International Inflation Cycles Sync Up

Lakshman Achuthan


In the 21st century international inflation cycles have become more synchronized, enabling even earlier detection of cyclical turns in inflation.
 
Taming Inflation

The behavior of international inflation cycles has changed substantially in the 21st century in terms of the coordination of cyclical timing as well as amplitude. These shifts have made it feasible to devise a long leading index of those inflation cycles that works sequentially with ECRI’s 11 existing international future inflation gauges (FIGs), offering the earliest forecast of cyclical turning points in international inflation.

To understand how dramatically the international inflation landscape has changed, we first showcase inflation volatility in the 11 OECD, i.e. rich-country economies, whose inflation cycles are regularly monitored by ECRI (Chart 1). For these economies, we present the five-year moving standard deviation of year-over-year (yoy) CPI growth – a proxy for its volatility – comparing the 20th-century (1969-99) and the 21st-century (2000-17) patterns.
 


 
Without exception, it is clear that inflation volatility in all 11 economies has decreased considerably in the 21st century (red bars) from the 20th century (blue bars), with Mexico seeing the greatest drop from the hyperinflationary highs of the 1980s, followed by Korea and the U.K. Across all countries, CPI inflation volatility in the 21st century is, on average, only about a quarter of what it was in the 20th century (rightmost set of bars).

A number of factors are responsible for this plunge in volatility, including the waning power of OPEC – in part resulting in smaller oil shocks – alongside high oil prices incentivizing greater supply, as well as concerted efforts by major central banks to target and curb inflation. Also playing an important role were the disinflationary and deflationary effects of globalization, as China, India and ex-Soviet economies were integrated into the global economy, starting in the late 20th century. As globalization advanced, economies turned much more trade-dependent by the early years of the 21st century (ICO Focus, October 2016), with significant consequences for international inflation cycles, as we shall now detail.
 
Inflation Cycles Increasingly in Sync  

More than a decade ago, we showed that cycles in industrial growth for major economies tend to be more or less synchronized (ICO, October 2006). A key reason for such synchronization has been the growing global interdependence among countries through expanding trade and financial linkages. It therefore makes sense to monitor global industrial growth cycles, and to do so we have employed a set of sequential leading indexes.

We now examine whether there is also a distinct international inflation cycle marked by broadbased cyclical upturns and downturns in inflation rates across different economies.

That is, do economies exhibit similar cyclical patterns in inflation, or do they move independently? If a single international inflation cycle can be identified, monitoring a country’s inflation outlook would entail monitoring both this international inflation cycle and country-specific swings in inflationary pressures.

Aligning the yoy CPI growth rates of the 11 economies for which ECRI has developed country-specific FIGs over the two different timespans shown in Charts 2 and 3 offers some visual clues. White areas and blue bars represent cyclical upturns and downturns, respectively, in each country’s CPI growth. The reason for splitting the overall timespan into two periods, namely, 1969-99 and 2000-17, is that the drop in volatility is so sharp that cycles in the 21st century become largely imperceptible when plotted on the scales appropriate for the earlier period.
 


 
Comparing the two charts, it is apparent that there is greater alignment of cyclical upturns and downturns in the 21st century than in the 20th century. For instance, in the 30-year period from 1969 to 1999, the 11 economies experienced roughly concurrent inflation cycle downturns only three times, starting in the mid-1970s, early 1980s, and early 1990s (Chart 2). Since 2000, however, these economies have already had four fairly concerted inflation cycle downturns in 17 years – starting around the early 2000s, the mid-2000s, 2008 and 2011 – and are currently all in cyclical upturns (Chart 3).

To objectively measure the degree of synchronization of cyclical upturns and downturns among the 11 economies, we calculated the concordance of cyclical swings, i.e., the proportion of months during which those economies were in simultaneous inflation cycle upturns or downturns. According to this measure, the proportion of time that all 11 economies spent in synchronized upturns or downturns has more than tripled in the 21st century, while the proportion of time that over 80% of the economies were in the same phase of the inflation cycle rose more than 1½ times (not shown).
 
