(Excerpted from the May Global Market Perspective)
In March 2016, when the ECB's preferred gauge of inflation fell to a multi-decade low, we called it a "remarkable picture of deflation's gathering strength, made all the more remarkable by the ECB's herculean attempt to stop."
Today, the financial community remains dimly aware of Europe's deflationary potential; however, most people still gravely underestimate just how much deflation can make an economy sick. In Poland, for example, "deep and persistent deflation is a fact," says the chief economist at a large Warsaw-based bank. (Bloomberg, 4/6/16) Indeed, Polish consumer prices dropped nearly 1% in March 2016 (top chart), marking the country's longest run-in with deflation in 60 years. In other words, you would need to travel all the way back to the mid-1950s to find a time when consumer prices fell this far and for this long.
Moreover, Poland's economic depression is unlikely to end soon. After trading flat from 2011 to 2015, the WIG 20, which comprises 20 large-cap stocks on the Warsaw stock exchange, fell 35% beginning in March 2015. Because stocks lead a nation's economy and the culture at large, Poland's economic, financial and societal deterioration is probably still in its infancy.
Meanwhile, global bond investors are sticking with their investments no matter how low the yield. The Bank of America Global Broad Market Index, which tracks the yield on investment-grade public debt around the world, just fell to its lowest level in 20 years. So, clearly, fixed income investors, who closely follow price indexes due to their effect on coupon payments, show almost no concern for a central bank--driven surge in inflation.
The Catch-22 is that while bond investors remain distracted by what they perceive to be historically benign inflation, the more dangerous enemy of deflation continues to gather strength. For example, the number of troubled retailers in Britain has quietly doubled since 2013, as the following Bloomberg chart shows. Bloomberg defines financial trouble as "insolvency or a marked deterioration in key financial ratios." But because financial ratios lag the economy -- which in turn lags stocks -- the number of troubled businesses in the UK will surely rise more if stocks continue to fall...
