By GRAHAM FROST 09/03/2009
The trend in inflation will be a decisive factor in determining how investors construct portfolios over the next few years. In fact, the degree to which you are a deflation or inflation advocate will influence what assets you will be willing to hold. For example, if you believe that mild deflation will occur now before a return to mild inflation by 2011, then you might want to fill your portfolio with shorter dated nominal gilts or investment grade corporate bonds since these will provide a real return of their yield plus the deflation number. If you believe in rising inflation though, you wouldn’t want to hold nominal bonds as the real return would be lessened by inflation. But if your view was that deflation would be dramatic and long lasting, the economic impact would be devastating and you wouldn’t want to hold corporate bonds either as the companies issuing them would all be going bankrupt. So, a view on the direction, magnitude, and longevity of inflation moves is clearly important so let’s examine the possible scenarios.
Governments can’t let treasury yields rise as that offsets the stimulatory effect of lower long term borrowing rates. The balance between borrowing more to spend fiscally and the negative impact of higher rates due to increased issuance is a tricky one and may be why the measure of printing money in order to buy bonds is being undertaken. As we saw in Japan, printing money - or quantitative easing - does not necessarily end in inflation. We could print a zillion pounds and stick it in a building, maybe even a bank, and nothing would happen - unless it was lent out. At the moment banks don’t want to lend and consumers don’t want to borrow.
Inflation is already in negative territory in developed economies. The main reason is that commodity prices are now half the level of a year ago. Excess capacity coupled with an inventory overhang and a long deleveraging process will keep pressure on the downside whilst infrastructure spending and commodity supply cutbacks will operate in the opposite direction. The catalyst for a change in direction will be a rebound in leading indicators, which seems unlikely before 2010 and even then a V shaped recovery looks doubtful. Food and energy prices will be key though. Some deflation is the most likely outcome at least for 2009. Should policy actions prove effective and the world resumes growth it seems unlikely that central bankers, having spent their careers in controlling inflation, will allow that particular genie out of the bottle. Wages are the key factor in entrenching inflation but with unemployment expected to rise for the next two years, approaching 10% in many places, labour costs will not be an issue. Whilst 2010 may not see normal service resumed, assuming things simply stabilise, as today’s numbers become year ago numbers, statistically inflation rates will turn positive. That should be more noticeable in the UK, where import prices are rising due to sterling weakness and the VAT cut gets reversed.
As credit extension and interest rates have plunged, lower house prices, rentals, and mortgage costs have depressed various inflation indices. In addition, consumers have had over $20tn wiped off their net worth and plummeting demand is being met by inventory liquidation at lower prices. Economists seem to be moving to the view that deflation of between -1% to -3% is likely by mid 2009 in most developed countries. The US and UK have not seen deflation since 1955 and 1960 respectively.