Predicting International Inflation Cycles 

With 21st century inflation cycles across major economies becoming fairly synchronized, it makes sense to define and forecast the resultant international inflation cycle. The international inflation cycle consists of cyclical upswings and downswings in the yoy growth rate of the 11-Country CPI (11CPI), a weighted average of the 11 individual countries’ CPIs (Chart 4, bottom line). Meanwhile, ECRI’s 11-Country Future Inflation Gauge (11FIG, middle line) is constructed in an analogous weighted manner, combining the 11 corresponding future inflation gauges. The 11FIG is a summary measure of underlying inflation pressures across these economies, and leads cyclical turning points in 11CPI growth by a little over one quarter, on average.
 


 
Adding to this toolkit, we introduce the International Long Leading Future Inflation Gauge (ILLFIG, top line), designed to be a long leading indicator of the international inflation cycle. The ILLFIG leads the 11FIG by almost one quarter, on average, at cycle turning points, therefore leading the international inflation cycle by a little over half a year, on average. Together, the ILLFIG and the 11FIG serve as a sequential leading indicator system for international inflation cycles, increasing the forecast horizon and enhancing the clarity of the international inflation outlook.

As the chart shows, in the most recent cycle, the ILLFIG and 11FIG turned up in early 2015, signaling with conviction an upcoming cyclical upswing in international inflation pressures. Indeed, 11CPI growth started to turn up, as well, in the fall of 2015. In their latest readings, both indexes remain elevated, though slightly off their recent highs.

With the yo-yo years unfolding as the major developed economies experience long-term declines in secular trend growth (ICO, March 2012), lowflation, and even occasional deflation, has become the norm. Meanwhile, with CPI inflation volatility having dropped markedly, especially in the 21st century, international inflation cycles have become more subdued.

The synchronization of international inflation cycles highlights the importance of global factors in assessing domestic inflation prospects. Our analysis underscores the 21st-century reality that the timing of inflation cycles may be beyond the control of any individual central bank. Yet this very development makes it possible for ECRI to provide even earlier signals of peaks and troughs in the inflation cycle.

Currently, both the ILLFIG and the 11FIG remain in cyclical upturns, and close to multiyear highs. However, they both dipped in their latest readings. As such – and especially in the context of the global industrial growth downturn that is now at hand (ICO Essentials, April 2017) – they bear watching for early signs of a potential reversal in the global reflation cycle that we flagged last summer (ICO Essentials, August 2016).


How North Korea Views the Situation on the Peninsula

By George Friedman


Conducting foreign policy or preparing for war requires the ability to put yourself in your adversary’s position. Unless you understand what he sees and how he thinks, his actions will make no sense to you. This will cause you to miscalculate because you will confuse a lack of understanding on your part with insanity or stupidity on your adversary’s part. If you dismiss your enemy as a clown or lunatic – when in reality he knows what he is doing and he understands what you are doing – his chances of succeeding soar, while your chances plummet. This is an important lesson to apply to the current situation on the Korean Peninsula.

The Democratic People’s Republic of Korea was founded as a communist state and a client of the Soviet Union. The Soviets encouraged North Korea to invade South Korea to control the entire peninsula. North Korea’s founder, Kim Il Sung, saw his regime nearly destroyed when the United States, contrary to Soviet expectations or North Korean calculations, intervened and decimated the North Korean army. North Korea exists today only because the Chinese intervened as the Americans approached the Yalu River, which forms the border with China. The Chinese were not concerned about North Korea. They were concerned about their own national security.
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Korean People’s Army tanks are displayed during a military parade marking the 105th anniversary of the birth of late North Korean leader Kim Il Sung in Pyongyang on April 15, 2017. ED JONES/AFP/Getty Images

China’s intervention led to a stalemate on the peninsula roughly where the current lines stand, which is not far from the original boundary between the North and the South. In other words, the North Koreans gained nothing from the war, and in surviving, they were dominated by the Chinese. Whatever economy North Korea had was shattered, and the regime was nearly destroyed.

