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The Dog That Never Barked? | 24th March 2014

Why deflation may yet bite | Deflation has come back on to the agenda. It never really left – it is the dog that never barked in the wake of the downturn: the sheer scale of the fiscal stimulus around the world has meant that, with the notable exception of Japan, we have experienced dis-inflation, or falling price levels, rather than deflation, which is negative price levels. With recovery in Europe and North America apparently beginning to take hold, why would commentators and analysts start to fear its bite now?

The answer is that it is not just Europe that needs to worry about deflation. Chinese trend growth is falling and March’s declines in copper and iron ore prices underscore the over-capacity in the Chinese economy that are symptomatic of lower domestic demand and that raise the spectre of deflationary contagion for Asia and the rest of the world.

The similarities with Europe are striking. Lack of demand in Germany  keeps inflation low in the Eurozone. While this benefits the weaker economies in the Eurozone in terms of competitiveness, making their prices cheaper and giving their consumers some spending power, if German demand remains low, then its inflation remains low. Because it is a surplus nation, its over-production pushes down prices in peripheral countries too, putting further downward pressure on investments and increasing the cost of their debt.

The threat of deflation from China’s lack of demand is best seen through the lens of South-South trade, illustrated in Figure 1a and 1b. China’s demand is a major determinant of South-South Trade, and the two charts show clearly the inverse relationship between South-South trade and the strength or weakness of the currency.


Figure 1a (left)  |  Real-USD and Zloty-USD Last Price Monthly versus monthly USDm monthly value of South-South trade, June 2001-Feb 2014

Figure 1b (right)  |  INR-USD versus monthly USDm monthly value of South-South trade, June 2001-Feb 2014

Source  |  DeltaMetrics 2014, Bloomberg

The post-crisis recovery in trade continued until the beginning of Q2 2011 and the emerging currencies 
continued to strengthen. Since then, however, South-South trade has been volatile but with flat trend growth. The Real and the Rupee have deteriorated against the US Dollar. The Zloty has strengthened slightly, but this is because Poland is integrated into European supply chains, especially through Germany.

This points to two dangers: first, the fact that China’s trade is volatile and not increasing at the rate that it was between 2010 and the middle of 2011, meaning that South-South trade is relatively unpredictable and not as buoyant as it was either pre- or post-crisis. This will put downward pressure on prices in China and in other emerging economies. As prices fall, servicing debt becomes more difficult.

Second, the fact that emerging market currencies (here proxied by the Rupee and the Real in particular) are associated with South-South trade growth presents a further challenge for US denominated debt. Emerging market trade is slowing and the pressure on prices is downward. This puts downward pressure on the value of the currencies too, making dollar denominated debt more expensive – further exacerbating the debt challenges caused by any potential deflation.

Figure 2 looks at the problem on a global scale and shows how deflation may already be working its way into trade values and into lower metal prices.



Figure 2  |  World Trade (USDm) versus Copper, Steel, Platinum and Gold Spot Last Price Monthly (June 2001-Feb 2014)

Source  |  DeltaMetrics 2014, Bloomberg

The first point from this chart is the clear flat-lining of trade values since March 2011 and a decline from May 2013 through to February 2014 in nominal value terms. Second, through the whole period, key metal prices are highly correlated with world trade, at above 0.79 for all metals. However, since August 2008 only Copper and Gold have been highly correlated (0.71 and 0.79 respectively) with world trade.

Both Copper and gold prices have fallen over the last 14 months but for quite different reasons. Copper is a proxy for economic development and manufacturing. In this context, its price will be strongly associated with economies that have strong manufacturing components to their trade, as illustrated in Figure 3.


Figure 3  |  Copper Spot prices against the world’s largest exporters (value of exports USDm against Copper Last Price Monthly, June 2001-Feb 2014)

Source  |  DeltaMetrics 2014


The copper price is highly correlated (at above 0.85) for all these countries’ exports. However, since August 2008, China’s exports have exhibited the weakest correlation at 0.57. This may suggest that investors are already looking at stronger growth in Europe and the US in the near term while also expecting flatter manufacturing exports from China as a reflection of over-supply in Asia.

