In our world of fractional reserve banking, the money we use for transactions is only created when commercial banks lend money and, through the true alchemy of finance, thus create bank deposits. It is those bank deposits with which we purchase goods and assets and not the bank reserves created by central banks. As commercial banks continue to struggle to lend money, the actions of the central banks have not led to the scale of money growth associated with previous robust economic expansions. If the Nobel prize-winning economist Milton Friedman was right, and inflation is ‘always and everywhere a monetary phenomenon’, then the lack of growth in money suggests that deflation is increasingly likely.
If central bankers in the developed world are failing to ‘print’ money, central bankers in the emerging markets have a similar problem. As central bankers in these jurisdictions seek to prevent their exchange rates declining relative to the US dollar, they have to adjust the supply of their currency if there is market pressure for the exchange rate to decline. In short, the supply of money has to be curtailed to support the chosen exchange rate.
So inflation is low and falling, global growth is low and falling and key central banks are failing to boost the supply of money that is the most likely precursor to future inflation. A low average rate of inflation hides a wide range of changes in individual prices. While some prices are rising rapidly, others, most notably crude oil and other commodity prices, are falling rapidly. For the companies and countries that rely on selling such products, the decline in revenues, associated with the decline in selling prices, can threaten their ability to meet their liabilities. In other words, bankruptcy beckons for key companies and countries with major negative impacts for the global credit system.
Could all this really impact growth and inflation in the developed world? It could, through its negative impact on the banking system and particularly the banking system of Europe, which is very exposed to the emerging markets of Brazil (Spain), Eastern Europe (Austria), Angola (Portugal) and Turkey (Italy). The negative impact on the price of corporate bonds is already creating liquidity problems for open-ended bond funds, and two such funds in the US were forced to suspend redemptions before Christmas.
At current levels of valuation, equity markets offer little upside for investors. However, should we see the development of deflation and the likely associated recession and credit crunch, then equity prices could halve if they return to the levels seen in the four great bear market bottoms. That is a risk/reward balance that favours selling equities and waiting to buy when valuations are much more reasonable. Not all bear markets are created equal but this one looks like a big grizzly.