Deflation? Not Here

economist at Montreal's BCA Research,

A low-inflation, low-return world sounds rather dull to us, but to a highly regarded economist at Montreal's BCA Research, these are "strange" and "fascinating" times. Strange, because despite so many inflationary pressures, the good times continue, according to Martin Barnes, who is also the managing editor of the equally acclaimed Bank Credit Analyst report on investing and business trends. Fascinating, because it seems the economy can keep moving at a decent clip for the foreseeable future. As for low returns, get used to it. We'll let him explain.

Q: How big a deal is the revaluation of the Chinese currency?

A: It wasn't a big move and we weren't expecting a big move. We've been in the camp that, from an economic perspective, it doesn't make any sense for China to revalue. They've got very low inflation and, if anything, a bit of a deflation problem in some sectors. In that environment, you don't want a strong currency, you want a weak currency. But, of course, with all the protectionist pressures building up in the U.S., they had to do something. They were backed into a corner.

We thought they'd do as little as possible just to get the U.S. off their back and to try to minimize the impact on their economy. That's just what they've done. A 2% move is enough for the U.S. as a good start, and it holds out hope they will do more down the road. They won't be in any hurry to do anything else for quite some time, so the economic impact of it is not going to be much at all, but it was a big, important political gesture.

Q: Do you think the Unocal bid by CNOOC had anything to do with it?

A: That, too, was tied up with this protectionist movement in the United States, against China in particular. I don't think this is going to clear the way for that takeover, but the opposition was sending a strong message to China that they needed to do something to show they were prepared to try and help reduce the huge trade imbalance.

Q: Is this a wake-up call to those who thought China would continue to invest in U.S. treasuries?

A: I'm not sure it changes that story a whole lot. The key issue here, and the Federal Reserve has bought into this view, is that there is tremendous excess savings globally, not just in Asia but in OPEC countries as well, at a time when there is weak demand for credit in most countries. That savings was going to find its way into the bond market, and that doesn't change a whole lot with the Chinese revaluation.

To the extent people are now thinking this is the first of many moves to revalue China's currency, you could see some speculative capital inflows moving into China on the back of expectations the currency is going to move up. If that is the case, and China needs to neutralize the effect of that, they will continue buying bonds. But it doesn't have to be U.S. bonds; it could be European bonds or other kinds of bonds. But to the extent that there are speculative inflows into China, China will have to keep recycling that money. The story of global money available to keep bond yields down isn't about to change any time soon.

Martin Barnes

Q: What do you point to when you say that?
A: There are a lot of things and data you can point to. Mainly, if you look at the data on the capital stock, which the Federal Reserve publishes in its flow-of-funds report, the growth in the capital stock is the lowest it has been in the postwar period. The capital stock is the stock of equipment and software in the corporate sector. All the investment that is made over the years adds up to how much capital you have and whether it is machines or computers or whatever. Relative to gross domestic product, the capital stock is not particularly high by historical standards. The rate of return on capital has been rising recently and is still reasonably high by historical standards. The capacity-utilization rate is low, but that is just a measure of manufacturing and it is driven by the business cycle. It is a short-term problem, and there is no evidence it is a structural problem. The Fed has put a lot of resources into looking at this issue, too, and it couldn't come up with any clear evidence there was a big overhang of excess capital. Companies bought a lot of computers and information-technology equipment in the run-up to Y2K, but a lot of that stuff is obsolete now. It has depreciated. It needs to be replaced. The capital stock now turns over so fast that you have to keep investing just to keep in place. But, in fact, net investment as a percentage of gross domestic product -- investment minus depreciation -- is as low as it ever gets. So there has been a dramatic cutback in corporate capital spending, and that matters, that has an impact.

Q: And you think that's about to change?
A: The pieces are in place for capital spending to improve. There's been no investment for years. There is a good gap between return on capital and the cost of capital. The cost of capital is still very low. The fact that productivity growth stayed strong tells you there is a payoff to capital spending. But what is missing is confidence, and that is a big thing to be missing, of course.

