Economic and market themes: 2014-10-20 Inflation, Fed reaction function, Amazon, Apple
It’s been a while since I did a multi-theme review as I used to do on Fridays but there are a number of threads out today that deserve mention. So I want to pack them into an economic and market theme post today.
Market meltdown. First, the market meltdown from last week seems to have abated. I am expecting an official market correction at worst. But, as I indicated on Friday, I do not think we are in the early stages of a global financial crisis because the real economy is still robust enough in the US and UK to succumb to exogenous shocks and because the distress in trigger markets has not developed, let alone acute. Loan loss provisions are still declining at US banks, for example. So I think we have a ways to go here.
European sovereign debt. On the other hand, the problems in Europe are more severe. While the real economy in Italy is pretty dire and bad debts in Spain have now risen for three months on the trot, I do not think the signs of market and real economy distress is enough to precipitate a full-scale crisis across the Eurozone. However, I do believe the uptick in sovereign yields, the meltdown in shares, and the political uncertainty in Greece presents Europe with a problem. Greece desperately wants to follow the route other Eurozone countries have done in leaving the Troika oversight safety net. But the backing up of yields is a loud signal that this would be folly. If Syriza can force elections next year and come to power, we are going to have a problem. We will see more writedowns of Greek debt before this is over. And public sector participation will increasingly become an issue. Thus, I think we can consider this the beginning of round two of the European sovereign debt crisis, involving only Greece right now.
Inflation vs. deflation. We are still firmly rooted in the deflationary part of this secular credit crisis, with the fall in oil prices precipitating a global downshift in consumer price inflation. This is a debt problem – or better put a debt deflation problem because the problem with deflation is that it increases the real value of debt and represents a redistribution from debtors to creditors. Absent debt agreements contracted in nominal terms, deflation could be considered “good” in nearly all circumstances. But, economic downturns introduce debt distress into the picture that is exacerbated by a decline in asset prices. And to the degree we see a general price deflation, the feedback into asset prices creates a nasty downward spiral. With interest rates at zero percent, central banks have less control over credit markets than they used to because they have to turn to unconventional policies, which are less effective. The economists and market players who have been concerned about inflation are very premature here. All of the factors that make deflation an economic threat are still in place and will be for the foreseeable future.
Technological disintermediation. On that front, Apple and Amazon are interesting examples. I see the Internet as a price discovery mechanism that increases price competition and lowers margins. It is inherently, deflationary until we get to a “winner take all” moment in which companies like Amazon can raise prices without competition. But we aren’t there yet. Amazon is still working to increase its size and scope. And it is doing so by ploughing cash back into its business. Justin Fox’s take on the massive increase in operating free cash flow at Amazon is instructive here. Apple, despite its adherence to high-end devices, is equally committed to the deflationary model in other arenas of its business. iTunes disintermediated the record industry’s revenue streams. And I see Apple Pay as another area where Apple is in a race that will ultimately lower margins. If Apple plays it right, the Apple Pay initiative can be a huge beach head into the finance space, which will do to the personal finance industry what iTunes did to the recording industry. Time will tell.
Credit. But back to central banks’ ability to stop deflation, we are still seeing signs that credit in Europe is going nowhere. Even in the UK, where GDP growth is highest, lending to small and medium-sized business is contracting despite the Funding for Lending scheme. The ECB is starting its covered bond program today. And it is in part basing its new covered bond and ABS-styled QE scheme on the FLS program in the UK. And given both the results in Britain and the small size of the ECB scheme, we should not expect great results. I would argue that the UK’s economic advance is all about asset price inflation. And once this inflation comes off the boil, so too will growth.
Final comments. In the US, I would watch corporate earnings and jobless claims for direction that will impact asset markets. Claims data is at a cyclical low. Depending on how quickly it moves off this low and how quickly earnings growth decelerates, we could see growth in 2015 undershoot current estimates. In the tech sector, Intel was a standout, but the numbers have generally been weak, with IBM recording the latest sub-par numbers. This is an late-cycle development in my view.
That’s it for today. More comments later in the week