Daily Themes - 5 August 2010

Deflation risk and investment implications

If historical relationships between output gaps and consumer prices hold, the US economy is headed toward deflation in the next year. While there is little in the way of past deflationary experience to draw on, government bonds look likely to benefit as rates remain at their extreme lows for the foreseeable future and quantitative easing (QE) restarts in the US and other major developed economies. Gold is also likely to remain in strong demand as the ‘ultimate’ currency. For equities, financially weaker companies and those that are sensitive to the domestic economy look most vulnerable.

The combination of spare capacity built up during the great recession of 2008/09 and the anaemic nature of the subsequent recovery is in the process of pushing the major advanced western economies into consumer price deflation – a state Japan has been mired in pretty much continually for a decade. In the US, headline inflation is just 1.1%, down from a pre-recession peak of 5.5% and core, which excludes food and energy, is 0.9%. The picture in the euro-zone is pretty similar with headline inflation falling from 4% before the financial crisis to 1.4% now and core inflation running at just 0.9%, the same as in the US. So far, the decline in UK inflation has been more modest with headline inflation falling from 5.2% to 3.2% and core inflation running at 3.0%.

The relative "stickiness" of UK inflation partly reflects sterling’s slight depreciation over the past year, but is also the result of increases in a variety of indirect taxes and duties as the government has strived to start rebuilding the public finances. Were it not for these tax increases, UK headline inflation would be 1.6% rather than 3.2%, much more in line with inflation in the US and euro-zone.

Monetary Policy will be eased further

If historical relationships hold, the current level of spare capacity in the US economy suggests that core inflation is likely to go negative over the coming year. Central bankers fear deflation even more than they do inflation, which is more of a known quantity and something they feel they know how to deal with. Consequently, increasing signs that the major advanced western economies are heading for deflation will cause central bankers to engage in further QE in an attempt to avoid such an outcome. It almost goes without saying that against this backdrop, base rate rises are likely to be off the table for the remainder of this year and next. The US Federal Reserve (Fed) has been much more openly engaged in the debate about deflation risks and policy options than either the Bank of England (BoE) or the European Central Bank (ECB). So of the three, the Fed seems likely to loosen monetary policy first.

Government bond yields likely to fall further

Already historically low US, UK and German government bond yields are likely to fall further amid falling core inflation rates and the growing realisation that interest rates are set to stay where they are and central banks will need to engage in bond-buying to thwart the deflationary threat. This is also likely to lead to further curve flattening, or a drop in long-term yields relative to shorter-dated yields.

For example, if US core inflation hits zero by mid- 2011, as we expect, then US ten year yields could fall to a range of around 1.6-2.1% from their current 2.9% level, provided that past relationships hold. Such a fall in yield would generate a total return on US 10-year Treasuries of around 9-14%.

If core inflation were to go significantly negative, which we would expect if the output gap remains at current levels for more than a year, then ten year yields could fall even further to somewhere between 1.2-2.0%. As inflation rates continue to fall and deflationary concerns become more widespread, we expect break-even inflation rates to decline and index-linked government bonds to underperform conventional government debt.

Currencies

We continue to favour emerging-market currencies to the major reserve currencies of the US, UK and Europe. We expect all the reserve currencies to depreciate as their central banks keep rates on hold to counteract fiscal tightening and electronically print money for bond-buying/QE purposes.

Gold to gain as deflation brings uncertainty

Deflation is not likely to be a supportive environment for commodity prices, with the notable exception of gold. Gold is likely to benefit from macroeconomic uncertainty that will come with entering the largely uncharted waters of deflation, and from the dollar weakness that will come with further QE.

Little history to go on for equity implications

Japan’s experience of deflation for the last 12 years can be used as a guide, but with some caution given the isolated nature of the deflation and a very slow implementation of QE. Nonetheless, Japan’s export-oriented sectors have outperformed domestically focussed sectors for more than 20 years. Financials have underperformed, as have those sectors with weak balance sheets.

Given the limited historical experience of deflation, anticipating potential problem areas in equities is largely a theoretical exercise. An appropriate approach would therefore be to identify the economic consequences of deflation and its potential impact on specific sectors and investment styles.

While labour costs have become more flexible in recent years, they remain rigid enough that companies with large labour forces will be reluctant to hire new workers in a persistent deflationary environment. Deflation would also exacerbate large pension deficits, and we would therefore expect companies with wage-intensive cost structures and large pension obligations to underperform. Falling prices would also cause consumers to delay spending on durable goods.

Defensive sectors in general are likely to outperform cyclical areas. Other outperformers could include monopolies, given an inelastic revenue base, and large companies with a high proportion of foreign revenues that would be boosted by a weak domestic currency. Companies with strong balance sheets would outperform those with weaker balance sheets. Finally, sectors used to deflation, such as technology, and companies exposed to areas of the world without deflation, would also outperform.

Conclusion

Deflationary appears pretty likely in the US within a year, a development that would be unprecedented in the modern world outside of Japan. In such an environment, government bonds appear likely to make positive returns. In equity markets, deflation would be likely to cause a marked divergence in sector performance. Finally, as central banks look for unconventional means to thwart deflationary forces, the prospect of more dollars, pounds and euros rolling off the printing presses will increase the allure of emerging currencies and gold.

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