There are stock market rallies that are currently on across various parts of the world. The stock market rally in the United States is now nearly 5 years old, having started in March 2009. But there is a small factor that investors who are driving up these markets are not taking into account. And that is the current low inflation scenario as well as the prospect of deflation.
As Gavyn Davies writes in The Financial Times "The vast majority of developed countries are currently reporting a headline inflation rate of below 1.5 percent, with the trend in virtually all of them headed downward."
Inflation in the Euro area (17 countries in Europe which use the euro as their currency) for the month of December 2013 stood at 0.8 percent. In December 2012 it had stood at 2.2 percent. The inflation in the European Union (which includes the euro area countries plus 11 more European countries) was at 1 percent in December 2013. It was at 2.3 percent in December 2012.
A similar trend seems to be playing out in the United States. For the month of November 2013, the consumer prices, as measured by the personal consumption expenditures deflator, rose by 0.9 percent. This number was at 1.7 percent in November 2012. The personal consumption expenditures deflator is a measure of inflation favoured by the Federal Reserve of United States, the American central bank. The Federal Reserve has an inflation target of 2 percent. Hence, to that extent consumer prices in the United States are rising at a much slower pace than the target favoured by the Federal Reserve.
As Davies writes "It is hard to remember a period, other than in the months immediately following the financial crash in 2008, when...headline inflation has been so low in so many different economies."
And why is that a worry? Lets look at the European Union inflation data in a little more detail. Countries like Greece, Cyprus, Latvia and Bulgaria are facing deflation. This means that prices in these countries are falling. In other countries like Sweden, Spain, Italy, France and Portugal, the rates of inflation are less than 1 percent. In fact, in case of Spain and Portugal these rates are close to zero percent.
When prices are falling or it looks like they will soon start falling, consumers tend to postpone their consumption decisions in the hope of getting a better deal in the future. This has an impact on businesses, and, in turn, the economy in general.
When consumers postpone their buying, businesses try to attract them by cutting prices of their products. This means a loss of revenue and a further fall in the rate of inflation. And this might lead to consumers postponing their consumption even further. So the loop works.
Once countries get into what is known as a deflationary spiral, it is very difficult for them to get out. Japan is an excellent example of the same. The country has been trying to come out of a low inflation/deflation kind of scenario for close to two decades now, without much success.
Investors across the world have chosen to ignore this threat which has been lurking around the corner for a while now. As Albert Edwards of Society Generale writes in a research note titled Markets still refuse to price in deflation threat..... for now dated January 15, 2014, "Investors have yet to react to the deflationary threat however. They do not seem to care that they are sitting on the edge of a cliff. Markets remain stoic about the risks of outright deflation in the US and eurozone for one very simple reason - they simply do not believe a recession that would trigger outright deflation is on the horizon. Quite the reverse - they believe with all their heart that we are at the start of a self-sustained recovery. That is despite the fact that the US recovery is already noticeably longer than average, and that the classic signs of old age, such as rapidly slowing productivity growth and stagnant corporate profits, can clearly be seen."
A reason for the confidence of the stock market investors is the fact that over the last few years, at the slightest sign of trouble, central banks around the world have printed money (or what they like to call quantitative easing or QE) to keep interest rates low. This has allowed investors to borrow at rock bottom interest rates and invest in financial markets throughout the world. And that will keep the stock market rallies going. As Edwards puts it "Because the market has firmly got it into its head that QE will always be good news for equities. So if the economy swoons, equities will look through any short-term disappointment as more QE will save the day. Investors see bad economic news as good news for equities."
Hence, investors expect central banks to print more money once they start feeling that deflation is a serious threat to their economies. And the logic is that a lot of this money will find its way into the stock market and drive prices higher. But there is a problem with this logic.
Until 2012, every time central banks cranked up the printing press, prices of commodities like gold rallied. But that hasn't happened in the recent past, even though central banks continue to print money. Hence, the proposition that central banks printing money will lead to stock markets rallying, may not always hold true.
As Edwards puts it "I do believe this to be utter nonsense. For in the same way as investors believe, axiomatically that QE will drive up equity prices, they believed exactly the same thing of commodities until 2012. Commodities are a risk asset and benefited massively from QE1 and QE2, so why has QE3 had absolutely no effect on commodity prices? Exactly the same thing could happen to equities if a recession unfolds and profits plunge at the same time as the printing presses are running full pelt. Do not assume equities MUST benefit from QE."
And this can really spoil the global stock market party. I had asked the well respected financial historian Russell Napier, who works for CLSA, in an October 2012 interview I did for the Daily News and Analysis, by what level does he see the stock markets falling in the coming deflationary shock. And he had replied "I will just go back to my book Anatomy of the Bear, which was published in 2005 and in the book I forecasted that the equity market, the S&P 500 (an American stock market index constructed from the stock prices of the top 500 publicly traded companies) will fall to 400 points [On Thursday, January 16, 2014, the S&P 500 closed at 1,845.89]. As you know, in March 2009 it got to 666 points. It got somewhere there but it did not get to 400. So I am happy to stick with the number of 400."
And once the S&P 500 starts to crash, the rest of the world will follow. Of course, till that happens, there is money to be made.
Vivek Kaul is a writer. He tweets @kaul_vivek
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Updated Date: Dec 21, 2014 04:05:28 IST