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Monday, January 27, 2014 5:09 AM


Deflation Will Return: Europe First, Then US; Global Supply Arbitrage


In an email update last week, Saxo Bank chief economist Steen Jakobsen commented "Europe has a more than 50:50 chance of deflation, while the US is 25:75 against."

Steen is talking about a general decline in prices of goods and services, which is also how central bankers use the term deflation. For now, let's use that definition. I will tie things back to money and credit (my preferred way of discussing inflation and deflation) a bit later.

In contrast to Steen, I believe deflation is near-certain in Europe, and strongly odds on in the U.S.

Global Supply Arbitrage

A simple statement by economist Andy Xie is what got me thinking about the prospects of deflation once again: Demand is local, supply is global.

Here is the complete context as noted in Keynes Is Dead, Abenomics Fizzles, US Fails to Reach Escape Velocity, Stimulus Fatigue

Keynes Is Dead

I have argued for many years that this round of globalization has fundamentally changed how an economy works, even for a large one like the United States. While demand is and always has been local, the supply side has become genuinely global. Both manufacturing blue-collar jobs and most white-collar jobs have become global. Today's information technology allows a multinational company to position research, marketing, finance and managerial jobs to anywhere. Hence, when a country stimulates demand, it's met by supply from anywhere.
Supply From Anywhere

With supply arbitrage in mind, please consider Invasion of Spanish Builders Angers France Struggling to Compete.
The earth movers digging out a sandy pit in the beach town of Biarritz could be any construction site in France. Except the builder of the 300 homes and its workers are Spanish. In the neighboring town of Anglet, a Spanish company built the concert hall inaugurated this month. A kilometer up the road, in Bayonne, a Spanish company is building a 15-lodging apartment block.

And that’s just in a small corner of southwestern France.

The losing French bidders are crying foul, saying the Spanish pay lower wages and cut corners on regulations. The Spanish, fleeing a construction slump and an unemployment rate of 26 percent at home, say they’re just using European Union rules allowing free movement of businesses and workers.

“We thought for a long time we were in an industry that couldn’t be shifted offshore,” said Didier Ridoret, president of the French Constructors’ Federation, or FFB. “Instead, the reverse happened: the offshore came to us.” 
    
With the best French bid in Anglet priced 40 percent higher than the winning offer, reversing the trend won’t be easy.

French builders say a majority of homes in border regions are now being built by Spaniards, Portuguese and Italians.

"These contracts are often awarded solely on the basis of price,” said Patrick La Carrere, head of the builders’ federation in southwest France. “The Spanish have much lower charges so they can always undercut us.”

For companies hiring Spanish builders, the choice is clear. The 2 million-euro contract for the Anglet concert hall was awarded to Altuna y Uria SA, based in the Basque town of Azpeitia, after its bid was 800,000 euros less than the best French offer, said Jerome Poties, head of culture for the town.

According to accounting firm KPMG, Spanish companies pay 30 percent of a worker’s salary in social security contributions, and the employee pays 6.35 percent. In France, companies can pay as much as 45 percent and labor another 22 percent.

It’s not just lower charges that help Spanish firms, said Maxime Alimi, an economist at Axa Investment Managers in Paris.

“There have been reforms in Spain that have made labor more flexible,” Alimi said. “In France, salaries are extremely rigid. It’s a tendency that’s not likely to change.”
"The Offshore Came To Us"

The offshore came to France. And the implications are enormous.

In Europe, with free movement of citizens, supply of labor could theoretically come from anywhere. In practice it didn't, at least on a large scale. But that is starting to change, and the repercussions will be huge.

Worst Ahead for France

Spain is still in the state of economic depression, but the worst is arguably behind. For France and Italy, the worst suffering is clearly ahead. Both countries are in huge need of work rule reforms and pension reforms. Public sector spending must decline. Wages and prices are going to have to decline for France to be competitive.

One way or another, it's going to happen. Even in Germany, the harmonized CPI is barely positive, with the most recent reading at 1.219%.



What happens if President Hollande lives up to his promises to make France more competitive and to reduce the size of the public sector?

