Is the third wave of deflation over?
This was the third wave of deflation in a decade, following those prompted by the global financial crisis of 2008/09 and eurozone sovereign debt crisis of 2011/12.
According to the FT, this third deflationary wave was caused by the emerging markets crisis.
As volatility starts to reduce in global equity markets, is this third wave of deflation now over?
Dominic Rossi, Global CIO of Equities at Fidelity International thinks it probably is.
In a new briefing note for investment advisers, Rossi explained why he believes the third wave of deflation is over.
He said that developed economies have stood up well to the latest wave of deflation emanating from emerging economies that has seen a combined volume and price shock depress global trade and output.
According to Rossi, this third wave of deflation is now over, as is the period of dollar appreciation which was tightening financial conditions.
He says that dollar strength has ultimately acted as the catalyst for much-needed central bank coordination that is now easing financial conditions.
Fears that the US might enter a recession now look exaggerated and Rossi expects another up-leg in the bull market in US equities.
The briefing note explained the central bank coordination of the past few months which immediately eased financial conditions.
Despite drawing criticism from many quarters, Rossi argued previously that we were in a situation where communication errors were unnecessarily contributing to tighter financial conditions and equity market volatility.
Specifically, he felt the US Federal Reserve were much too forceful in signalling that money markets were underestimating interest rate rises in 2016.
“The strength of the US dollar has been the main channel through which global financial conditions have tightened in recent years.
“Since global financial markets and commodities are priced in dollars, the upward move in the dollar meant that the value of the same assets priced in stronger dollars had to fall.
“Now, the reasons for the appreciation of the dollar are many, so it is not something that can be pinned solely against the Fed, but since only the Fed can print dollars, it does have the ultimate responsibility for ensuring that the currency does not become a constraint on activity.
“Unfortunately, as the dollar continued to appreciate, we experienced a challenging period when central banks were effectively pursuing their own domestic agendas. This was a mistake.
“Fortunately, we are now seeing a clear recognition that the net effect, or more rightly, the unfettered consequence of independent actions saw the dollar reach a level that was a threat to financial stability.
“Recent actions by central banks suggest a greater level of coordination with respect to currency than we have seen for some time.
“While we are not talking about something akin to the formal Plaza or Louvre accords of the 1980s, there now seems to be an important recognition between the major central banks that no one stands to benefit from further dollar appreciation.”
Later in the briefing note, Rossi talked about comments from The People’s Bank of China, which has been explicit that the renminbi will not be devalued, and also their actions in the foreign exchange markets to support that position.
In Europe, he talked about the expansion of the European Central Bank’s programme of quantitative easing, suggesting that ECB president Mario Draghi is refraining from using the foreign exchange channel.
According to Rossi, Draghi was clearly concerned that the easing stance and move to negative rates would be seen as an opportunity to short the euro.
As a result, Draghi very deliberately used the press conference to say there would be “no more cuts” to rates. This had the intended effect of reversing euro weakness.
Rossi doesn’t think the post-Fed meeting weakness in the US dollar is the start of any material depreciation trend, but he does think that the period of dollar appreciation we have been witness to over the last few years (and particularly since mid-2014) is now at an end.
According to Rossi, this immediately eases financial conditions and should allow elevated volatility levels in financial markets to subside.
Rossi concludes his briefing note by saying developed economies have weathered the effects of the third wave of deflation pretty well.
Whilst there has been a volume and price shock in traded goods and industrial production, the US domestic economy has continued to perform well, and the Eurozone and UK have also held up reasonably well.
In his view, the fears of only a few weeks ago that the US might enter a recession were greatly exaggerated.
Rossi believes we should now enjoy a period of stable growth with benign financial conditions providing the platform for a new up-leg in equites, once again led by the US stock market.
He says that a Chinese devaluation would be a risk to this thesis, potentially supplying yet another deflationary wave, but this risk appears to have materially subsided.
In terms of what might happen next; the recent bounce in emerging markets and commodities from distressed levels will most likely fade as both areas still face pressing structural challenges, which will take years to work through.
Instead, he sees leadership reverting to those areas least impaired by recent developments; that is the sectors with high levels of intangible assets and intellectual property, such as information technology and healthcare.
Do you agree with Dominic Rossi that the third wave of deflation over?