The North Koreans drew some important conclusions from the war. First, communist ideology had little to do with their communist allies’ actions. The Soviets saw an opportunity to test the United States at little cost or risk to themselves. If North Korea had taken the peninsula, the Soviet position in the waters off the Asian mainland would have been strengthened. But if North Korea had been occupied, the Soviets would not have been worse off than they were. The Chinese were willing to supply troops only until they themselves were at risk and were also prepared to see North Korea destroyed or truncated. International socialist solidarity was secondary to national interests.

North Korea also learned that the United States was utterly unpredictable and dangerous. Although the U.S. indicated that the Korean Peninsula was not a central part of its policy in Asia, the U.S. entered the war, fighting capably and at times brilliantly, as with the landing at Inchon. While the U.S. remembers the fighting with the Chinese from the standpoint of the retreat at Chosin Reservoir, the U.S. killed around 180,000 Chinese troops. The U.S. stood its ground and gave better than it got.

The North Koreans learned that what the Americans said had little to do with what they did, and that the Americans, if they chose, could bring enormous forces to bear.
 
North Korea also realized that the Soviets regarded North Korean interests as subsidiary to even secondary Soviet interests. As for the Chinese, they had a capable force but one that would be deployed only when Chinese interests were at stake.

Therefore, the North Koreans believed their position was strategically impossible.
 
They faced three major powers, any one of which could annihilate North Korea. Their strategy was to avoid annihilation by proving it would not be worth anyone’s trouble.
 
This did not mean being meek by any stretch. It required convincing other powers that they would incur a huge cost by absorbing or defeating North Korea. The country’s greatest strength was its relative unimportance. If it could also increase the dangers involved in being subdued, it could survive.

To do this, the North Koreans would have to build a military machine capable of deterrence. A country as poor as North Korea had to militarize the entire society. It had to produce the wherewithal to survive and field a military force capable of keeping all others at bay. North Korea is still poor, but despite that poverty it is too dangerous to deal with. Modern North Korea is a rational adjustment to its perceived reality. It might follow that the populace would be restive. But whether through intimidation or contentment, little evidence exists that they are. So the North Korean government operates from a stable platform.

The Sino-Soviet split of the 1960s brought about another dimension. North Korea learned to manipulate these countries and used their distrust of each other to extract support by shifting its weight from side to side. The North Koreans used the tensions on their border to increase their value to each country at different times and, therefore, to control their relationships. After 1991, this became even harder and in some ways more profitable as the residual ideological ties dropped away and all sides could pursue their national interests. But the fall of the Soviet Union and the emergence of China brought their own perils. China became the overwhelming force, and one that was difficult to manipulate. Therefore, North Korea’s core strategy had to be updated, and this involved a nuclear program with serious intentions.

North Korea sees itself as alone and isolated. Its history shows that attempting to cooperate with its neighbors can lead to catastrophe. It also believes that it can predict and control American behavior, but this could also end in catastrophe. It has survived since the Korean War by not being a significant strategic prize and by possessing a force that deters intervention. North Korea’s world consists of China, Russia and the United States. South Korea and Japan are not going to take any steps without the United States. Therefore, the U.S. is the permanent threat, while Russia and China (particularly China) are both dangers and possible allies depending on circumstances. North Korea must be helpful to China but never again become a pawn or a battlefield.

In a deterrence strategy, the method must always match the fear of the enemy. The United States fears terrorism and nuclear weapons. North Korea is unable to strike the U.S., so it is a secondary threat. But it believes that acquiring nuclear capability against the United States would protect it from American unpredictability.

However – and paradoxically – creating the deterrent leads to U.S. unpredictability temporarily surging. Between the time that it demonstrates the ability to create a nuclear deterrent and the time it achieves it, the United States becomes extremely dangerous. Therefore, to mitigate if not remove the danger – or at least to buy time – North Korea must use China and Russia as a counter. They may not want North Korea to have nuclear capability, but they have other issues with the United States, and they might see an advantage in the U.S. focusing on a minor country.

A safer course might be to abandon the nuclear program, but the North Koreans calculate that if they were to do this, they would be putting off the inevitable. Their deterrent power would decline, and their dependence on China and Russia would increase. That did not work well in the past. Therefore, the only prudent course is to hope that short-term considerations will force the Chinese and Russians to help them buy time to complete their nuclear deterrent.

