Does inflation or deflation carry the greater threat?

Inflation

Bill O’Neill,Head of CIO WM Research UK, UBS Wealth Management

Expansive monetary policy in developed economies has been deliberately deployed to sustain inflation expectations in the face of a prolonged balance sheet adjustment.  As a consequence of this, it is possible that actual goods and services price inflation rises as the cyclical recovery gets underway.

At the turn of the decade, potential shocks to US inflation in fact looked to be firmly skewed to the upside. However, the decision by the US Federal Reserve to explicitly state a 2 per cent inflation target has limited the potential upside risk to inflation. In the absence of a loss of Fed independence, technical complications from exiting current policy or policymakers’ willingness to look through above average inflation, US inflation is less likely to rise dramatically from here.

The arguments for an upside risk to inflation in the US are a positive surprise in economic growth, which triggers a big release of pent-up consumer demand. This then prompts companies to exercise their pricing power in order to supplement profitability, by raising prices and passing on costs to the end consumer. A rapidly tightening labour market (another of the Fed’s specific targets for setting interest rates) could also lead to higher inflation through a build-up in wage gains at the same time as faith in the US dollar is being eroded. The net result would see a simultaneous rise in both domestically generated as well as imported inflation via higher commodity prices.

In the UK, inflation expectations remain significantly higher than the US, not least because the Bank of England expects inflation to be above the 2 per cent inflation target out to 2015. Indeed, the recent YouGov survey shows inflation expectations for the longer term (five to 10 years) at above 3 per cent. The scope for miscalculation by the Bank of England in setting monetary policy, so as to ensure inflation expectations are capped, is quite limited.

Looking further afield than the UK and US, emerging market economies’ inflation trends present challenges. A shift toward domestic consumer demand will necessitate both wage gains and improved access to credit with a dollop of asset price inflation. Clearly the risk arises that these income gains are not compensated by improvements in productivity or efficiency. Currency weakness would likely follow adding to the inflationary impulse. Policy would in the end have to wrestle price pressures back but not before actual inflation has been uncomfortably high, for an uncomfortably long time.

In case of rising global inflation, we advocate holding real assets that can work as hedges against inflation in portfolios. Index-linked bonds provide a coupon payment that is linked directly to rates of inflation and so provide a certain degree of protection. Property, as a real asset, tends to retain value and rise in line with inflation but it is a relatively illiquid asset. Gold may also work as a perceived inflation hedge. However recent price movements have shown that the precious metal is sensitive to the stance of central bank policy.

Equities can provide a real income stream if quality stocks paying dividends are chosen. There is also scope for earnings to rise in line with inflation. However, this comes with the risk of higher volatility in earnings stream itself, and the equity risk premium (the return that stock markets are required to generate over the risk-free rate) may rise. Certainly, cash and government bonds look set to provide returns less than the rate of inflation. If inflation continues running above target then the yield on high-grade government bonds will not match increases in the aggregate price level. 

Deflation

Peter Leahy, Founder, Sovereign Leadership Group

Peter Leahy, Sovereign Leadership Group

Should you be losing sleep about inflation? Only if you have failed to notice that inflation is exactly what most governments, consumers and even possibly pensioners want right now – but it is proving worryingly elusive.

Instead, it is deflation you should be worrying about. Deflation really is a risk and even though it remains some way from being a reality, there is real evidence the risk is increasing.

Deflation would not be good for equity markets – anyone who doubts that should look at the performance of Japan’s Nikkei 225 index. It is currently at about a third of its 1989 peak.

The grand gesture of Abenomics had markets quite convinced for a while that with a big enough ‘bazouka’ the Japanese might be able to get their economic wheels out of the sand. But since doubts crept in around a month ago, the Nikkei has shed about 20 per cent. This has taught us three things – the Japanese desperately want inflation; it continues to elude them; and that other countries (including the UK and Mark Carney) are competing for the same prize.

But unfortunately, there is no quick fix.

Domestic inflation pressures do not really exist in most major economies. If we are to believe it, the recent buoyancy of the US stockmarket reflects good times in that economy – all happening with little or no employment growth. Most observers agree that the recent monthly non-farm payroll releases, while in some cases better than expected, remained well short of what would be expected of a healthy economy.

Internationally however, a currency devaluation competition has quietly begun. Japan’s government fired the starting gun in December with the election of Shinzo Abe who is vocally determined to dig Japan out of its deflationary rut. Others are already following. Australia, South Korea, the UK, the eurozone and India have all either ‘talked down’ their currencies or lowered interest rates with the same ambition – to spark activity and avoid deflation.

Few finance ministers will say it but after presumably careful analysis of their own and the global economy, there is something they will engage in financial warfare to avoid. Why go to war unless you feel that the risk is real? That ‘thing’ is of course deflation.

The only inflation we have been seeing is in equity prices. The classic deflationary trap is that consumers and financial institutions perceive no incentive to spend so they continue to save. However, with interest rates at negligible levels and the ‘yield gap’ having returned, they save in equities rather than anything else.

This, together with still anaemic money supply growth and velocity are clear indicators that much of the industrialised world will be lucky to escape deflation.

Consider this against the backdrop of opinion that it is “over for bonds”. Consider also the “bed of nitro-glycerine” that one commentator described them as reposing on – before enjoying a substantial rally – and start to wonder how much of a contrarian you might need to be to give bonds another look. Long-term UK gilt-edged prices would be about a third higher than where they are now if yield were to fall to the kind of levels that are current in Japan.

Nothing is ever a one-way bet. Equities are not without risk and rumours of the demise of bonds are greatly exaggerated. For as long as there is deflationary risk then there is potential upside in long-term UK gilts and US treasuries even from these seemingly low levels of yield. Private investors should continue to hold a substantial allocation in bonds.