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Avoiding a Black Swan in 2015

Friday, January 16th 2015, 12:41PM

by Andrew Hunt

Many investors are familiar with the oft-quoted line from Warren Buffet that “when the tide goes out, you find out who is swimming naked”.

In general, this quote is used to describe what is presumed to happen when “liquidity” leaves markets but we wonder whether it is the tide of “prices” that is going out at present. Although it is the fall in the oil price that is dominating the headlines, we should also note that tin, iron ore, copper, rubber, palm oil, timber and milk powder prices (amongst others) have each fallen heavily over the last year – and particularly over the last few weeks.

Potentially more importantly, though, it is not only commodity prices that are falling at present; we also find that many countries’ finished goods export prices are also deflating at present. Specifically, many Western and Asian producers have reported that the selling prices of finished consumer goods are also falling and, as a result, we have not, so far at least, witnessed the types of terms of trade improvement within economies of the world’s oil importers that we might usually have expected to see when oil prices have fallen.

As a result, business confidence in these economies has remained decidedly modest despite the supposed “boost” of lower energy prices.

Instead, it would seem that the fall in oil prices is merely part of a wider trend towards deflation within traded goods prices that we believe has its roots in the collision between the trend in “Western economies’’ towards more saving and less consumption (which has resulted in the “West” running its first aggregate current account surpluses in perhaps two generations) and North Asia’s inability to move away from its “export-led growth” models. Quite simply, it seems that the Asian economies have either overestimated current global demand trends or (more likely) simply been unable to move away from their export dependence, with the result that they are now being obliged to both limit their current production and clear their inventories of unsold goods by offering either specific pricing discounts or by resorting to the more general solution of weaker currency policies.

Consequently, we have a situation in which the West is attempting to import less, while Asia is both attempting to export more and import fewer raw materials, something which has been highly damaging to global pricing trends.

Much of the commentary that is offered on the likely effects of falling traded goods prices tends to focus on the possible gains to household real incomes that may emerge from lower fuel and even goods prices. Certainly, other things being equal, in the first instance, the fall in the prices of consumer goods will tend to have a beneficial impact on the household sectors’ financial positions. If one sector of an economy experiences an improvement in its financial balance, though, then there must be at least one other sector that experiences a deterioration and it is usually assumed that it will be the “foreign” sector that suffers the counterparty fall in its financial balance; in layman’s’ terms, it is generally assumed that falling energy and other import costs will lead the importing country’s trade accounts to improve. 

This would certainly seem to be the common sense “usual outcome”, but so far there are actually few signs that this is happening – we have been surprised by how little the West’s trade accounts have improved and by how little the trade accounts of the commodity exporters have deteriorated so far and we would attribute this to the fact that the fall in commodity prices is part of the generalised deflation that we noted above.

If, though, it is not the “foreign sector” that is suffering the counterparty deterioration to the improvement in the household sector’s financial position, then it must be some other sector and we find that, in many of the countries that we have studied of late, it has been primarily the domestic corporate sectors (and, to some extent, the governments). Because the fall in commodity prices seems to be part of a generalised deflation, it has depressed corporate sales receipts and government tax receipts, with the result that we find that it has been the financial balances of these sectors that have deteriorated.

The most dramatic case has been Russia. The fall in the oil price combined with the impact of the economic sanctions have led to a sharp deterioration in the domestic corporate sector’s already vulnerable financial position. Consequently, the Russian corporate sector has needed to borrow even more on top of its already substantial levels of debt to simply “keep the lights on”. Until the Ukrainian Crisis, the Russian corporate sector had made extensive use of foreign funding sources (with the result that at the end of 2013 the sector owed the rest of the world perhaps as much as USD250-300 billion), but the Ukrainian Crisis has now closed this funding route, with the result that the Russian corporate sector has had to become a massive borrower domestically.

For understandable reasons, the Russian central bank initially decided to accommodate this increase in the domestic demand for credit by, in effect, printing more money, with the result that the currency has plummeted (an event that may yet cost both Russia’s corporate borrowers and their foreign creditors dearly), but now the central bank seems to be raising interest rates and limiting credit growth once again. Russian companies are therefore facing the prospect of unfinancable financial deficits and usually this implies only one thing – namely a deep (CAPEX) recession. A drop in Russian CAPEX, though, will also hit not only German but also Swedish and Korean exporters hard, thereby impacting their own financial positions.

Russia is an extreme example but, as we have trawled through the latest flow of funds accounts for many countries (particularly outside Asia), we have found that many of the world’s corporate sectors are cashflow negative at present, largely as a result not of their own spendthrift behaviour but, rather, as a result of their weak nominal revenue streams of late. Some of these deficits were expected but even we were surprised by the size of, particularly, the UK, French, Italian and even US corporate financial deficits. It should also be noted that at least three of these countries have significant oil/energy components within their industrial sectors.

It would seem to us that the latest outbreak of price deflation within the global economy has not only not been limited to commodity prices and “costs”, it has also exerted a powerful and potentially very adverse impact on the cashflow situation of many of the world’s more important corporate sectors. If one is looking for Armageddon scenarios for next year, perhaps the worst thing that could now occur within the world economy would be for these newly cashflow negative corporate sectors to seek to adopt austerity regimes of their own by cutting employment and CAPEX in an effort to return to the types of surpluses that the financial markets have grown to expect (that is, so that share option schemes and equity buybacks can be financed). Such an austerity drive would, we believe, provide a second leg down in the deflationary trend that we have noted above and we believe cause the next global recession. For financial markets, crises tend to occur as the result of the risks that the markets have not recognised and possible financial difficulties in the corporate sector would certainly fit this description.

If this outcome is to be avoided, we would argue that governments need to do two things. Firstly, they and their respective central banks must ensure (almost at all costs) that corporate credit channels remain open – even we would argue this is no time to allow a corporate credit crunch if this implies the FRB seemingly falling “behind the curve”. 

Secondly, we would argue (despite our usual deregulation/supply-side reform bias) that governments or their agents such as the European Investment Bank should endeavour urgently to enact easier fiscal regimes so as to provide an alternative source of top-line income for the world’s corporates. Unfortunately, if neither of these are enacted, we suspect that the next global recession may turn out to be a corporate affair in late 2015.

More positively, in the near term, we suspect that financial markets will continue to want to bet on the adoption of easier fiscal stances in Europe, Japan and perhaps even the US coupled with a still dovish Federal Reserve and overtly expansionary Bank of Japan, PBoC and, hopefully, the ECB. Such events would certainly allow the world to “dodge” the Armageddon scenario that we describe above but for markets to remain buoyant as 2015 continues, we may need to see some “concrete signs” that these policies have actually had some effect in the real economies, rather than just in the financial markets.

Andrew Hunt
International Economist, London

Andrew Hunt International Economist London

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