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Slowing demand and over-capacity create a Cycle of Deflation

Economic growth
By Paul Hodges on 31-Jul-2013

Deflation Jul13

“More buyers than sellers” was financier JP Morgan’s famous reply, when being asked why stock prices had risen.  The same, of course, is true of inflation.  During the 1970s, there were large numbers of Western BabyBoomers, and relatively few older people producing the goods that these young people wanted to consume.  So inflation rose sharply, to peak at 15%-20%.

But since then, inflation has been reducing as the Boomers joined the workforce.  And the stability of their demand, as the largest and wealthiest generation that has ever lived, brought the potential for economic growth to other parts of the world, such as the Former Soviet Union and those countries now known as the emerging economies.

But today, this dynamic is reversing itself.  Low fertility rates around the world, plus vastly increased life expectancy, means there are now record numbers of people in the New Old 55+ generation.   And as they enter their low-spending and low income years, inflation is inevitably being replaced by deflation.

Yesterday’s blog post thus highlighted how four dynamics were now at work:

  • The downside of the inventory cycle, as companies seek to adjust to lower growth expectations
  • China’s decision to slow its economy, combined with the continuing recession in the Eurozone
  • The arrival of new capacity planned on the assumption of a return to SuperCycle growth levels
  • The end-game in terms of the asset bubbles created by the central banks

This combination is not good news.  It means the next few years will almost inevitably see an expansion of recent trends whereby excess debt and excess capacity create a loss of pricing power, competitive devaluations and then protectionism, as the chart describes.

This situation is, of course, far worse than it need have been.  Wise and far-sighted leaders would have recognised what was happening a decade or more ago, and implemented the necessary policy changes to enable a relatively smooth transition to the New Normal.   Instead, however, they wasted the budget surpluses built up during the SuperCycle years in a vain attempt to prolong the period of constant growth.

Japan is the classic example of what has gone wrong.  It has been in deflation for 20 years, as its babyboom was ahead of the West’s.  But even today, the new Abe government is still focused on new stimulus packages and liquidity, rather than accepting reality.  Thus it has now become one of the top risks to the global economy according to the IMF.

Yet in the blog’s experience, very few companies or investors have seriously developed their plans for surviving the arrival of this Cycle of Deflation.  Instead many companies are still pushing on with new investments, rather than closing unwanted capacity.  Whilst investors, like policymakers, have become obsessed with the 24-hour news cycle, and have forgotten that yesterday’s long-term outlook becomes today’s short-term reality.

The blog’s thoughts on how individuals, companies and investors should seek to survive the Cycle of Deflation will be the subject of tomorrow’s final post in this series.