O QUE DIZ ROUBINI

The financial wildfire has turned around the stagflationary trends seen earlier this year into a vicious cycle of global deflation in debt, assets, wages, and goods.

Headline consumer inflation has peaked in most of the developed and emerging world, except in places where food/fuel subsidies were recently rolled back or post-Q3 data are still unavailable. According to the IMF’s October World Economic Outlook, the world’s average consumer prices have increased 6.2% y/y Q2 2008. JPMorgan expects world CPI inflation to slow to 2.6% y/y Q2 2009. Lower commodity prices subdued headline inflation and are expected to continue doing so on slackening global demand. Core inflation has yet to show a significant decline but a feedback loop of debt deflation, asset deflation, commodity deflation, wage deflation, and slower global growth will likely lead to flat or lower headline and core consumer and producer prices in Q4 2008 through 2009. But in the short- to medium-term, stag-deflation seems the most likely scenario for the world economy. The continued fall of U.S. house prices has morphed into global de-leveraging, which threatens to spark global deflation. Debt deflation at first sent investors seeking safety in commodities as inflation accelerated worldwide due to the weakening dollar. The dollar weakened as the world seemed resilient to the U.S. slowdown. But the lag between U.S. growth and growth in the rest of the world soon ended and so did the lag between growth and inflation. Commodity prices slid on fund liquidation to cover losses in other asset classes and on expectations that commodity demand will weaken in a global recession. The prospect of a U.S. hard landing and a global recession, and demand destruction triggered by high commodity prices earlier this year, has already led to an across the board commodity selloff, with the CRB falling almost half from its July peak. Oil has fallen even further as the prospect of slower demand growth from China and other emerging markets may fail to offset falling demand from the OECD, especially the U.S. where demand for all petroleum products have fallen. Not even a 1.5 million barrel production cut from OPEC and the news that many producers were cutting production (erasing this year’s earlier production increase) was enough to stem the decline. Meanwhile many oil producing companies (even state-owned ones like Russia’s )are feeling the double whammy of lower demand and tighter credit which may freeze capex and new projects, especially from the most expensive, unconventional supplies. With marginal costs of production still rising (for now), this may point to a mid-term supply crunch once an expansion finally begins. Such supply constraints could occur in agricultural and metals over time, especially given that some base metals are trading below cost. Commodity exporting countries are being pressured by falling prices and the withdrawal of global credit which may sharply reduce inflows and thus imports– contributing to another source of slack in the global economy in the next few quarters. Countries like Russia, Venezuela and Iran could account for the most significant slowing though many petro-states have become used to oil prices above $70-80 a barrel – and the negative wealth effects of current and looming asset price corrections will have an effect. While Chinese government infrastructure spending might limit the drop in demand for some commodities, its coffers do have their limits and even if Chinese property sector stabilizes, the past forecasts of Chinese demand growth for products like steel, copper and coal might have been over optimistic meaning that fundamental and technical factors could point to further downside for commodities until the credit markets stabilize. As investors recast their outlook for corporate earnings in light of a slowdown in global activity, stock and corporate bond prices all over the world declined in a virulent episode of asset deflation. Debt deflation exacerbated asset deflation by reducing the amount of leverage investors could take on. Wage deflation will most likely contribute to a worsening the corporate earnings outlook by inhibiting consumer spending. Labor markets have slackened on the corporate belt-tightening triggered by tighter financing and sagging sales. Continued loosening of labor markets, marked by rising unemployment, will slow wage growth as jobs are cut back. With household financial wealth shrinking in bearish markets and rising debt servicing burdens, lower household income will further erode consumption. The carry trade succumbed to bank de-leveraging and investor repatriation, resulting in the appreciation of carry trade funding currencies - the most popular being the JPY and USD. Bank de-leveraging has led to a shortage of these currencies, as most cross-border bank liabilities were denominated in them. With tighter lending, investors have had to unwind their carry trades to meet margin calls and, as asset prices adjusted to a recessionary outlook, to avoid further losses. U.S. and Japan provided the lion's share of the world's investment flows. The repatriation of U.S. and Japanese investor funds sapped the strength of other currencies versus the USD and JPY. The spread of recession and financial crisis beyond the U.S. to several other countries kills the appetite for foreign investments, driving repatriation. This leads to further currency depreciation in carry trade destination currencies – especially emerging markets which had over-hedged or under-hedged against USD strength. A stronger dollar may contribute to further commodity price declines as countries with weaker currencies are able to purchase fewer goods. By the same token, weaker non-U.S. currencies may sow the seeds of higher inflation in countries vulnerable to imported inflation. In an environment where high yield alone is no longer attractive, the combination of slowing growth and rising inflationary pressures may set up emerging markets for further punishment from currency markets.