Dona Merkel Quichotte vs the Mills of Inflation

We might be at a turning point. As you may know, I've started the year with the Bulls and my main argument was that the Sheriffs, governments and central bankers "worldwide", having learnt the lessons from the Great Depression would do anything possible, whatever the price is, to make sure the recovery would sustain. It may be time now to re-assess this view and it might be the time for the Bear Lord to come back. Since the very beginning of the crisis, I've been thinking that the better way out was to articially create some inflation (or at least prospects of it), thinking that ultimately this inflation once started could be controlled with the modern tools the Sheriffs have handy (or not but it's not the topic now). A few weeks ago, the situation as I could see it was a battle between two different groups of countries, those whose interest is the fight of deflation notably the US, Europe and Japan and those whose interest is to fight inflation, the emerging countries eg China and India. My bet was that ultimately, the fight against deflation would prevail but the recent moves tend to show I was wrong on this.

On the one hand, China announcing it would "enhance" the CNY rate flexibility and signalling the end of the peg of the CNY to the USD is to me a move in this battle. It's also good news for my equity funds position. As a reminder, I've switched in January 2010 most (I hate diversification) of my managed funds holdings to an Asian equities fund, the Far East fund managed by Aberdeen. The idea was to profit both from the stock growth and on the asian currencies appreciation (the fund is in GBP) and so far, the strategy has more or less paid off (I'm about +8-10% off on this). There's on bloomberg an excellent comment from William Pesek regarding the chinese "chess" move :

- It allows China to shut the mouth of some Americans that tend to make appear the undervalued Yuan as the root of all the US problems. "Go and find another scapegoat"

- The rising yuan will help China (along with other asian economies) to stem asset bubbles, increase Chinese purchasing power (hey there are 1.3 billion guys there) and reduce inflation risk.

On the other hand, the recent moves towards austerity and budget cuts seen in Europe, Germany and UK, show in my opinion that some are not fighting the right enemy : they fight inflation while they should fight deflation. As Desproges a famous French humorist put : "The enemy is stupid. They say that we are the enemy, but the enemy, that's them!". Seriously, it sounds to me like Dona Merkel Quichotte fighting against the mills of inflation. I'm not sure where she has seen inflation. Put deflationary measures and you may get some deflation, while the crisis is not over, look at the unemployment and the double dip in the US house price.. This debate between austerity and growth is currently the hot topic, including at the G-20 meeting this weekend and the media and the web are loaded with tons of arguments for the two camps. I won't add any arguments here, you know in which camp I am. I'd just say it's to some extent reminiscent of what happened in 1931 when, while the country was in a Depression further to the crisis of 1929, the UK government decided to raise taxes and cut unemployment benefits while close to 20% of the workers were unemployed in the name of a balanced budget. The summer 1931 was the turning point where the crisis that started in 1929 turned into the Great Depression. We have to keep in mind the lessons of History.

Now to be frank, I've not totally joined the Bear side yet (but I'm close, the Bear side is strong with me) as the US are (in my opinion) on the right side and they're still ruling! As in any (bad) hollywood scenario I expect they will save the world once again. This said, the situation has to be monitored closely as I think the game is playing now.

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