Investors split over the deflation dilemma
By Richard Milne
Published: October 14 2010 19:04 | Last updated: October 14 2010 19:04
Investors are torn between two extremes. Is the US heading for a decade of Japan-style stagnation characterised by years of falling prices – or will the hundreds of billions of dollars likely to be pumped into the economy by the Federal Reserve lead to the opposite: rising inflation?
That is the biggest unanswered question in financial markets. On Thursday, the near certainty of Fed action drove the dollar to its lowest level this year against a basket of currencies. Yields on short-term government debt hit record lows.
The fixed returns and relative safety of sovereign bonds should make them an attractive bet in a deflationary world. But stocks on Wall Street and in Europe are also rallying strongly, while the prices of many commodities are soaring.
If deflation is imminent, there is no sign of it in equities and commodities trading. In fact, shares are rising on the belief that a big dose of quantitative easing will encourage bank lending and keep the dollar low, leading to stronger growth. That, the Fed hopes, will lead to rising prices.
“Investors are quite schizophrenic at the moment. They are worried about deflation in the short term but are concerned further out about inflation,” says Keith Wade, chief economist at Schroders, the fund manager.
“It means they will have to change horses over the next year or two.”
Few investors reckon that prices will fall persistently, especially with the Fed determined to head off that outcome. But, with economic growth still anaemic and core inflation at less than 1 per cent in the US, the immediate threat is clear enough.
“The deflation risks are probably higher than the inflation risks,” says Richard Urwin, investment head in fiduciary mandates for BlackRock in London. “While we are in a low-growth environment, these deflation concerns aren’t going to disappear easily.”
Richard Batty, strategist at Standard Life Investments, says: “The risks with inflation are still to the downside, although there are a lot of unknowns currently. The worry is that central banks, having spent the last 35 years devising policies to combat inflation, face the prospect of deflation, of which they have little experience.”
Mr Urwin says the risk of deflation has already been well priced into markets. Yields on benchmark government bonds remain close to record lows in Germany and the UK, and close to multi-decade lows in the US.
Indeed, at little more than 2 per cent, 10-year yields in the three countries are not that far from the 1.5 per cent average for the past decade in Japan.
Yields on inflation-linked bonds are also close to record lows. But, if anything, demand for these bonds has been stronger recently because of the protection they afford from rising prices. Inflation expectations in the US, measured by the difference between cash Treasury bonds yields and those on inflation-linked debt, are at their highest since June.
Gold, too, traditionally seen as a hedge against inflation, has hit a nominal record. One senior US fund manager says: “Gold is setting new highs every day. That is your inflation hedge. And bonds are your deflation hedge and they are setting 50-year lows. Something has to give.”
Investors, unsurprisingly, are analysing Japan’s experience of the past two decades. But, beyond the widely held view that falling prices are positive for government bonds and negative for equities, they are wary of reading too much into the country’s “lost decade”. “I’m sceptical that Japan is a useful yardstick. The reasons were specific to Japan,” says Mr Urwin.
Some even doubt that a period of deflation would be as catastrophic as some economists have been warning. “Will the sky fall in if deflation happens? The sun still rises over Tokyo,” says one fund manager.
Mr Urwin says that, in true deflation, prices are not just falling, but people expect them to continue falling. It is then that their behaviour changes: by holding on to savings rather than spending, for example.
“There are environments that might feel deflationary but are actually just periods of disinflation,” he says.
Still, a number of strategies for hedging against deflation have arisen. Schroders suggests investing in emerging market debt. Goldman Sachs points to hedge funds because of their nimbleness.
But the main problem for investors is that, while many are adept at pricing in the possibility of events, it is more difficult to jump quickly from one extreme to another. What might be a good investment for deflation could be a terrible one for inflation.
“There is a conundrum in that quantitative easing is pushing yields down but the market thinks it will lead to inflation eventually. It is a puzzle as to how that will be resolved,” says Johan Jooste, strategist at Merrill Lynch Wealth Management.
Investors are likely to want to stay flexible. Christian Hille, co-head of the multi-asset team at DWS, Germany’s largest fund manager, says: “It’s probably 50-50 between deflation and inflation. You need to play very short term, not look for themes for two to three years. We are in a trading environment.”
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Questions:
1) According to the article, should investors be considering the market to be in a state of inflation or deflation?
2) Why can investing in a market of uncertainty be difficult? What strategies are offered?