It is an enormously risky path for the North Koreans, but ever since the Soviet Union collapsed and the Chinese focused on Walmart, they have been on a precipice. They have survived by cunning, bluffing and the indifference of others. That is hope, not a strategy. Their strategy is to become too dangerous to attack. The U.S. is unpredictable, but one thing is certain: It will not engage a nuclear state that can strike back. The North Koreans have drawn China into the game, buying them more time. It is the witching hour for them, but they expected this and will play it out.

The North Korean government does not consist of one man. It has been pursuing a consistent policy for over half a century. It is now in the end game, and we do not know the answer to the most important question: Have the North Koreans already built a nuclear weapon, and if not, how much time do they need? We also do not know if China wants North Korea to be a nuclear power to absorb U.S. attention, or if it would be afraid of a nuclear North Korea. The U.S. and North Korea likely don’t know the answer, and perhaps the Chinese haven’t yet decided. But the point here is that North Korea is not stupid nor crazy. Such powers do not create conundrums vastly beyond their apparent resources.


China Looks to Export Auto Overcapacity on Slow-Growth World

By Anjani Trivedi



Beware global auto makers: China is getting ready to flood the world with its car exports.

Last week, a number of Chinese ministries and the National Development and Reform Commission jointly announced long-term plans for the auto industry. Among the goals: Higher developed-market export sales and market share.

Lofty goals for China’s car makers are understandable. The report said autos and related industries bring 10% of the nation’s tax revenue and account for 10% of all jobs. And the industry has capacity to spare. Utilization rates vary widely but range from 60% to 80%. Meanwhile, production continues to rise.

China pumps out 28 million cars a year—compared with 17 million from the U.S. But it probably doesn’t have the consumer demand to absorb all those vehicles. Buyer tax incentives have given sales a periodic boost, but that just brings demand forward. The government trimmed its incentives last year, causing sales growth to fall by two-thirds through April.

A Guangzhou Automobile Group SUV at an auto show in Shanghai on April 20. Photo: Bloomberg News


Overcapacity is reflected further by the dozens of car makers in existence, many of which are propped up by local governments that are loath to part with these job generators.

Consolidation, a more obvious way to improve the industry, doesn’t seem to be a priority.

If there is one thing China knows how to do well, it is export. So why not export its auto overcapacity, as it does with solar panels, steel and glass? China has made inroads in exporting to other emerging markets, where it isn’t dinged for its lower-quality vehicles. China exports 2% to 3% of all automobile production on a monthly basis to places like Iran, which accounts for about a half a million vehicles a year, though growth in this area has stalled in recent years.

Getting into developed markets like Japan, the U.S. and Europe will prove more challenging, given quality constraints. The antiglobalist tone taken by President Donald Trump and others would also seem to be an obstacle, unless China maneuvers its cars in through trade pacts.

Yet that doesn’t mean global car makers shouldn’t view China as a threat. Global auto demand in terms of sales outside China is set to grow just 0.6% this year, according to Nomura estimates. Any attempt by Chinese producers to focus on the highly commoditized industry could put pressure on prices, even if they don’t succeed at becoming major players in developed markets.

The more likely outcome is that China continues to push into emerging markets. This would be troubling for emerging-market experts such as Renault, Hyundai and local brands like India’s Tata or Maruti.

Global car makers will have to contend with the sheer force of Chinese production volumes. Beijing is targeting 30 million cars a year over the next three years and 35 million by 2025, according to the government’s plan. That’s a lot for the world to absorb.


Reprieve or Reform in Europe?

Michael Spence

Elysee Palace


MILAN – The first round of the French election turned out much as expected: the centrist Emmanuel Macron finished first, with 24% of the vote, rather narrowly beating the right-wing National Front’s Marine Le Pen, who won 21.3%. Barring a political accident of the type that befell the former frontrunner, conservative François Fillon, Macron will almost certainly win the second-round runoff against Le Pen on May 7. The European Union seems safe – for now.
 
With the pro-EU Macron seemingly headed toward the Élysée Palace – the establishment candidates on the right and the left who lost in the first round have already endorsed him – the immediate threat to the EU and the eurozone seems to have subsided. But this is no time for complacency. Unless Europe addresses flaws in growth patterns and pursues urgent reforms, the longer-term risks to its survival will almost certainly continue to mount.
 
