Facing the twin threats of inflation and deflation

Gareth Colesmith, Senior Portfolio Manager, Fixed Income at Insight Investment

The ECB is better equipped to deal with an inflationary rather than deflationary environment

Deflation may prove to be a short-lived threat to the eurozone economy. The European Central Bank’s (ECB) commitment to meet its inflation target as it embarked on quantitative easing, even though green shoots of a recovery were visible, suggests inflationary pressures may build as economic growth takes hold.

The annual rate of inflation in the euro area picked up in May to 0.3 per cent, according to the first cut, touching a six-month high and exceeding consensus expectations. In the short term, we are probably past the worst of the deflationary risks that have largely been spurred by a sizeable negative output gap.

Economic growth, while still anaemic, is also picking up. Italy experienced its first quarter of economic expansion since mid-2013 during the first three months of this year while Spain saw its strongest growth in almost eight years. The level and rate of potential growth in the eurozone fell steeply after 2008 and has flatlined since. Economists currently estimate the potential growth rate to be below 1 per cent in the euro area compared with more than 2 per cent in the US. But this provides a relatively low hurdle for actual growth, making the output gap easier to erode.

Once the output gap closes and real growth picks up more meaningfully, there is the potential for markedly stronger inflation in the longer term, depending on what is happening in the rest of the world. The ECB is better equipped to tackle an inflationary environment than a deflationary one and will attempt to sidestep the latter at any cost. The threat of a debt deflation cycle would likely end the single currency.

For the ECB, the risks associated with prematurely ending its bond purchases are too great, not least in terms of its credibility. This sets the scene for a continuation of unorthodox monetary policy until at least September 2016. The ECB has already expanded its balance sheet by a quarter of its Ä1tn target since it launched its sovereign bond-buying programme earlier this year.

The ECB’s broad measure of money growth, M3, considered by some as a strong leading indicator, accelerated by more than 5 per cent year-on-year in April. Even if these funds are not being fully channelled into new lending and investment yet, they should eventually feed through to the real economy. The rebound in the oil price, meanwhile, is also yet to wash through the inflation data. 

Should inflation materialise as the key risk in the medium to long term, investors’ attention ought to be focused on assets that provide a real, positive return. In fixed income, German government inflation-linked bonds look attractive. Despite having negative real yields, it is possible that German linkers could be the best returning asset in fixed income. Investors could also consider reducing duration. 

Conversely, should inflation expectations become unanchored and the eurozone slide back into deflation, long-dated German government bonds could be the best returning fixed income asset class. But given that yields remain at what are extremely low levels  histororically in spite of the recent sell-off, one would have to question whether any intrinsic value remains. 

Emilio Franco, CIO and Deputy General Manager of UBI Pramerica SGR

No one can predict what might happen as a result of central banks’ policies so solutions must be in place for any possible outcome

The topic of future long-term development for general price indexes is very interesting and challenging. Traditional monetary theory would predict an inflationary outcome, due to the unprecedented monetary policy experiment – QE – put in place by central banks in the aftermath of The Great Recession and the financial crisis. 

At some point, credit channels should start to work again and the immense amount of  money created by policymakers through the purchase of bonds should start to be re-cycled into the real economy as loans. This dynamic will contribute to closing the output gap and will put pressure on labour costs, the most important contributor to inflation. 

Exit strategies at that point will be crucial, because there is no past experience of what may happen when a central bank as important as the Fed begins to leave the zero interest rate bound. The communication and technical challenges are overwhelming and volatility will probably rise, ending the period of financial repression. 

Accidents could happen, either to inflation or to markets. So far, only asset prices have responded with upward movements and inflation has been further depressed by the recent collapse in commodities. 

On the other hand, theorists of global stagnation forecast low growth, low rates and low inflation as the consequences of unemployment, demographics and lack of investments. The policy recipe should be a boost to aggregate demand, a very different path from what the eurozone chose to manage its sovereign debt crisis – austerity.  

Clearly, uncertainty is the name of the game. We must build investment solutions able to navigate any future environment, with either low or high inflation.  

Our answer is to build global dynamic asset allocation portfolios following an innovative approach to diversification which we call “multi-dimensional”. 