Q: With all this worry about deflation, it's hard to have confidence.
A: If you were the proverbial man -- or lady -- from Mars and came and saw the current environment, you would see interest rates among the lowest they've been in the postwar period, and a very expansionary monetary policy. Money growth is strong. You would see the budget deficit up sharply. You would see the dollar collapsing. You would see we just had a spike in oil prices and commodity and gold prices are moving up. You would see a hot housing market. And you would likely say, 'My God, this is a pretty inflationary mix, very much like the conditions we had in the 'Seventies.' Those conditions suggest we're in an inflationary time not a deflationary time. The thing that is different, of course, is demand is weak. We do have excess capacity in the short run, so it is a tough environment for companies. But if you believe the economy is just facing a cyclical problem, not a structural problem, that will change. Isn't it interesting how you can have people worried about deflation and a housing bubble at the same time?

Q: Yet you're not terribly concerned about deflation?
A: I don't agonize over consumer debt the way some people do. I don't agonize over the idea there is a huge amount of structural excess capacity, because I don't think it is true. Asia is another thing. Not many people have noticed, but China's inflation rate has turned positive. Export prices out of Asia are positive in year-over-year terms. The big fall in the dollar -- and as I said I think it has a lot farther to fall -- is going to push up import prices. So even external deflationary forces are going to diminish. Still, deflation fears are going to be with us for a while because we have an output gap and that will keep downward pressure on prices in the months ahead. But by the middle of next year, deflation fears will be shifting to worries about inflation and concerns about the Fed raising rates.

Q: Tell that to the bond market.
A: In our view, there is a bit of a bubble in the bond market.

Q: Explain.
A: Deflation fears. Mortgage refinancing. Asian central banks buying Treasuries to try and keep their currencies down. All are powerful sources of demand at the moment. If another rate cut doesn't work, there's the idea that the Fed could start buying Treasuries. But from our point of view, the only rationale for buying Treasuries at current yields of 3.5% is if you really believe the economy is in deep trouble and that we are going into recession or there's a real deflation problem.

Q: What's your favorite asset class at this point?
A: Emerging markets offer the best value. It is a volatile and niche asset class, but the conditions are in place for emerging markets to do very well. They are cheaper than they have ever been. They've got a very positive liquidity environment. Other major markets are much trickier. Europe looks cheap, but the economics are terrible and the rise in the euro, which could increase a lot further in the next few years, is going to be deadly for European profits.

Q: Some people have started comparing Europe to Japan.
A: I would accept a comparison between Germany and Japan more readily than I would accept a comparison between the U.S. and Japan because of policy mistakes in the case of Japan and policy mistakes and a lack of flexibility in Europe. The U.S. has used every weapon available: it has eased fiscal policy, it has cut interest rates and it has let the dollar go. Europe has done nothing. It can't do any of these things. The European Central Bank could cut interest rates, but they've got a hairshirt approach of how they view the world. It looks tremendously complacent from our point of view, and it's an enormous policy mistake.

The German financial system is in pretty bad shape. They have very inflexible labor markets. To the extent that in a deflationary environment you want to be as flexible and adaptable and nimble as possible, Germany is dragging around a lot of anchors. Germany is at risk of deflation much more than the U.S.

Q: That still can't be very good for the U.S.
A: Japan has been in deflation for more than a decade, and it hasn't really affected the U.S. Now Europe looks grim also, and that will make it a lot harder for the U.S. To me, that is one of the big problems in the outlook at the moment and one thing that certainly does make me quite nervous: There is still too much reliance on the U.S. The U.S. grew faster than Europe and Japan in nine of the past 10 years -- 2001 was the only exception. The U.S. has a huge trade deficit, and it is time for the rest of the world to start doing better.

Let Europe and Japan take up the running and let the U.S. get its trade position into better balance. But that shows no sign of happening. If you look at the OECD [Organization for Economic Cooperation and Development] forecast and IMF [International Monetary Fund] forecast, they show the U.S. continuing to grow considerably faster than Europe and Japan into next year. But there is a big problem with this kind of imbalance. It puts all the pressure on the dollar to adjust and then we are back to where we were earlier on.

