The Personal Consumption Expenditure (PCE) Deflator is a United States-wide indicator of the average increase in prices for all domestic personal consumption. Along with the CPI, it is commonly used as a measure of inflation.
The PCE has very rarely dropped below 1.0%. Global macro-economic forces, however, are pushing the PCE down towards a very dangerous level. As countries battle to devalue their currencies they become more competitive as their goods are cheaper for foreign consumers to purchase. This cheapening of goods leads to downward pressure on the average price of goods.
The recent devaluation of the Yen has is a good example of how this is affecting prices in the US presently. The drop in the Yen has substantially increased the competitiveness of Japanese manufacturers in global trade. As Asian manufacturers struggle to retain market share they also drop the prices of their USD goods. This compounding effect raises serious issues for importing nations such as the United States as their manufacturers become less competitive and consumers become accustomed with the idea that goods will continue to cheapen, hence preferring to save for when they are cheaper than to invest and buy goods today.
The chart below shows that the PCE deflator (in blue) has been dropping consistently for the past 20 months. The yellow line shows the 5-year breakeven rate, a measure of the market’s future expectation of inflation, in this case in five years’ time. The breakeven rate shows that the FED has, so far, been very successful at buoying the market’s expectation of future inflation by promising to keep monetary policy very loose for a long time.
The issue, however, is that the enormous quantity of money printed by the FED is not making its way down to consumers. Instead, it has inflated equity markets and created the largest credit market bubble in history. At some stage the perception of the FED’s efficacy in easing will fade and inflationary expectations will fall to more realistic levels.
Equity markets on the edge of a precipice
This could cause a serious re-rating of equities as market participants set more realistic expectations of companies’ future earnings.
The chart below shows that inflationary expectations tend to move in sync with equity market movements.
Unfortunately, as seen in the previous chart, inflationary expectations tend to follow the PCE deflator which is most certainly on a downward trajectory.
George Magnus, the well known economic consultant and former chief economist of UBS, recently wrote an interesting article in the Financial Times link highlighting the risks of ever richer equity markets fuelled by monetary easing in a world facing anaemic growth.
Investors should always expect return when taking risk. The current environment doesn’t offer a very rewarding environment for risk takers. Savy investors would be wise to take profits and watch the events unfold from the sidelines.