Gold prices, in contrast, are often used as a hedge against inflation and deflation. Theoretically, where deflation is a risk, gold, as a store of value during low or negative interest rates, would rise in price, although, as Figure 4 shows, the price of gold rose up to early 2008 despite sustained Japanese deflation. But Figure 4 also shows a marked decrease in the price between January 2008 and October 2008 and then from September 2012. These were periods of marked disinflation, as opposed to deflation.


Figure 4  |  Gold Spot Last Price Monthly against Export Trade values for Germany, China, the US and Japan (June 2001-Feb 2014)

Source  |  DeltaMetrics 2014, Bloomberg

For the whole period, China, Germany, the US and Japan’s export trade has been highly correlated with Gold prices at 0.85 and 0.90 for China and Germany and 0.94 for Japan. Since the crisis, the correlation with Gold for Germany, the US and Japan has remained strong at 0.75, 0.79 and 0.86 but has weakened for China to 0.48. This is purely descriptive data but it suggests that investors have potentially been more concerned about the direct effects of deflation in developed economies until recently and have not regarded falling export prices in China as anything other than a competitive correction leading to disinflation rather
than deflation itself.

How worried to we need to be about either German or Chinese surpluses? There clearly is a deflationary trend globally manifesting itself through nominal trade values. But will this spill over into either the Eurozone or more widely across Asia?




Figure 5  |  China and Germany’s Trade Ratio (exports/imports), June 2001-Dec 2014

Source  |  DeltaMetrics 2014


If the problem in either Germany or China is the balance of exports over imports, then Figure 5 is enlightening. Germany’s trade ratio has remained remarkably static since June 2001 suggesting that it is not Germany’s surplus that is causing new problems. Similarly, China’s trade ratio has tipped in favour of imports over exports since the downturn since it has declined overall since 2001. In other words, the challenges of over-production are not new for two economies that are export-driven or for their neighbours.

However, if there is an issue, it is that investors and commentators alike may yet talk themselves into a deflationary spiral based on what is, increasingly, compelling evidence that disinflation could turn into deflation.



Figure 6  |  China and Germany’s trade balance, USDm against Gold Spot, Last Price Monthly, June 2001 – Feb 2014

Source  |  DeltaMetrics 2014, Bloomberg


Figure 6 shows a high correlation between the Gold Price and Germany and China’s trade balances. It is the most recent months, where disinflation has been present, that both the trade balances and the gold price have declines most sharply. The only other time when the simultaneous decline was as strong was between July 2008 and January 2011. But while German trade is highly correlated since this point, suggesting investors have priced in European disinflation, the decline in gold prices appears to lead the Chinese trade surplus since September 2012. In other words, investors began to worry about Asian prices then but may not see this as a real issue of deflation since recent price rises are strongly associated with geo-politics rather than economics.

In the end, trade flows in nominal value terms provide evidence that disinflation is an issue in both China and Germany with obvious effects for Asia, South-South trade and Europe. Of particular concern is the size of the debt burden of peripheral countries in Europe and Dollar-denominated debt in Asian markets. Defaults alongside downward pricing pressures could make deflation really bite and this is what markets are currently nervous about. And, as Figure 7 shows, the correlation between World Trade and the S&P 500 was positive up until August 2013 but has been negative since suggesting some form of correction is perhaps overdue.



Figure 7  |  World Trade Values (USDm) against S&P 500 Last Price Monthly, June 2001-Feb 2014

Source  |  DeltaMetrics 2014, Bloomberg

However, whether or not the dog will start to bark will depend on recovery in Europe and the US. If this proves sustainable, then it is yet possible that deflation’s bark may be worse than its bite.