Letting the dollar fall is necessary and is part of the adjustment, but it runs risks because currency moves can get out of hand and it has the potential to create turmoil in the markets. The 1987 market crash was partly tied up with the weak dollar.

Q: So what are the odds of that happening again?
A: It is hard to say. It has been amazing how calm and benign markets have been with the dollar sliding. We've had this strange situation in which the dollar is going down and bond yields are going down and the stock market is holding up.

You wouldn't have thought those three things could continue like that indefinitely. What's allowed this to happen are the deflation fears and foreign central banks buying dollars, which is keeping yields down. But it begs the question: If people are so worried about deflation, why isn't the stock market collapsing? As Greenspan said in his testimony recently, markets aren't behaving as if they fully endorse the deflation story.

Q: It's been so long since we've experienced deflation, perhaps no one is around who knows how to behave accordingly.
A: Greenspan noted that all we can do is see what happened in Japan and read the history books for what happened in the 'Thirties. But, as I have said already, the only reason to think we are going into deflationary times is if you think the economy has got real structural problems that will prevent any response to the really significant stimulus that is in place.

I don't believe there are huge structural problems. There are certainly some problems. I don't want to sound complacent or as if I'm looking at the world through rose-tinted glasses. But maybe the danger becomes self-fulfilling. If companies continue to delay, delay, delay increasing capital spending, then we may just slide into deflation. The irrational exuberance of investors in the 'Nineties has been replaced by an irrational pessimism on the part of corporate executives.

Q: Martin, you said earlier you don't agonize about consumer debt levels. Why not?
A: People have been worried about consumer debt for 40 years. Yet the consumer debt-to-income ratio, which is now above 100%, has been rising through the whole postwar period. At any point in time you could have agonized that it is at a new peak. I guess there is a limit, a level at which it will cause a problem.

I don't know what that level is. I am not sure anybody does. And if you don't know what the level of debt is that may cause a problem, you just have to look for symptoms. You would expect to see rising bankruptcies, and we are, but there are other things beyond that. You would also expect to see rising loan-delinquency rates, and, in fact, they are falling. They are quite a bit lower than they were back in the early 'Nineties recession.

Q: Isn't much of the debt tied up in housing now?
A: Housing is a big part of this. People have refinanced mortgages and restructured loans and shifted to low-interest-rate loans, which makes sense. Mortgages represent more than 70% of household debt, and that is collateralized by the house. There has been a big rise in the home-ownership rate. If you are just looking at the debt-to-income ratio, it shows there has been a big rise in debt. But there is also an asset now -- the house -- on which they are making mortgage principal repayments every month. That means there is forced savings going on and maybe they are better off in a cash-flow sense. Prices are high relative to incomes, but at this level of interest rates, housing is very affordable.

Q: You have referred to the current economic climate as strange. Did it just get stranger?

A: We have a situation where the near-term picture looks not bad at all. There are more people talking about a Goldilocks economy, though there are way too many issues out there such as housing bubbles and financial imbalances for me to use the term Goldilocks. But near term, we are going to have a decent economy. We've got low inflation. We've still got relatively low long-term interest rates, and the stock market is doing well.

These conditions could well persist for yet another year.

In another year's time we will still be worrying about these imbalances, which will be even bigger. Eventually, the long term does become the short term. But as long as Asia is going to recycle its money back into the U.S., then this situation can persist.

Q: And the unsustainable is further sustained.

A: The current account is the big imbalance out there, and that is the one most people talk about in terms of being unsustainable, but which can be sustained for years. As long as people are prepared to buy dollars for whatever motive or reason, then this situation goes on. OPEC, Asian central banks and, more recently, private investors have been willing buyers of dollars, and so the show goes on.

The current account now is running at almost an US$800-billion annual rate, or 6.4% of gross domestic product. It's in new territory for the U.S., at least.

Q: How sustainable is the strength in the dollar?

A: It's sustainable for as long as the Fed is tightening and the U.S. economy is perceived to be strong. The next leg down will come when people revise their expectations about the economy. That will be when the Fed stops raising rates and we see interest spreads look less dollar-friendly.

