From Growth Compression to Reflation: The Road Ahead – Guest Post: Jay Pelosky

by Dan November 28, 2012 2:32 pm • Commentary

Jay Pelosky, a friend and Principal at J2Z Advisory, LLC, is an investment strategy consultancy and former head of Morgan Stanley global asset allocation research. He is an expert on all things macro and emerging markets.  Jay can often be seen on Bloomberg and CNBC. I wanted to share his latest piece, Cross posted at HuffPo:



From Growth Compression to Reflation: The Road Ahead

– Consultant, J2Z Advisory


Five years into the global socio-economic crisis, five basic points have become clear. First, the can-kicking approach to economic policymaking is not sustainable. Second, time is not our friend; delay leads to fewer, poorer policy choices, not more, better options. Third, the world needs growth, not endless austerity and deficit reduction. Fourth, monetary policy alone cannot generate growth. Fifth, as growth compresses and investment returns shrink, a policy pivot approaches. Next year may well see the Great Growth Compression begin to turn into the Great Global Reflation.

Growth rates have compressed around the world. Take the developed market economies (DM) for example; growth rates have converged to very low, Japan-style, rates of economic growth. Europe is in recession; 2013 U.S. GDP forecasts call for 1.5 percent growth and Japan slouches in and out of recession. Anemic growth and heavy debt burdens represent a dangerous combination.

A look inside the European Union finds growth rates have compressed between the periphery and the core. In the first years of the European crisis, growth in the periphery collapsed while core growth rates in general and German growth rates in particular remained relatively robust. Today, peripheral growth contractions have moderated while core growth rates have collapsed. Holland just reported a sharply negative Q3 growth rate while France is barely positive. German 2013 GDP growth forecasts have been cut in half over the past month to less than 1 percent. Economic weakness has spread from the periphery to the core — a vivid example of the downside of delay and an open invitation to financial market volatility.

Emerging Market economies (EM) have not proven immune to growth compression, either. Compression is clearly visible for example, in China’s growth rate vs. the rest of the EM. China has downshifted from 10 to 12 percent growth rates to 7 to 8 percent. Given its nascent economic and political transition, lower growth rates are likely in the years ahead. EM growth rates more broadly have compressed to around 3 to 5 percent; levels that used to be called an EM recession.

The world lacks a demand and growth engine. This suggests that unless policy is changed, growth will continue to compress, inflation will become deflation, debt burdens will grow heavier and policy options fewer. It also implies that no one nation or region can go it alone; the days of U.S. locomotives or Chinese growth engines are over. To offset synchronized growth compression requires a synchronized reflation effort.

A look at inflation reinforces this sense of compression. China’s inflation rate has declined to the 2 to 3 percent range while U.S. inflation is below the Fed’s preferred level. Europe’s inflation rate is likely to fall under the ECB target level next year. Japan remains mired in deflation.

Weak growth and low inflation combined with ultra-low interest rates have compressed financial assets as well. In the financial sector itself, trading volumes have collapsed and leverage has shrunk, together with returns on equity and compensation. Bank lending remains impaired. The financial industry is in the early stages of a comprehensive business model review.

Compression is evident in the flattening of interest rate curves within and across both DM and EM. Return differentials between regions have narrowed while return expectations around the world have compressed to form investors’ Holy Grail: a high single-digit return with low volatility. That this has become the return standard for investors of all stripes hasn’t made it any easier to achieve.

Credit investors struggle with the low yields on offer for “new money” investments; corporate debt issuance sets records while trading volumes collapse (no one wants to sell higher yielding instruments). Equity investors look ahead and question the viability of double-digit 2013 S&P earnings growth forecasts at a time of record high profit margins and shrinking GDP growth rates.

Compressed rates of economic growth, inflation and investment returns, coupled with the realization that monetary policy is at the end of its tether (for what lies beyond “open-ended money printing”) set the stage for a policy pivot. The Great Compression will give way to the Great Reflation, not next month or next quarter but at some point over the next 12 to 24 months. How this is done will make all the difference — via beggar-thy-neighbor policies or internal, pro-growth policy implementation?

Japan is most exposed to continued global growth compression and thus may become the Great Reflation’s standard-bearer. With its back against the wall, its iconic companies at risk of failure, (Fitch just downgraded Sony and Panasonic to junk status) elections next month and new BOJ leadership in the spring, Japan is likely to lead the way forward via aggressive monetary and fiscal policies. Significant investment opportunities are likely to accompany this policy shift.

Can Europe follow? Growth has been the biggest casualty of the European austerity drive; for Europe to grow a new policy path is necessary. One such policy could be the implementation of a multi-tier euro system that would rebalance Europe internally by allowing the periphery to restore growth much more quickly than “internal devaluation” alone while blunting the core’s export focus and thereby encouraging consumption. A major challenge to one of the core states — France comes to mind — might be the lever necessary for such a policy shift.

EM growth reflation requires migrating from external demand driven growth to a domestic demand driven economic growth path. This transition is not easy and will take time. Currency weakness to boost exports will give way to currency strength to foster consumption, productivity will drive profits and winners and losers will become clearer. China is likely to be the leader here — RMB strength could provide an umbrella for the rest of Asia.

The U.S. benefits from a revived manufacturing sector, cheap domestic energy and agricultural supremacy as well as a slowly recovering housing sector. The U.S. economy is like a twin-engine plane: The external demand engine is limited by global growth compression while the internal demand engine is thwarted by excessive unemployment and anemic income growth. The result: subpar growth.

Completion of the fiscal cliff negotiations could offer the U.S. an opportunity to pivot to an infrastructure- and investment-focused (perhaps at the state level) jobs-based program that would reinforce its internal advantages and jump-start growth. That such a pivot sounds almost laughably optimistic today suggests it could actually happen. Preparing for the pivot is the job of policymaker and investor alike.