Half the world covets the UK’s precious inflation

Inflation is now a rare commodity in most of the developed world but the UK's falling prices are also a tax cut we should all enjoy

By Ambrose Evans-Pritchard

3:20PM GMT 13 Jan 2015

The Bank of England was right to ignore its inflation target at the height of the crisis Photo: AFP
Inflation is now the most precious commodity in the developed world. 
The great economic powers are almost all trying to steal a little from each other by currency warfare. Perfidious Albion got there first. We are good at the game.
Britain still has an emergency reserve, thanks to the good judgement of the Bank of England.
The Monetary Policy Committee ignored the howling commentariat and the hard money populists when headline inflation spiked above 5pc. "The MPC should not be obsessive about bringing inflation back to target as rapidly as possible,” was how they nonchalantly put it in the minutes from January 2008.
The Bank of England ploughed on with full-blown quantitative easing even through the inflation scare of 2011. That showed courage. Historians will judge this to have been a masterful decision.

The effect was to erode the real debt stock, slash the ratio of household debt to disposable income from 170pc to 147pc, and broadly stabilize the overall debt trajectory. It ensured that the recovery reached “escape velocity” despite the headwinds of fiscal tightening.
The UK revived the successful reflation formula of the mid-1930s. It eschewed the failed deflationary formula of the 1920s, which merely pushed debt ratios even higher.

The shock fall in CPI inflation to 0.5pc does not yet put Britain at risk. Inflation expectations remain at safe levels. They are not close to becoming “unhinged” – with all kinds of nasty self-fulfilling consequences – though the experience of Japan and now the eurozone tells us how suddenly if can happen if you let your guard down.
The chart below shows five-year/five year forward swaps used to filter distortions and measure longer-term expectations. Britain is still well above the water line.

The beauty of having a safety buffer is that you can enjoy the benefits of an oil-price crash – a “positive supply shock” in the jargon – without sliding into a debt-deflation trap. It acts as a tax cut. Enjoy it.
It is no great mystery why the world is edging from “lowflation” to deflation. It lies in the structure of globalisation over the last quarter century. Above all it lies in China.
Chinese factory gate prices are falling at a rate of 3.3pc. There is massive spare capacity. The country's fixed investment was $8 trillion last year, more than in Europe and North America combined. The country is exporting deflation worldwide. And so is Japan.
As I wrote in last week’s column, there is an excess of global capital. The world's savings rate keeps rising and has hit a record 26pc of GDP. One culprit is the $12 trillion accumulation of foreign reserves by central banks, money that is pulled out of consumption and instead floods the bond market. Large parts of Pacific Rim and central Europe have reached a demographic tipping point. Call it worldwide "secular stagnation" if you want.
The eurozone already has one foot in deflation. This is not benign, for reasons that are by now well known. Firms make the entirely rational decision to put off investment, creating a macro-economic bias towards contraction. They each feed off each other in an amplification effect.
Deflation plays havoc with debt dynamics. The real interest rate on the existing stock of debt rises. The economic base of nominal GDP that supports this burden shrinks. This is the “denominator effect”.
It can be lethal for high-debt economies, and that now means the entire developed world (with minor exceptions). You can of course opt instead for an “Austrian-school” purge of the debt through mass defaults, but be careful what you wish for. We tried that in 1931 and lost a few democracies.
This contractionary effect is why debt ratios have continued to rise across southern Europe, in some cases at an accelerating pace. It is why Italy’s debt has jumped from 116pc to 133pc of GDP in three years despite deep austerity and a big primary budget surplus. Deflation is pushing these countries over a cliff.

Index: 2006=100. Source: Berenberg Bank

The ECB’s chief economist Peter Praet alludes to some of the dangers in this watershed interview two weeks ago.

“What we are increasingly worried about and what explains the sense of urgency expressed by our President Mario Draghi is the very high risk that after seven years of crisis and very poor economic performance in the euro area, businesses and households are reducing their long-term growth expectations and adapting to weak growth and low inflation," said Mr Praet. "To some extent this risk is already materialising: companies are starting to adjust to a '1pc growth/1pc inflation economy'. 
"There is a risk of a real economic vicious cycle: less investment, which in turn reduces potential growth, the future becomes even grimmer and investment is reduced even further.”
He also warned that an "underemployment equilibrium" is setting in. This is the term used by Keynes in the 1930s.
One has to admire Frankfurt’s QE gang of Mario Draghi, Peter Praet, and Vitor Constancio.

