Global equity markets are battling against the third wave of deflation which Fidelity first spoke about last summer. The first wave was the US housing and financial crisis of 2008-9, the second the euro crisis of 2011-12, and now, the third, the emerging market crisis of 2015-16.
All emerging market crises start in the foreign exchange markets and this one is no different. It has been brewing for the last 18 months and its epicentre has now become clear: the misallocation of capital and over-investment in fixed asset investment in China over the last decade or more.
Past experience teaches us that it takes years of capital scarcity to restore capital and cost discipline after years of over-investment. Consequently, investors are fleeing Chinese equities and those parts of the global economy most directly affected, particularly commodities.
In response, the People’s Bank of China (PBOC) is understandably attempting to manage an orderly devaluation of the yuan. The yuan’s formal link to the US dollar has been a problem for the PBOC over the last two years as the dollar has strengthened: de facto forcing the yuan to revalue higher against China’s key trading partners in Asia, particularly against the Japanese yen. Recent policy moves to measure the yuan against a basket of currencies and not just the dollar, and adjusting the mid-rate against the dollar, are designed to ease the competitive pressures on Chinese manufacturing. The devaluation of the yuan effectively exports domestic deflationary pressures across the global economy, however, which is why global markets are falling as well.
There is no doubt that the third deflationary wave will mean that world GDP will continue to operate below its potential for some time. Downward pressure on prices will persist and a supply-side contraction in developing nations will be required before prices stabilise. A further fall in potential global output is unavoidable and further downward adjustments to global GDP forecasts lie ahead due to more weakness in emerging markets.
The impact on the developed world will be bifurcated. Those sectors directly concerned with commodity production and exporters of trade goods will face recessionary conditions. It is safe to say that a global manufacturing recession started in late 2015 and will persist for most of this year.
Consumer and service sectors in the developed world, in contrast, will ride out this storm relatively well. Personal real incomes are growing, in part thanks to lower commodity and manufactured goods prices. Moreover, inflation in 2016 will now be non-existent. Even in the US, the case for higher interest rates can once again be pushed back by international considerations.
In sum, an economic landscape, formed with low nominal growth and low nominal interest rates, will now shape the developing world as it has the developed world since 2008. Those who thought the secular opportunities within emerging markets would insulate them from our woes will need to rethink. Our only escape from secular stagnation lies in innovation, and not in a blind trust in central bankers who somehow know more than we do. They don’t.