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Update: Central Banks & Deflation

By beled | February 3, 2016

Extract from the December 2015 quarterly report:

The widely expected but largely irrelevant 0.25% increase in the US Federal Open Market Committee (FOMC) target interest rate in December remains a red herring to the proper assessment of US and global US$ liquidity conditions which in our opinion remain dire and accordingly very deflationary. While it could be argued that an FOMC target range of 0.25-0.5% is accommodative, the US private sector appears either unwilling or unable to borrow at these low rates to fund capital investment or consumption. As a result, both Federal Reserve credit and US money supply (M1) growth rates are approaching post- global financial crisis lows (chart 1). In terms of monetarist theory this offers a good explanation for the re-emergence of deflationary conditions in 2015 (chart 2):

Chart 1: US Fed Credit & M1 (% change pa)

US Credit








Chart 2: US Inflation (% per annum)










Until reflationary forces regain the upper hand, one must expect global liquidity-sensitive assets such as emerging markets, commodities and emerging economies’ currencies to remain under pressure, a situation which has generally prevailed since the Eurozone crisis of 2011. Chart 3 shows how emerging markets have underperformed developed markets in US$ over the past 4 years, but it is important to note that this is a cyclical phenomenon. In fact, chart 4 shows that emerging markets have provided superior long-term returns in US dollars:

Chart 3: EM vs DM Indices (4 years)

MSCI Ind vs Emerging








Chart 4: EM vs DM Indices (15 years)

MSCI Ind vs Emerging LT








Accepting the above, the key question devolves to when reflation will succeed in the US and Eurozone. The Fed has emphasised its inflation target of 2% and it is hard to see how this can be achieved without further QE which should result in a rise in oil and other commodity prices. The ECB has recently extended its QE program and together with the Fed hold the near-term recovery in both developed and emerging markets, especially China, in their hands. As we have said before, it is impossible to predict the timing of central banks’ actions. The following quote from the December FOMC minutes puts this in perspective:

“As with real activity and inflation, the outlook for the future path of the federal funds rate is subject to considerable uncertainty. This uncertainty arises primarily because each participant’s assessment of the appropriate stance of monetary policy depends importantly on the evolution of real activity and inflation over time. If economic conditions evolve in an unexpected manner, then assessments of the appropriate setting of the federal funds rate would change from that point forward.”

So even though the central banks themselves are unclear about the future and are reactive to emerging data, looking at the cycles shown in the long-term charts above we have no doubt that they will eventually capitulate to the deflationary conditions and “do what it takes” (quoting ECB’s Draghi) to ensure reflation. In other words, we believe a high medium-term probability is much more useful for investment decision-making than specific near-term predictions which are most influenced by the recent past. Trying to see “the wood but not the trees” prevents us from reacting emotionally to short-term movements which are the death-knell of successful long-term investing.

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