They understand the problem perfectly. They have been battling for almost a year to overcome resistance to radical action.
One also has to admire the Bundesbank’s Jens Weidmann for arguing that sovereign QE on a large scale amounts to fiscal union by the backdoor, a constitutional leap without democratic consent. Both sides are right. It is the EMU construct that has led to this impasse.
We will find out soon whether the ECB is willing to launch QE on a big enough scale to stop a deflationary psychology taking hold. If they fail – and a respectable argument can be made that the inflation will recover of its own accord – Britain will find it hard to avoid being sucked into the deflationary vortex as well.
Should that moment ever threaten, the Bank of England will have to turn on the printing press yet again. Next time let us do it differently. Let us use the money to rebuild our crumbling infrastructure, or dust down the old “Chicago Plan”, or simply do the proverbial Helicopter Drop of money until the problem is solved.
It is always possible to defeat deflation if you really mean it, and if you are a sovereign nation.

But that argument is for another day.

January 13, 2015

Danger, Will Robinson! Danger!

— Robot, Lost in Space

Oh, the pain, the pain.

— Dr. Zachary Smith, Lost in Space

We all have our favorite childhood TV shows, and Lost in Space was one of mine. I’m really not trying to insult your intelligence by quoting fictional TV characters, but I do see some serious stock market danger ahead, and the Lost in Space robot may be more right about 2015 than the high-paid experts on Wall Street.

I hope the 320-point plunge on Monday followed by the 130-point fall on Tuesday got your attention, because I believe there is a lot more pain left to come.

I could list dozens of reason why caution is in order, but here are four serious warnings signs just from last week.

Danger Will Robinson #1: ISM Manufacturing Index. The December index of the US manufacturing sector came in at 55.5, below the forecast for 57.5 and the weakest reading since May. The New Orders component of the Index dropped to the worst level in seven months.

The culprit is the strong dollar, which hurts US exporters, and a general slowdown of the global economy.

Danger Will Robinson #2: ISM Non-Manufacturing (Services Sector). The December figure of 56.2 was well below the expectations of 58.0 and a big drop from the 59.3 in November.

Moreover, the services index has dropped three out of the last four months and saw the largest one-month fall in six years!

Danger Will Robinson #3: Construction spending. The Commerce Department reported that Construction Spending fell 0.3% in November, which was (again) below expectations of a 0.4% increase.

Danger Will Robinson #4: Chicago PMI. The Index fell to 58.3 in December, below the 60.0 expectation, as well as November’s 60.8. According to the report, “The slowdown in the pace of activity exhibited since October’s one-year high of 66.2 has been marked. It was a disappointing end to the year with the pulse rate of our business panel slowing noticeably in December.”

The below-the-headline details paint an even drearier picture:

  • prices paid fell;
  • new orders fell;
  • supplier deliveries fell;
  • production fell; and
  • order backlogs fell.

Those four warnings signs don’t mean that the bear market will start tomorrow morning, but the growing laundry list of economic warnings signs combined with rough start to 2015 tells me that you need to prepare for some stock market trouble.

There are three basic options:

Option #1: Do nothing—get clobbered. Most people think they can ride out bear markets. But the historical reality is that most investors, professional and individual alike, panic and sell when the pain gets to be too much.

Option #2: Hope for the best, prepare for the worst. Have some sort of defensive strategy in place. That could be some type of simple moving-average discipline or a more complex technical analysis. At minimum, I highly recommend the use of stop losses.

Option #3: Portfolio insurance. Buy some portfolio insurance with put options or inverse ETFs.
That is exactly what my Rational Bear subscribers are doing, and I expect those bear market bets to pay off in a big, big way.

Whether it’s next week, next month, or next year, a bear market for US stocks is coming, and you’d better have an industrial-sized bottle of Pepto Bismol to help you stomach the pain or have some rational, methodical strategy to protect your portfolio.

Tony Sagami
Tony Sagami
Mauldin Economics

January 13, 2015 5:44 pm

How to share the world with true believers behind global terror

Martin Wolf

First, accept that we are playing the long game of containment

Ingram Pinn illustration©Ingram Pinn
How are we to understand last week’s events in Paris? Why are people prepared to kill and die for their beliefs? How should liberal democracies respond? Many people must be asking themselves these questions. A remarkable man, Eric Hoffer, addressed them in a book published in 1951: The True Believer: Thoughts on the Nature of Mass Movements . The ideas in his book, developed in response to Nazism and communism, echo powerfully today.
Hoffer was born at the turn of the 20th century and died in 1983. He worked in restaurants, as a migrant farmhand, as a gold-prospector and, for 25 years, as a longshoreman in San Francisco. Self-taught, he could penetrate to the core of a topic in brilliant and limpid sentences. The True Believer is among my favourite books. It is once again an invaluable guide.