Not many believe he will do that, but it really won't matter. The offshore came to France.

Currency Crisis

A second deflationary factor in Europe is the emerging market currency crisis. Foreign bank exposure to Turkey is $350 billion, and Greece is particularly exposed. For details, please see Start of a Global Currency Crisis?

Stress Tests

A third deflationary factor in Europe is the pending stress tests. Although the ECB Watered Down 2014 Stress Tests Second Time, some banks are still likely to have capital shortfalls.

Increased lending? Forget about it.

Recession in Germany and France

In December, France's statistics body, the INSEE, said France would avoid recession. I did not believe it then, and I sure don't now given Eurozone PMI Strengthens, Except France.

It's going to be very difficult for Germany to avoid recession when France slides back into one.

Europe First, Then U.S.

In the U.S., the Fed and others way overestimate the robustness of the jobs market. The discrepancy between the household survey and the establishment survey is 65,000 jobs a month.

For details, please see Employment vs. Jobs Discrepancy based on December 2013 Data, released in January.

Retail Sales Cost-Cutting, Competition, and Cannibalization

Numerous retailers are cutting employees. Wal-Mart, J.C. Penney, Macy's, Target, Aéropostale, and numerous other retailers have announced cutbacks as noted in Tsunami of Retail Store Closings and Downsizings Coming; Expect Layoffs and Shorter Hours.

Notably, Sam's Club CEO Rosalind Brewer announced a 2% Reduction in Sam's Club Employees to thin middle-manager ranks. Where are those managers going to get another job?

In "Retail Sales Cannibalization" I noted
"Brewer aims to better compete with brick-and-mortar rival Costco as well as to take on online membership clubs like Amazon Prime service. She seeks to double revenue and turn it into a $100 billion business, roughly the size of Costco."
Is doubling revenue remotely possible? If so how?

The only way it is possible is via reducing prices and costs to the bare bone and taking customers away from Amazon, Macy's, J.C. Penny and its own parent company, Wal-Mart.

The deflationary repercussions are enormous.

The China Factor

China is slowing. This puts pressure on commodities which in turn puts pressure on producer prices, then final prices.

A 3 billion-yuan ($496 million) Chinese trust product is on the verge of collapse. $496 million is a tiny amount, but it's also a sliver of the problem.

Bloomberg reports China Trust Products Gone Awry Evoke Soros Crisis Echoes
China’s $4.8 trillion in shadow-banking debt, arranged by trusts and fund managers with less transparency than commercial-bank loans, was equivalent to as much as 55 percent of the nation’s 2012 economic output at the end of that year, according to Moody’s latest estimate.

Goldman estimates the 2 trillion yuan in lending by trusts last year accounted for 10 percent of financing in the economy and a removal of credit flows from trusts would knock 0.8 of a percentage point off the nation’s growth rate. Gross domestic product will expand 7.45 percent this year, the slowest since 1990, a Bloomberg survey of economists signals. 

The first default of a trust product in at least a decade would shake investors’ faith in their implicit guarantees and spur outflows that may trigger a “credit crunch,” according to David Cui, China strategist at Bank of America Merrill Lynch in Hong Kong. The government and state banks may bail out a significant portion of bad debt “to prevent a financial crisis,” he said. Guangdong International Trust & Investment Corp. failed to pay Yankee notes in 1998, the nation’s first default since the People’s Republic of China’s founding in 1949.

A credit crunch in China will not be good for global growth, and that is on top of China's efforts to ease slowly.
For further discussion, please consider ZeroHedge's report China's First Default Is Coming: Here's What To Expect.

Equity and Bond Bubbles

The Fed (central bankers in general), once again spawned enormous asset bubbles in equities, corporate bonds, and housing.

For discussion, please see Bubblicious Questions: What Causes Economic Bubbles? When Do Bubbles Burst? Can the Fed Prevent Bubbles?

The popping of bubbles is inherently deflationary.

