THE BIG PICTURE: Deciphering deflation

The ‘hot button’ issue on global financial markets is deflation, or falling prices. This issue has been brewing for some time with a rash of retailers and consumer-product manufacturers forced to trim prices. But the issue has been given another kick along after the St Louis Federal Reserve President, James Bullard, cited the risks of the US falling into a Japanese-style situation of weak growth and deflation.

Certainly the Federal Reserve chairman Ben Bernanke doesn’t see a deflation risk, believing that inflation will gradually move higher from levels around 1% to 2%. And while other Federal Reserve members are also more positive, believing that the Fed should drop its guarantee of rates remaining low for “an extended period”, others no doubt share Bullard’s concerns. All of which sets up an interesting meeting of the Federal Reserve next Tuesday. Some in the market believe that the Fed is close to another round of ‘quantitative easing’ – buying securities in exchange for cash to stimulate the economy.

How real is deflation? In the US, the inflation rate stands at 1.1% while the core rate (excludes food and energy) stands at just 0.9%. In Germany inflation stands at 1.1%, The Swiss inflation rate stands at 0.4% and Japan still is in the grip of deflation with prices down 0.7% on a year earlier.

Of course, most people would see Australia in a different situation with firmer economic growth and a tighter job market. But as is clear with most things, Australia is very much influenced by global trends. And of course if overseas producers are being forced to trim prices to stay competitive, those trends will also be reflected in Australia. Add in the fact that the Australian dollar is stronger, putting downward pressure on import prices and tourism-dependent areas of the economy. And then there is the relentless decline in prices of technology goods and commensurate increase in speed and quality.

Think deflation is still some way off in Australia? More than a third of items in the Consumer Price Index are cheaper now than a year ago. Electrical goods, clothing, cars, sporting equipment, toys, furniture, phone/data services and airfares are all down on a year ago together with food/grocery items like fruit, eggs, breakfast cereals, meat and toiletries. Less than a third of CPI items grew at a faster rate than the headline rate of inflation in the year to June such as utility costs, housing, property rates and education fees and many of these are set once a year and lag other trends in the economy.

While deflation sounds like good news for consumers, it puts downward pressure on profits and wages as well and it can be hard to eradicate once entrenched – just ask the Japanese.

The week ahead

Usually the Reserve Bank features prominently in the weekly schedule of events. But that won’t be the case in the coming week with its main contribution being to provide the latest estimates credit card lending on Thursday.

But certainly there is a full week of economic data releases. On Monday, housing finance figures are released together with job advertisements. The NAB business survey is issued on Tuesday with consumer confidence and lending finance slated for Wednesday. And the latest employment report is issued on Thursday alongside the aforementioned credit card figures.

The distinction between the number and value of home loans probably continued with the June data. The number of loans refers just to owner-occupier loans – people buying homes to live in, rather than as an investment. The number of loans may have fallen two% – the eighth fall in nine months. But the value of loans, which includes investor activity, may have risen by 2%. Investors see value in housing as an asset class at present but owner-occupiers are still spooked by the rapid fire rate hikes earlier this year.

The other economic indicators should be more positive. Job advertisements probably rose in July, but at a far slower pace than in previous months as the economy softened. Business sentiment probably rose in response to the revised mining tax proposal. And consumer confidence probably stabilised in August, as judged by the weekly Roy Morgan confidence rating.

Both the lending finance and credit card lending figures probably remained subdued in June with businesses and consumers still cautious about taking on more debt.

Employment probably rose for the 11th time in 12 months, reflecting the strength in job ads earlier in the year. But while jobs grew by around 25,000, that increase would just enough to offset new entrants, keeping the jobless rate at 5.1%.

Turning to the US, the feature is likely to be the Federal Reserve meeting on Tuesday. There are rumours that the Fed will provide another batch of “quantitative easing” in order to give the economy a kick-start. That move could be more negative rather than positive as confidence is the main factor holding employers back from creating jobs rather than interest rates or lack of money. Profit levels are certainly OK. The Fed decision is announced Wednesday morning Australian time.

Of the economic data, the highlights are late in the week with retail sales, consumer prices and consumer sentiment all released on Friday. Earlier in the week productivity data is out on Tuesday with trade and the monthly budget on Wednesday and import/export prices on Thursday.

Overall we expect tame inflation (core rate 0.1%), modest retail sales (up 0.4%) and flat consumer sentiment (reading near 68.0).

It is also important to point out that monthly Chinese economic data is released over Tuesday and Wednesday.

Sharemarket

The Australian earnings season cranks up a notch in the coming week. Effectively three big weeks lie ahead as the bulk of the ASX 200 companies issue results. On Monday, Bendigo and Adelaide Bank and JB Hi-Fi are among those reporting. On Tuesday the line-up includes Alumina, Bradken and Cochlear. NAB also issues a trading update on Tuesday. On Wednesday, CBA, Computershare and Stockland are among those reporting. On Thursday Telstra, James Hardie, Coca Cola Amatil. Qantas, Austereo, SingTel and Transurban are among those that are expected to report earnings results.

Ahead of the peak earnings period, it’s worthwhile to update our views on the broader market. Overall we believe that the sharemarket is fairly valued at present with healthy earnings results in the current season likely to be followed by more subdued results for the current six month period through to December. The ASX 200 and All Ordinaries are expected to reach 4,800 points by end year, 5,100 points by June 2011 and 5,400 points by December 2011. While the forecasts appear conservative, the Australian sharemarket is still in a tight relationship with the US Dow Jones and it is clear that the jury remains out on the health of the American economy.

Interest rates, currencies & commodities

Football commentators regularly fall in to the trap of saying that it was a ‘game of two halves’. Well the adage may end up being apt for the commodities markets this year. The CRB futures index eased over January and February before consolidating over March and April and then easing further to late May. But after again consolidating over June and the most of July, there are suggestions that the CRB could claw back lost ground over the remainder of 2010. From January to May the CRB fell 15%. But from the trough, the CRB has managed to rebound 12%.

The interesting point is that a raft of commodities – clearly with different fundamental drivers – have posted solid gains over few weeks. Oil, sugar, base metals, iron ore and wheat are amongst those showing the strongest trends at present, with wheat doing the best, up 70% in the space of almost two months. Sugar has also lifted around 40% since early June while iron ore is up 21% in just the last three weeks.

Craig James is chief economist at CommSec.