If inflation and deflation are the weather systems that help determine how our investments grow, then we need to know what the forecast is so we can plan accordingly. So should you inflation-proof or deflation-proof your portfolio? Read our two fund managers' verdicts and make your own mind up.
Inflation is not dead
We are certainly living in an unusual world, as global GDP has gradually picked up through 2014 but this acceleration in activity has, as yet, been unaccompanied by a rise in inflationary pressures or commodity prices. In this article I will examine why this is and discuss our future expectations for inflation, as well as questioning whether we have seen the Death of Inflation.
Inflation gauges around the globe are currently mostly very weak. Those of you who have the same misfortune as I of sitting on Southeastern Trains or using Southern Water will dispute this, but the lack of inflationary pressures is a fact.
The obvious culprit for generating inflation over the last decade has been commodity prices, especially due to the increasing “consumerisation” of the emerging market economies. This year commodity prices have mostly been very well behaved and the oil price, despite rising geopolitical temperatures, has fallen. There are a number of reasons for this. First, while economic momentum has built, the world is not spinning at such a velocity to drag oil prices higher. In addition, in the West we are becoming greener and our oil intensity has fallen. In China, despite general increased usage, there are sensible government initiatives to curb pollution and their focus away from infrastructure has blunted the dragon's appetite for all resources. Another major factor suppressing the oil price (and other commodities) is the excess supply currently enjoyed, particularly in the US, where shale production is now a decisive factor. As we look forward, we struggle to envisage a demand driven influence on commodity prices in the short term. Longer term is a totally different story and we at Psigma are particularly worried over long term imbalances in foodstuffs and fertilisers.
So the good news is that we shouldn't fear the price at the petrol pump or the opening of our electricity bills. The bad news is that wage settlements across the developed world are meagre, particularly in our fair kingdom where wage growth is basically nothing. Mrs Becket had better buy just the one Mulberry bag this Christmas! In the US and Europe headline wage inflation is also contained, allowing the central banks breathing space with monetary policy. However, if one scratches beneath the surface of the data, there are clear inflationary pressures building in certain sectors, such as construction and high end manufacturing. We feel strongly that the US Federal Reserve and the Bank of England are missing the point when they look at the unemployment situation and wider wage inflation, as they mistakenly think that the long term unemployment in the former industrial heartlands of the UK, US and other developed economies is coming back. It seems unlikely to us that they will and this current distortion to the employment situation is creating an illusory disinflation picture.
As many potential new employees have become structurally unemployable, we would expect their influence on wages to diminish and we could start to see greatly improved wage settlements in the coming quarters, which could both spook central bankers and impact upon corporate profits. Ultimately central bankers should embrace this as it would help to break the secular stagnation in the developed world, although it would leave some unhappy souls behind.
The key link to our long-term fears of inflation is monetary policy and the distorting influence of all the cheap money that has been force-fed in to the financial system over the past few years. We are yet to know the true result and possible side-effects of the greatest financial experiment in history, but all past examples of such largesse have created issues; chief among them is inflation. The reason why quantitative easing has failed to stoke the inflationary fires thus far is that there has been a failure in the lending mechanisms and a mismatch in lending intentions. In short, those who want to borrow are not those that banks wish to lend to and vice versa. If at some point this situation changes then one could start to see a decisive move higher in lending and, subsequently, inflation. The loose money will end up somewhere and it could well lead to a mess. I wouldn't trust the central bankers to be able to remove excess liquidity “just in time”. In fact, I’m pretty sure they’ll mess it up.
So it makes sense to persist with an inflation-proofing strategy, despite the recent meagre rates of inflation. In fact, given the collapse in break-even rates of inflation-linked bonds and the fall in commodity prices, inflation-proofing can currently be achieved at reasonable prices. If we are right and the great disinflation that we are experiencing will eventually give way to higher rates of inflation, then taking measures to protect your assets now could be vital to your future wealth.