Who, then, is a true believer? Said and Cherif Kouachi and Amedy Coulibaly, the men responsible for last week’s terrorist attacks in Paris, were true believers. So are those active in al-Qaeda, the Taliban, Islamic State of Iraq and the Levant (Isis) or Boko Haram. So, once, were Nazis and committed communists. True believers, argues Hoffer, are not characterised by the content of their faith, but by the nature of its claims. Their beliefs claim absolute certainty and demand absolute loyalty. True believers are those who accept those claims and welcome those demands. They are prepared to kill and to die for their cause, because its success in the world is more important to them than their lives or indeed anybody’s life. The true believer is therefore a fanatic.
The fanatic is a familiar character in history. Fanaticism is born of temperament, not ideas. The fanatical temperament can express itself in many different ways. Hoffer’s was an age of secular religions. Reality killed the religions that promised salvation on earth. But it cannot kill religions that promise eternity. The latter are now, once again, the most powerful forms of belief, though nationalism may yet run them close.

Indeed, religion and nationalism have frequently reinforced one another: God, after all, is so often held to be on “our side”. Thus, Hoffer states that “in modern times nationalism is the most copious and durable source of mass enthusiasm and that nationalist fervour must be tapped if the drastic changes projected and initiated by revolutionary enthusiasm are to be consummated”.

One of Hoffer’s important insights is that it is not poverty that turns someone into a true believer; it is frustration. It is a sense that one deserves far better. It is not surprising that some of those engaged in terrorism are petty criminals. Hoffer argues “that the frustrated predominate among the early adherents of all mass movements and that they usually join of their own accord”.

Among their characteristics is that they may feel they do not fit into their societies. This is not unlikely to be the case for some children of immigrant minorities. Their attachment to the culture of their family’s origin and identification with the culture of their family’s destination are both quite likely to be fragile.

What then does the belief offer? In essence, it offers an answer: it tells the adherents what to think, how to feel and what to do. It provides an all-embracing community in which to live. It offers a reason for living, killing and dying. It replaces emptiness with fullness, and aimlessness with purpose. It offers a cause. This is sometimes noble and sometimes base, but it is a cause, and that is what matters.

“All mass movements generate in their adherents a . . . proclivity for united action,” notes Hoffer.

“All of them, irrespective of the doctrine they preach . . . , breed fanaticism, enthusiasm, fervent hope, hatred and intolerance.” All demand “blind faith and single-hearted allegiance”.

Communism has waned. So, in many places, has secularism. Religion has taken its place. The moral and intellectual bankruptcy of secular rulers — particularly corrupt secular despots — has encouraged this revival. But western secular democracies are also vulnerable to assaults from true believers in militant Islamism. Wars may control them. But violence will not eliminate them, as the west has learnt in both Iraq and Afghanistan. The enemy is not “terrorism”, it is the idea of which terrorism is the fruit. Deterring people willing to die is hard.

Killing ideas is hard. Killing religious ideas is nigh on impossible. If such ideas are to wane, they will do so only at the hands of more attractive ideas. Possibly, the more extreme might perish of exhaustion. But this could take a long time. Remember that Luther’s ideas triggered 130 years of religious wars in Europe. It is a disturbing precedent.

What is to be done? I claim no expertise in this area. But I claim at least an interest: that of a citizen of a liberal democracy, which I very much wish to remain so. My answers are as follows.

First, accept that we are playing the long game of containment.

Second, recognise that the heart of the struggle is elsewhere. The west can help. But it cannot win those wars.

Third, offer the lived idea of equality as citizens as an alternative to violent jihad.
Fourth, appreciate and respond to the frustrations many now feel.

Fifth, accept the need for measures to provide security. But remember that absolute safety is never achievable.

Finally, remain true to our beliefs, since without them we have nothing to offer in this struggle. We must not abandon either the rule of law or the ban on torture. Once we do, we have already lost this war of ideals and ideas.

True believers do, once again, want to do us harm. But the threat they pose is not comparable to the ones that liberal democracy survived in the 20th century. We should recognise the dangers, but not overreact. In the end, this too will pass.