Together with the traditional diversification, through asset classes (including commodities and real estate), regions and currencies, banks can add different strategies and processes, both discretionary and quantitative, proprietary and multi-manager, traditional and alternative. A lot of effort must be devoted to the portfolio construction process, with an increasing focus on liquidity risks. 

Building blocks need to be assembled on the basis of different optimisations, aimed at maximising expected returns, information and/or sharpe ratios and the number of uncorrelated sources of risk, in strict compliance with a predefined risk budget. We are strong believers in the importance and value of a clear ex ante pact with the customer, allowing them to choose the risk-reward profile for their portfolios, in order to satisfy investment objectives over the appropriate time horizon with the short-term drawdown risks that can be managed without liquidating assets and consolidating losses. 

It is easy to manage customers’ expectations in a bull market. It becomes much more difficult during bear phases. This is why private banks must focus on explaining what may happen to a portfolio on the downside: it is the ticket a customer should be willing to pay for in order to get the benefit of expected returns over the longer term.

Richard Jeffrey, Chief Investment Officer, Cazenove Capital

The risk of deflation has been exaggerated, while equities and property offer protection against the greater threat of inflation

The direction of change in the real value of portfolios is always a topic close to investors’ hearts. In tough times, investors are keen for the real value of their wealth to be protected; in better times, they want to see it increase. When prices are rising, it is conceptually not too difficult to understand what this means. When prices are falling, it becomes more complex – what, precisely, is it that you are trying to protect yourself from?

The word ‘deflation’ has been tossed around by economists with near-reckless abandon. Deflation is not just about falling prices; it is about an environment in which there is a pernicious and self-perpetuating decline in real spending, real incomes and real growth. Assets with nominally fixed values work well in this environment – for instance government bonds. The belief that deflation was becoming a more pervasive threat helps explain why government bond markets, until relatively recently, had been so strong. 

In some countries, Italy for instance, deflation has been a real threat; in others, such as Japan, it has become more of a reality. 

However, my belief is the threat of deflation was exaggerated by a misunderstanding of how it arises and what it entails. So far as economies such as the US, Germany and the UK are concerned, the likelihood of entering a deflationary environment was never high and recently has diminished. 

Deflationary forces tend to arise from within the internal metabolics of an economy. The negative influences on prices in the three countries just mentioned have come from developments outside their borders, most obviously in the form of falling energy and food prices. Far from having a negative impact on growth, negative or dis-inflation is helpful. While bonds are not unattractive if the price level is falling, the boost to domestic economic activity arising from the stimulus to real spending power suggests assets such as equities and property should perform better in the medium term.

As the larger industrial economies establish more momentum, our strategic thinking must change. With the helpful impact from falling commodity prices beginning to fade, the greater influence on prices will come from domestically-generated inflation – most obviously in the form of rising wage levels. 

Low productivity growth rates have been reflected in a more substantial tightening of labour markets in the US, Germany and the UK than might have been anticipated at this stage of a recovery. Consequently, there are signs higher wage inflation could be the next surprise. 

How we orientate portfolios towards this threat depends on what policy response is anticipated. Bonds look unattractive if it is concluded we are now entering a period of higher inflation – with the exception, perhaps, of inflation-linked bonds. On the other hand, equities and property offer long-term protection against the damaging impact inflation has on real values of assets with nominally fixed values. 

The problem comes in judging consequences of the policy response to increased inflation. 

The more aggressive the increase in interest rates, the poorer the near-term outlook for growth becomes. In this environment, a higher weighting of inflation-linked bonds, very short-term bonds and cash is appropriate. On the other hand, if you think the probable tightening in policy will be insufficient to significantly dent underlying economic growth, then a higher weighting in equities is appropriate, alongside some insurance in inflation-linked bonds. 

Policymakers are currently more concerned about taking action that bears down too heavily on economic growth. Therefore, they are likely to raise interest rates more slowly than circumstances would seem to require. In this situation, maintaining a full weighting to equities is appropriate. 

Within the equity arena, investors should be positively oriented towards growth in Western economies, remaining wary of emerging markets and commodity producers.