And, as has often been noted, the French election, like other key votes over the past year, represents a rejection of establishment political parties: the Republicans’ Fillon came in third, with about 20% of the vote, and the Socialist Party’s Benoît Hamon finished fifth, with less than 6.5%. Meanwhile, the left-wing Euroskeptic Jean-Luc Mélenchon won 19.5%, putting the total share of voters who chose candidates of non-traditional parties – Le Pen, Macron, and Mélenchon – at nearly 65%.
 
Unlike last year’s votes for Brexit in the United Kingdom and Donald Trump in the United States, which were driven by middle-class, middle-aged voters, in France, the young led the way in rejecting the establishment. Among 18-34-year-olds, Mélenchon – who has so far declined to endorse Macron for the second round – received roughly 27% of the vote. Le Pen was the second most popular candidate among young voters, especially the less educated.
 
This trend is not exclusive to France. In Italy, the anti-establishment, Euroskeptic Five Star Movement has surpassed the center-left Democratic Party in recent polls, with the young comprising a significant share of that support. Likewise, in last December’s Italian referendum, younger voters formed a substantial share of the vote against the constitutional reforms – essentially a vote against then-Prime Minister Matteo Renzi, who had staked his political survival on their adoption.
 
Of course, even in the face of weak and declining economic performance, there may be an upper limit to the support that populist parties can muster – a level that falls short of a governing mandate. But the fact that parties and candidates that reject the status quo are gaining ground, particularly among young people, reflects profound political polarization, which generates governance challenges that could impede reform.
 
Yet reform is precisely what is needed to address these trends, which reflect fundamental problems with today’s prevailing growth patterns. In France, Italy, and Spain, growth is too slow, unemployment is high, and youth unemployment is even higher. In France, the youth-unemployment rate is in the neighborhood of 24%, and trending downward only slowly. Youth unemployment in Italy stands at 35%, and exceeds 40% in Spain.
 
These are countries with substantial social-security systems. But those systems protect labor-market incumbents much more than new entrants. And the reforms that have been implemented, in order to ease entry into work, are not sufficient in the context of weak overall growth.
 
Without deeper reform, the demographic arithmetic suggests that the disenfranchised and anti-establishment share of the population may grow (unless today’s young people change their stripes as they age). The question is whether this trend will lead to a genuine disruption of the status quo or merely to political polarization that weakens government effectiveness.
 
The solution to European economies’ woes seems clear: a set of reforms that encourages more vigorous and much more inclusive growth patterns. After all, while globalization and technology lead to job displacement, sufficient growth can ensure that overall employment is sustained. To that end, reforms are needed at both the national and EU levels.
 
While each EU country has its own specific features, some common reform imperatives stand out. In particular, all countries need to reduce structural rigidity, which deters investment and hampers growth. To boost flexibility, social-security systems have to be largely disconnected from specific jobs, companies, and sectors, and rebuilt around individuals and families, income, and human capital.
 
The remainder of the domestic reform agenda is complex, but its goal is simple: enhance private-sector investment. Under this heading are items like regulatory reform, anti-corruption measures, and public-sector investment, especially in education and research.
 
At the European level, the most important recent development is the weakening of the euro relative to most major currencies, especially the US dollar, since mid-2014. This has caused the eurozone to run a substantial surplus and helped to restore some competitiveness in the tradable sectors in France, Spain, and Italy. In all three countries, tourism is an important sector for employment and the balance of payments, and expenditures have been rising when measured in euros.
 
Of course, the weaker euro has fueled large surpluses in Germany and northern Europe, where unit labor costs are lower, relative to productivity. In the longer term, convergence of unit labor costs is needed. But that will take time, especially in a low-inflation environment. In the meantime, the weak euro may help to spur growth.
 
EU-level action is also needed on immigration, which has emerged as a major economic and political issue. Faced with inflows of huge numbers of refugees from the Middle East and Africa – inflows that exceed many countries’ absorptive capacity – the EU may need to modify the free movement of people for a period of time.
 
