
The return of differentiation
In the happy days of disinflation, financial asset correlations strengthened, weakening the argument for international diversification. Disinflation also killed the economic cycle. Now widening inflation differentials will weaken correlations between the financial assets of high- and low-inflation countries dramatically. It will also reintroduce volatility to higher-inflation financial markets like the US.
Faced with being hoist by his own petard, Greenspan will have to increase interest rates far more than the market expects him to do or the bond market will do the job for him.
As inflation and interest rates rise in the US, wages and salaries will lag behind. Corporate America has plenty of alternative cheaper workforces worldwide. So US households will be in trouble as the cost of their debt will rise sharply, but wages won’t. That will put an end to US over-consumption.
This could take a few years to play out. But if Greenspan gets it wrong and prompts a dollar collapse, global liquidity will contract, financial markets will fall and rising US import prices could accelerate the whole process. If that happens, the outcome is global deflation.
Take your pick. I expect equities to keep rallying for a while. But if I’m right on renascent inflation differentials, I’d prefer gold, European government bonds, Japanese equities and emerging Asian currencies to US assets.
