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By HaleStewart March 13, 2015 10:21 am
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International Economic Week in Review: Causes of Global Deflation, Edition

     Last week was a very light week on economic numbers, so I wanted to take this time to look at a very interesting global phenomenon: deflation.  Across a wide swath of countries, we’re seeing remarkably weak price pressures.  First, consider the overall price level of all major commodity groups as expressed in the ETFs that track major commodity groups:

Over the last year, agricultural commodities are down 22%, industrial metals are down 5.32%, energy has dropped a whopping 43% and precious metals (which are a good indicator of inflationary expectations) are down 19.4%.  The conclusion to draw from this numbers is there is no price pressure in any major commodity group, period.

     But that’s not all.  Consider this long term chart of the Y/Y percentage change in China’s producer price index:

This number went negative in early 2012, and has been below 0% since, making this a consistent run of three years of price declines.  As China is considered the world’s factory, this is a very interesting development, signaling a remarkably long-lasting deflationary period. 

     And China isn’t the only area where input prices are negative.  Here’s a M/M of EU PPI prices that shows the same thing:

And US PPIs Y/Y rate just went negative as well.

     So, the three largest economic regions in the world are experiencing deflationary manufacturing prices.  And, these are not new developments for two of these regions.  The question now turns to why?

      I believe there are two overall causes, with the first being massive over-capacity in China.  China does not publish capacity utilization as part of their industrial production numbers.  But, we do know that they have been investing massively in capital.  Consider this chart that shows overall fixed capital investment over the last 9 years:

Notice the large, annual increases.  Also, consider this graph from the Chinese statistics agency:

The year over year rates of expansion have been massive for the last year, with decreases only seen in the latest year.

This has led to a large amount of overcapacity in the country:

China's latest large-scale governance of overcapacity happened after the world financial crisis in 2008, which was followed by a slack economic recovery and a new round of investment plans.

According to MIIT data, output totaling 720 million tonnes resulted in a loss of 28.92 billion yuan (4.67 billion U.S. dollars) for the country's iron and steel industry in 2012.

This was not a special case. In 2012, 93 percent of electrolytic aluminum enterprises suffered losses, considering the gap of 7 million tonnes between the industry's real output and capacity, MIIT said.

MIIT Minister Miao Wei regarded "moderate excess" as tolerable in economic growth, but warned of inappropriate overcapacity in some industries.

Feng pointed out that the phenomenon is becoming widespread.

Zhang Ping, former head of the National Development and Reform Commission (NDRC) , China's top economic planner, said the overcapacity problem is especially serious in traditional sectors like steel, cement, electrolytic aluminum, sheet glass and hard coke.

A capacity utilization of less than 70 percent is dangerous and could trigger vicious competition, Miao alerted.

A safe capacity utilization rate falls between 80 and 85 percent. Some industries in China have maintained a rate of just 70 to 75 percent.

Dr. Ed Yardeni also highlighted this trend in early February.

     But there are other issues as well: weak demand.  Although the US is growing, underlying employment data is still very weak, meaning there is little wage pressure.  This means the US consumers, while spending, aren’t doing so at a historically fast pace:

Above is a chart of the Y/Y percentage change in US PCEs, which shows that, while they are growing, they are doing so at the weakest rate of any expansion since 1960. 

     And consider the weak growth in the EU, which is printing near its lowest growth in 15 years.

     Also consider EU unemployment.

With a rate this high, demand is obviously lower, leading to a lack of demand pull inflation and, hence, price pressures.

     When looking at the three largest economic regions in the world, we see the following:

  1. Overcapacity in China, such that its producer prices have been negative for three years.
  2. US consumers, while spending, are doing so at the weakest pace of any expansion since 1960
  3. The EU is growing at a very slow rate.  And with unemployment over 11%, there is no demand pull inflation.

Considered together, it’s no wonder we’re in the middle of a deflationary economic scenario.

Hale Stewart is a former bond broker who has been writing about economics and financial markets since 2006 on the Bonddad Blog.  He is also a tax attorney with a domestic and international practice while also forming and managing captive insurance companies for US companies.   You can follow him on twitter at:@captivelawyer  



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