The jig is up for commodities. But more than that. The jig is up for inflation. A great tide of deflation is sweeping through the global economy right now and it is going to wash all before it. There are three reasons why.
The first deflationary wave is the global business cycle. It is mature and turning aged. Asset values are extreme and all major economies are experimenting with tightening. In Europe, internal deflation is under intense strain. In the US, monetary excess is being ratcheted back. In China, the post-GFC building boom is over.
The second deflationary wave is global economic restructuring. The above three withdrawals are exposing the flawed structure of the underlying global economy with massive over-capacity. In the last cycle it was industrial capacity but it is now moving swiftly down the production chain to raw materials.
Normally this would be good news for the world. It would result in a huge income windfall for global consumers and manufacturers. And it is still, in part. But it is too large and too fast for the global economy to cope with.
Take oil, for instance, which is now deflating at a spectacular rate. One has to understand just how far oil could fall to get the idea. Like we are seeing in iron ore, the oil production cost base is made up of a bunch of inputs that deflate as the price falls. This goes far beyond simple inputs like equipment. Throughout the world the biggest cost to oil producers is tax. In the North Sea nations levy rent taxes that make up to three-quarters of the oil price, and as it falls do too do the taxes, allowing firms to continue to produce despite a glut of supply.
Oil will have to fall to the cash cost of its marginal producer before its stops falling. That is unconventional production in US shale and Canadian oil sands. I’ve targeted $50 Brent for a while but that is all-in costs, it may have to fall far lower as costs come out. And because oil is a key input cost into every other commodity – from iron ore to wheat – they can all deflate further as well. Indeed, while oil falls, the entire Malthusian panic that has driven global investment patterns for a decade is in very serious question.
While in the past this deflation would result in, and be counter-balanced by, an income windfall for consumers and manufacturers, this time it is not or, at least, not as much. And this is a global phenomenon.
The US consumer is not willing to leverage into the income like it once was. Indeed, such windfalls seem to go to added savings these days as much as they do expenditure, after the wealth shocks of the GFC.
The European consumer is under intense assault from its Teutonic overlord who is determined to deflate Europe into the world’s first developed continental mercantilist state.
The Chinese and emerging market consumer would perhaps like to spend, indeed are spending, but these economies are so hooked into the global commodities production chain that they cannot transition fast enough to contribute net imports to the global economy. Moreover, they are under intense assault from capital outflows on US tightening and many will have to raise interest rates.
With the US unwilling to spend, Europe not allowed to spend and EM spending too small, the entire globe is in a process of resetting its production cost base lower.
The third deflationary wave are three megatrends that underpin the other two. They are debt saturation, declining demographics and decarbonisation. Each of these is deflationary in its own way. The first is promoting deleveraging all over the place, again hitting demand. The second is exacerbating the first by promoting greater saving all over the place as aging populations prepare for retirement. Again, it effects all three major economies though the US is best placed. The third is creating new green production all over the place but the process of creative destruction is being managed via politics not markets which is destroying its efficiency. Rather that creative destruction that gives more than it takes we have creation and not enough destruction leading to falling productivity and enormous oversupply in energy.
This all adds up to an historic deflationary tsunami for the world. For Australia over the next few years that means:
- a full reversion of the terms of trade to historic mean;
- an enormous and enduring income shock;
- followed by volume cuts in commodities, including iron ore and LNG, suppressing GDP versus expectations;
- interest rates going as low as they can go;
- a ruined Budget that had been restructured to permanently high commodity prices and sovereign downgrades;
- a dollar falling to historic lows but not as fast as it should as other nations keep pumping money, including the Fed, and
- a global end-of-cycle bust in which asset prices, including property, follow commodities down as global central banks both over-inflate assets and confront a lack of ammunition as they implode.
We are shifting into that point of the cycle when cash is king.