Tom Becket is chief investment officer at Psigma
A real risk of deflation
Expectations of inflation lie at the core of most investment strategies. The danger is that investors may not realise how much this matters. Although too much inflation is bad, moderate price rises favour shares over gilts or bonds. And, inflation is hard-wired into our psychology; few people expect prices to fall, other than temporarily. But some recent indications suggest deflation is now a real risk. How should investors react to a possibility of a radically different investment environment?
The gradual disappearance of price rises is the sort of quiet good news that does not make newspaper headlines. Yet, globally, inflation is now running at a five-year low. Within this, there are lows of four years or more duration for a range of commodities from corn and rubber, to iron ore and steel in China. In the UK, we see the benefits of cheap cotton in lower clothing prices, yet the press focuses on a perceived housing bubble. Deflation signals abound, but few investors seem prepared for the new environment.
Indeed, the suggestion of deflation might seem surprising when the UK economy is growing strongly, and the Bank of England talks about raising interest rates. Unemployment is also falling sharply, and it looks as if there is now much less spare capacity in the UK economy to keep the lid on prices. Yet, there are worrying signals. The most recent Bank of England quarterly report on inflation showed that wage growth has hit its lowest level on record. Average weekly earnings, excluding bonuses, are up just 0.6 per cent over the past year. Around the world, inflation is undershooting targets set by central banks. The European Central Bank’s Harmonised Index of Consumer Prices has gained just 0.3 per cent over the past year, compared to a 2 per cent target. This is the lowest level of consumer inflation in the eurozone since 2009.
Self-employment, low paid jobs, and the willingness of older workers to accept lower pay, suggest wage pressures are now muted. The 10 per cent rise in the pound from its lows of mid 2013 has also been a factor, as has intense supermarket competition. Discount retailing chains have moved mainstream, with additional deflationary pressure coming from the established major food retailers as they re-engineer their business model.
But, the most worrying trends are in continental Europe. Not only are some peripheral countries experiencing deflation, but investors have now driven German ten year government bond yields down close to 1 per cent. This is putting a high value on safety and suggests no fear of inflation. It also means that institutional investors may see little risk in holding cash deposits, given the marginal pick-up in income they would get from secure bonds. A recent survey suggested that institutional investors are holding much higher levels of cash than normal. This is despite the threat in Europe of banks charging depositors to hold cash, with Euribor overnight rates now negative.
The challenge of running a business in a deflationary sector has hit the big retail groups. Tesco recently slashed its dividend, alongside its third profit warning this year. It may now be tempting for Morrisons to follow in cutting its dividend to assist restructuring and potential growth. This pressure remains despite Morrisons claiming commitment to the payout.While shares on average offer attractive dividend income compared with returns on gilts or bank deposits, as Tesco has shown, the risk of dividend cuts increases with deflation.
When headlines feature rising house prices, it is easy to dismiss the thought of deflation. But pockets of rising prices can live within a generalised deflationary environment. Indeed, increasing prices for essentials such as housing, adds to the downward pressure on spending in other areas. It is these mixed signals that keep investors off-guard. Many of the official statistics point to the deflation story, but the concept itself is so alien that it is dismissed by most commentators, policy makers and central banks.
In the deflation of the 1930s, gilts and monetary assets such as deposits did well. Savers collected a real return just by sitting on cash. And the countries that tried to break out of the deflationary spiral were rewarded. Those that left the gold standard first were the first to recover. But, in the eurozone, it is hard for any individual member country to break free from Germany’s deflationary policies. Conventional measures and targets seem to be failing. A deflation risk may only be conquered when central banks are given more relevant targets for inflation, such as nominal wage growth.
For investors, the deflation risk may initially be helpful. It increases the likelihood of strong stimulation and money printing. But it may bring further competitive devaluations and dividend cuts, and even a break-up of the Euro. It would be a new environment for most investors; the best protection may be a balanced portfolio, including bonds and shares.
Colin McLean is managing director at SVM Asset Management
