For the past month, the investment question that has occupied most of my time has
been whether we should be positioning for rising or falling prices. Recent investor
meetings, both in Russia and in Western Europe showed that this question was at the
top of client concerns and – considering the market dynamic – this is not surprising.
Developed world price indicators charged toward zero over 1H09, and yet as they did
so the market moved in a reflationary manner.
Five year breakeven inflation indicators (see Chart 1) leapt from near zero to trade in
the 1-2% range, and famous investors like Hugh Hendry haemorrhaged money betting
– ironically accurately – that prices would fall. It all matters, because history teaches
that elevated inflation uncertainty (which could be broadly defined as inflation either
above 5% or below -1%) is highly negative for corporate performance. Whether you
are investing for the long- or the short-term, you need a clear view on inflation to
position with confidence.
As the breakevens snapped back to positive, I commented that the move reflected
normalization rather than surging inflation. This view reflected my sympathy with both
sides of the debate. Those fearing deflation point to:
- The actual decline in price pressures taking place;
- The sharp contraction in demand, creating enormous spare capacity, measurable by
the output gap.
Meanwhile, those fearing inflation see:
- A massive surge of liquidity, money that has to get put to work (especially in a zero
interest rate environment), which should surely show up somewhere in the pricing
system. Or, following the Fed’s logic, which should help sustain asset prices – ergo
household wealth – so as to reduce the scale of spending retrenchment by end
consumers;
- Single-minded determination on the part of central banks to do whatever it takes to
prevent deflation from taking hold (the sentiment that arguably drove breakevens so
sharply back to black);
- A far smaller than reported output gap, as the outlook for potential growth is much
less bullish than was the case in previous years.
The two sides of the argument are well framed, and neatly divided by time. It can
clearly be seen that deflation is a reality, but, inflation will come back. Yet, so far,
playing the deflation trade was only effective as the world melted down in 2H08. Many
would now agree that developed world equities are over-priced and due a correction.
And, there is a good chance that such a correction will be based on declining economic
confidence (the now thoroughly boring and seemingly universally accepted “slow
recovery” thesis). But, when the down-draught comes, will it pay sufficiently to be
positioned for deflation?
Until recently I would have argued yes. Clearly there should be some reversal of the
reflationary sentiment of recent months, and I have the greatest respect for Hugh
Hendry who has not only held his line through an impressive mark-to-market, but done
so publicly. But, a realistic assessment of where we sit in 2H09 causes me to revise
this position.
Yes, deflation will continue to play out in the real world as unemployment edges up
further over the coming months. And yes we should eventually see this impact on
market prices. But 2H09 is likely to bring some green shoots. Not the “getting worse
less quickly” variety but the “helpful YoY comparison, plus inventory rebuilding, plus
fiscal stimulus starts to take effect” variety. Market consensus sees the recession
ending either late this year or early next (albeit with a weak recovery).
In reality, the picture remains complicated if you look further out: Spare capacity in
China, which fed the Great Moderation by pushing rates down in the last decade or so,
weights up against central bank vigilance and the potential for greatly expanded QE
(somebody is going to have to buy all that government debt coming to market around
the world).
Last week Timothy Geithner assured Bloomberg news that the authorities have no
intention of making the same mistake of past – taking away the stimulus too early and
choking the recovery (as happened in the US in the 1930s and in Japan’s “Lost
Decade”). Leaving the punch bowl at the table too long creates a real risk of another
asset bubble, but the authorities will clearly favour that over a Great Depression style
double dip down.
The markets now trust the central bankers to do what it takes. In the near term we
can expect a dose of weak demand inflation. In the longer term, be ready for
coordinated global monetary expansion to anchor inflation expectations in positive
territory – arguably the fiscal authorities already see this, and are already spending the
QE to come.
The system is mildly deflating, but economic dynamics are changing – and the market
is edging closer to the green-shoots era that the equities rally supposedly predicted. It
may not be enough to get us out of deflation definitively, but the market is putting its
faith in the central banks’ readiness to go further.
If we learned anything from history, then this ought to bring enough residual demand
to keep chronic, systematic deflation at bay, even while the global spare capacity
stands ready to meet growing demand.
We are not about to enter a strongly bullish growth dynamic, but the recession is
closer to its end than its beginning. With that in mind, I value inflation uncertainty as
being low. That may sound anti-climatic, but it means I am now far less concerned
about systematic deflation.