Housing Bubble Returns

Even though household formation by millennials is at a record low percentage, home sales are at modest levels thanks to investor demand in the form of all-cash buying:  All-Cash Home Sales Hit Record 42% of Sales.

CNBC reports All-cash offers crushing first-time homebuyers
Insatiable demand from hedge funds, private equity investors and foreign buyers, all armed with ready cash, are elbowing first-time buyers out of the housing market.

First-time buyers tend to purchase lower-priced homes, but all-cash investors have cornered the market on those, leaving little behind. All-cash purchases accounted for 42.1 percent of all U.S. residential sales in December, up from 38.1 percent in November, and up from 18.0 percent in December 2012, according to a new report from RealtyTrac.
The equity, corporate bond, and home bubbles are poised to burst. When they do, demand for goods and services of all kinds will decline. In turn, prices will drop.

Subprime Car Loans

Automakers have been relatively happy lately. Unfortunately, Subprime Car Loans are the driving force.
As the fifth anniversary of the Federal Reserve’s policy of keeping interest rates near zero approaches, the market for subprime borrowing is again becoming frothy, this time in the car business instead of housing. U.S. auto sales, on pace for the best year since 2007, are increasingly being fueled by borrowers with spotty credit. They accounted for more than 27 percent of loans for new vehicles in the first half of the year, the highest proportion since Experian Automotive began tracking the data in 2007. That compares with 25 percent last year and 18 percent in 2009, as lenders pulled back during the recession. “Perhaps more than any other factor, easing credit has been the key to the U.S. auto recovery,” Adam Jonas, an analyst with Morgan Stanley, wrote in an October note to investors.

The money for subprime loans comes from yield-starved investors who buy bonds backed by them. Issuance of such bonds, which pay higher rates than U.S. government debt, soared to $17.2 billion this year, more than double the amount sold during the same period in 2010, but still below the peak of about $20 billion in 2005, according to Harris Trifon, an analyst at Deutsche Bank.
Technology, Education, Medical Expenses

Competition in electronics, computers, and even computer storage is intense. Falling prices are the norm.

Two days ago Microsoft announced "new worldwide prices" to match Amazon Web Services prices. "Effective March 13, customers will see lower prices for Block Blobs Storage and Disks/Page Blobs Storage matching AWS’ prices. We’re also making the new prices effective worldwide which means that Azure storage will be less expensive than AWS in many regions."

In general, price deflation reigns in areas where that has been little government interference in the free market.

Two areas of highest price inflation have been healthcare and education. However, online eduction offerings are starting to eat away at what used to be a rising-cost, brick-and-mortar college experience.

The number and quality of accredited online schools and colleges is growing, and costs have come down. On September 3, I wrote Future of Education is At Hand: Online, Accredited, Affordable, Useful

Healthcare Costs Slow

At long last, healthcare costs have started to slow. NPR reports Health Care Costs Grew More Slowly Than The Economy In 2012

Obamacare had nothing to do with the trend even though the Whitehouse tried to take credit, and even though we are talking about 2012, before the exchanges were operable.

Moreover, actuaries suggest the Affordable Care Act likely produced a small overall increase in spending.

Some cite lingering effects of the recession for slowing costs. I suggest it's nothing more than "what can't go on, won't".

Deflation in Terms of Credit

Above I talked about reasons why prices are likely to decline. But what about credit?

Subprime loans are likely to blow up once again. Demand for business loans will plunge. Writeoffs of all kinds will increase. Asset prices including stocks, corporate bonds, and houses will all take a hit.

These are all symptoms of deflation in a practical sense.

What about money supply?

I have little doubt the Fed (central bankers in general) will step on the money supply spigot in response to another slowdown. But credit dwarfs money supply.

Once again, those who view inflation and deflation in the myopic eyes of money supply alone will come to the wrong conclusions about prices of goods, services and assets, just as they did in 2008 when they thought hyperinflation was just around the corner.

Those who understand credit and credit market to market will get the picture right. I repeat my claim that I made in 2007. The US will go in and out of deflation over the course of a number of years.

Deflation is once again nearly at hand, but Europe will be first.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com

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