Brazil’s Petrobras Is Hit by Oil-Price Drop, Corruption

State-Run Oil Company’s Aggressive Offshore Expansion Is Threatened

By Will Connors

Jan. 14, 2015 11:08 a.m. ET

A Petrobras platform off the Brazilian coast in November 2010, when the company reported its output of domestic crude had hit a high. European Pressphoto Agency

RIO DE JANEIRO—Reeling from a massive corruption scandal, Brazil’s state-run oil firm, Petróleo Brasileiro SA, faces another major challenge: Falling global oil prices are testing the economic viability of the company’s deep-water oil fields.

Estimated by Brazil’s oil regulator to contain as much as 50 billion barrels of recoverable oil, these so-called pre-salt fields are central to Brazil’s goal of becoming a Top 5 oil producer by 2020.

    To see chart click here

But market prices hovering around $50 a barrel aren’t helping. Deep-water drilling is one of the most expensive undertakings in the industry, and it grows less attractive the farther prices fall. Petrobras said last week that the break-even cost of pre-salt production is between $45 and $52.

Already the world’s most deeply indebted oil major, Petrobras had been counting on robust oil profits to help it bankroll an aggressive offshore expansion, aided by foreign partners looking to tap Brazil’s massive underwater reserves.

“It’s going to be harder and harder for Petrobras to execute on this golden goose,” says Michelle Foss, an energy economist at the University of Texas. The pre-salt is “very challenging and expensive even in a high-oil-price environment.”

A Petrobras spokeswoman says the company is still moving forward on pre-salt projects “in an economically viable way.”

But cutbacks loom. While it has yet to provide details, Petrobras announced in December that it would scale back an ambitious $220 billion capital-spending plan, about half of which was earmarked for development of the pre-salt fields.

Unveiled in 2007, the deposits lie 200 miles off Brazil’s southeastern coast, deep below the seabed and covered by the thick layer of salt for which they’re named. The find was originally heralded as a bonanza that would catapult Brazil into one of the world’s top oil producers. Following the discovery, Brazil’s then president, Luiz Inácio Lula da Silva, famously declared that “God is Brazilian.”

Pre-salt already accounts for nearly a third of the company’s total production of 2.3 million barrels of oil a day. By 2020, Petrobras is looking to boost output to four million barrels a day, with the majority of that production coming from the pre-salt fields.

Where it will get the funding to do so, though, isn’t clear. Petrobras borrowed heavily to finance early exploration and development efforts, and it’s now burdened with some $170 billion in debt, according to Moody’s Investor Service.

Brazil has courted outside partners to help it develop its pre-salt riches. But few oil majors have invested, turned off by Brazilian government rules, including a mandate that Petrobras be the sole operator of pre-salt fields.

Brazilian officials are considering loosening those requirements. But even if that happens, it’s unclear how much foreign interest there would be with oil prices so depressed.

“They’re in a tough spot,” says Ms. Foss of the University of Texas. “International companies are going to stay clear of everything that’s high cost.”

Further complicating the company’s plans is a massive corruption scandal that has dominated headlines in Brazil since it first came to light in March.

Federal investigators charge that Petrobras was at the heart of an alleged kickback scheme in which construction companies overcharged for Petrobras contracts, splitting the ill-gotten gains with Petrobras executives and local politicians. Three former Petrobras executives have been arrested.

Petrobras says that it’s a victim of the alleged scam and is cooperating with investigators. The company has set up its own internal investigation, and it recently said it halted work with 23 construction companies linked to the alleged scheme while the investigation continues.

The company has twice-delayed its third-quarter earnings as it works to quantify potential corruption-related write-offs. The company says it will release its unaudited third-quarter earnings this month to meet obligations to creditors and prevent a forced early payment of certain outstanding debts.

Petrobras, whose shares are traded in New York, is also under investigation by the U.S. Securities and Exchange Commission and the U.S. Justice Department.

The steady stream of bad news has battered Petrobras shares, which have fallen 55% in the past six months. The company’s bonds are trading near record lows. Late last year, Moody’s Investor Service downgraded the company’s baseline credit to Ba1 from Baa3 and its foreign and local currency debt ratings to Baa2 from Baa1.

Petrobras debt remains investment grade. But the swoon has prompted Brazil’s government to declare it will guarantee the company’s debt if necessary.

All of these factors are weighing on Petrobras’ plans for the future.

The company “might not be able to deliver on some of their 2020 targets,” says Ricardo Bedregal, an analyst in Rio de Janeiro with consultancy IHS. “I think it will be difficult for them.”