That might not be until next year, though, so the dollar should have a relatively firm year this year, barring some unexpected shock. I do see this as a countertrend move within a longer-term downtrend. I'm conventional enough that I believe there can't be a trade deficit of this magnitude without having a cheap currency at the end of the day.

Although the dollar has fallen a lot, it has still not fallen enough to have any meaningful impact.

And currency moves can't do it alone. A weaker dollar has to be only part of the story. The real adjustment to the U.S. current account has to come from narrowing the growth rate and from the absence of boom times in the rest of the world, which I don't really see. We are going to have to crunch U.S. demand, and savings are going to have to be rebuilt, and that is going to be very, very painful, but it could be years away.

Down the road, there is a U.S. consumer recession lurking and a big housing downturn. It could be five years down the road. The world does not move to a precise rhythm, but it is interesting how well the four-to-five-year cycle has worked the last few decades. If we continue with that pattern, you would expect another recession in 2009-10.

Q: Doesn't a slowdown in money-supply growth foreshadow trouble brewing in the economy?

A: Some people have assumed the very weak money growth points to a sharp slowdown in the economy. But money is not as tight as it seems. There was so much liquidity created in previous years that there is still a large monetary overhang.

Bank lending is growing at double-digit rates. House prices are through the roof. There is money available for deals. None of these trends are consistent with tight money. Money policy is not yet restrictive. The monetary overhang will eventually disappear as the Fed continues to raise rates.

Q: What's your view on oil?

A: We haven't been very successful in forecasting it going to US$60. We've been structurally bullish on oil for some time, but that was when oil was US$30 a barrel and we thought, gee, it could go to US$40 to US$45 in a couple years. It has gone far beyond what we expected.

The bullish case for oil is very compelling. We all understand China's demand going through the roof. Chinese demand for gasoline, for example, rose 35% in the three years to 2004. That's huge. And auto sales in China continue to rise. But, at the same time, I believe the price mechanism works, and as prices rise it brings on more supply and, at the margin, it squeezes demand in some areas. I take the view there is a huge speculative premium in oil at these levels -- maybe it is US$15 -- so oil will come back down again by quite a lot, potentially.

Even oil at the US$40 to US$45 level is quite a high price compared to what people might have expected a few years ago. It is a high enough price that oil companies would still make a lot of money. It will still make energy a good sector to invest in. It is certainly one of our favourite sectors from a long-term structural point of view.

Q: Is there any sense it has dampened consumer spending?

A: Not directly, because consumer spending has held up very well. That takes us into one of the other big stories here, which, of course, is housing and low interest rates. With one hand, rising oil bills take away from people's pockets, but an even bigger amount is given back to them in terms of housing wealth.

When you look at the overall picture for consumers, they've got higher oil bills, but employment is rising -- not as fast as we would like, but it is rising; wages are rising -- perhaps not as fast as we would like, but they are rising; so incomes are growing, and you are giving homeowners huge wealth gains. Add it together, and consumers are better off. It is hard to detect, therefore, any real pain from oil. Also, it helps to put it into perspective.

The average family drives around 12,000 miles or so a year, and the average car does 20 miles to the gallon. Let's say a household uses 600 gallons a year. If the price of gasoline goes up a dollar, it's US$600 a year extra for their gasoline bill. I don't want to diminish the impact of that on low-income families, but for your average consumer, it is not crippling, especially if their home is going up by tens of thousands potentially. Housing has clearly been a huge, huge support to the consumer sector.

Q: So you don't see any major cracks at the moment in the consumer story?

A: I don't. The savings rate is obviously extraordinarily low at 1%. But at the same time, the increase in home equity last year was worth 16% of income. A lot of consumers would probably think of their savings in terms of the change in their net worth as very, very high. So the question is: Will that savings that comes from rising asset prices evaporate just as quickly as it went up? That leads to questions such as when the housing bubble is going to burst, and whether house prices are going to come crashing down.

The answer is not any time soon, it seems -- although there are some signs that gravity is taking hold in some markets.

Q: Thanks, Martin.