After Germany, France is the most important country in the eurozone. If a Macron victory is treated as an opportunity to pursue aggressive reforms targeted at boosting growth and employment, the French election may amount to an important turning point for Europe. If, however, it is treated as a validation of the status quo, it will produce only a short reprieve for a besieged EU.
 
 


Buttonwood

Exchange-traded funds become too specialised

One even invests in the shares of ETF providers
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THERE comes a time when every financial innovation is taken a bit too far—when, in television terms, it “jumps the shark” and sacrifices plausibility in search of popularity. That may have happened in the exchange-traded fund (ETF) industry. The latest ETF to be launched is a fund that invests in the shares of ETF providers.

The notion has a certain logic. The ETF industry has been growing fast, thanks to its ability to offer investors a diversified portfolio at low cost. The assets under management in these funds passed $3trn last year, up from $715bn in 2008. Some investors might well want to take advantage of that rapid expansión.

But by no stretch of the imagination would this be a well-diversified portfolio; it would be a focused bet on the financial sector. And many of the companies in the portfolio, such as BlackRock, a huge fund manager, and NASDAQ, a stock exchange, are involved in a lot more than just ETFs. Even if the ETF industry keeps growing, the bet could still go wrong.

The new fund (with the catchy title of the ETF Industry Exposure and Financial Services ETF) is just the latest example of the industry’s drive to specialisation. The earliest ETFs bought diversified portfolios that track indices such as the S&P 500. But there are now some 1,338 specialist funds worldwide, with $434bn in assets, according to ETFGI, a research firm.

Some of these specialist funds are based on industries, such as energy or media. They appeal to investors who believe an industry will outperform, but who do not want to pin their hopes on an individual company. But others are pretty obscure: an ETF that invests in founder-run companies, with just $3.1m in assets, for example; or another which buys shares in companies based near Nashville, Tennessee, with $8.5m. A recent fund was launched to back companies involved in the cannabis industry.

Heady stuff. But the more specialised the fund, the fewer companies it has to invest in. So these funds will probably be more volatile and less liquid—not the ideal home for the savings of small investors.
The financial industry has been down this road before. In the early 2000s Britain suffered a crisis in the investment-trust sector. Like ETFs, investment trusts are managed portfolios that are traded on the stockmarket; they have been around since the 19th century. But a craze developed for so-called split-capital trusts, which had different classes of shares; some received all the income from the fund, others all the capital growth. These shares had some tax advantages and were snapped up by small investors. However, some split-capital trusts only invested in the shares of other trusts. When problems emerged in some funds, they rippled right through the asset class, eventually requiring nearly £200m ($258m) to be paid out in compensation.

A similar pattern emerged, on a much bigger scale, with mortgage-backed securities (MBS) in America. The idea of issuing a bond, backed by mortgage payments, dates back to the 19th century, but the residential MBS market took off in the 1980s. The market jumped the shark only in the early 2000s, with the rapid growth of vehicles known as collateralised debt obligations (CDOs) that grouped mortgage-backed bonds together, giving different investors different rights over the assets and cash flows of the portfolio. Doubts over the creditworthiness of these securities in 2007 triggered the financial crisis.

The ETF sector has not yet reached the extremes attained by split-capital trusts or CDOs. By and large, funds do not invest directly in other ETFs; although there are a few “leveraged” ETFs, where losses and gains are magnified, they represent only 1% of the industry’s assets.

Still, there are signs that rapid flows into some ETFs can lead to price distortions. A rush of money into gold funds in recent years has caused the VanEck Junior Gold Miners ETF to be the largest investor in two-thirds of the 54 companies it owns, according to Factset, a data provider. The fund’s assets grew by more than half, to reach $5.4bn, between January 1st and April 17th. The rush was accelerated by another fund which made a leveraged bet on the performance of the VanEck ETF.

The danger is of a feedback effect: as the fund pours money into the smaller companies in its portfolio, their prices rise, attracting more money into the ETF. But should investors change their mind and want to withdraw their money, there could be a sharp fall in these mining shares. VanEck is allowing the fund to invest in larger companies in an attempt to solve the problem. But the more the ETF industry specialises, the more often such difficulties are going to arise.