The desire to cut inventory ratios, coupled with the accelerated depreciation in the yen, sets the stage for a renewed period of deflation coming primarily from Japan and South Korea. That pricing pressure is likely to radiate out to China and to Southeast Asia, and we're likely to feel its effects very soon.
First, let's remember that the last few years (since when?) have been a period of exceptional pricing and margins stability for most of Northeast Asia. Deteriorating terms of trade had been a way of industrial and trading life for most of Northeast Asia for as long as most managers can remember: between 1994 and 2011, terms of trade fell almost uninterruptedly for both Japan and S Korea; Taiwan held out a little longer and a little better, but was unable to escape, with a sharp and seemingly unstoppable slide between 1998 and 2011. However, since 2011, the pattern has been near-stability: between 2Q11 and the 3m to August, Japan's terms of trade fell only 5%, whilst they improved 1.7% for S Korea and rose 2.7% for Taiwan.
This new stability wasn't just the result of commodity price movements favouring Northeast Asia's industrial commodity-consumers – though that certainly helped. But in addition, there had been no repeat of the bouts of savage deflation in dollar export prices experienced in 1997-2002, again in 2006 and once again, briefly in 2010. In its place has been a period of unusual pricing stability for NE Asian exporters.
It is this stability which August's shockingly weak industrial data puts under threat. To recap:
- China's industrial output growth slowed to 6.9% yoy, on a monthly slip that was 0.7SDs below trend
- Japan's output fell 3.1% yoy, and was 1.3Ds below trend
- S Korea's output fell 2.8% yoy, and was 1.1SD below trend.
Now, this could perhaps be dismissed as a shared blip – and what's more, a blip in the month of the year which matters least as far as industry is concerned. And it remains the case that momentum trends in G3 imports and Northeast Asian exports remain sufficiently robust to allow a yoy acceleration through the rest of the year (although perhaps slightly less than expected six months ago). It also remains the case that global domestic demand remains in reasonable shape.
However, the problem is that at least for Japan and South Korea, August's slowdown has left both with an inventory problem which managements will want to address quickly (particularly in Japan). Japan's inventory/shipment ratio has spiked up to the sort of levels seen in the immediate aftermath of 2011's triple disasters, and again in the angst-ridden period which brought PM Abe to office. Getting rid of these inventories will demand either further cuts in production, or significant price-cuts to get the inventories off the books. Since the end of August, the yen has fallen more than 5% against the dollar, so the temptation simply to slash dollar prices will be hard to resist.
That then throws the pressure back onto Korea, where the inventory turnover ratio (total inventories/sales) has been climbing since 2011, and in August reached record heights.
And, of course, that pressure will also be felt in China. China's August industrial data was awful too: not only did output growth slow to 6.9% yoy, but the slowdown in the topline crushed profits, which fell 0.6% yoy in August (if the data is to be believed). Once again, if China's data is to be believed, mainland companies have spent the last 18 months or so successfully protecting their margins, and this was still the case in August's slowdown. However, as the chart also shows, China's margins are highly cyclical and tilted sharply towards the year-end. It is the fattening of these year-end margins which would be directly threatened by Japan and S Korea's efforts to offload inventories by cutting prices.
Conclusion? It's price-cutting time for Northeast Asia: there will be bargins this Christmas.
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