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Colin McLean: investing through the coming deflationary shock

by Colin McLean on May 07, 2014 at 14:34

Colin McLean: investing through the coming deflationary shock

Investors like to model and forecast, but it is their experience that drives this.

The analysis framework is therefore based on what they know and understand. Big issues such as deflation are ignored, as few have lived with it. Even if the risk is recognised, no-one really knows where to start. How can falling prices be factored into financial planning and stock selection?

Moderate inflation is a comfort zone for markets, but this bias to anchor on what we know could be one of the biggest investment challenges of the next few years. Inflation around the world is targeted at 2%, yet is undershooting in many major economies. Each month’s inflation updates bring the US and Europe nearer to deflation, quietly and without headlines. 

Politicians invite us to celebrate ‘lowflation’, as if undershooting a target is not really a miss. Yet deflation would be a step into an unimagined world for almost every investor. Preparing for change is hard when our experience creates an unhelpful bias.

Confusing signals

Certainly, mixed signals are confusing investors. Differing measures of inflation create noise and confuse the trend. Yet the European Central Bank’s (ECB) Harmonised Index of Consumer Prices (HICP), is probably the measure that matters most and shows a persistent downward trend. 

The ECB views price stability as keeping the year-on-year increase in HICP below, but close to, 2% for the medium term. Yet inflation is stubbornly sticking below 1%, which conceals actual deflation in some of the peripheral nations of Europe. 

In the UK, a comparable benchmark is the CPI, which has moved to a new four-year low. But this is not a cause for concern according to the government, which celebrated that it made real earnings look good.

In the US, the Federal Reserve target is 2%, measured by core Personal Consumption Expenditures (PCE). This is running at 1.1%, and the Fed’s economic model recognises that policy is less predictable when interest rates and inflation are very low. Policymakers and investors need to look far back into economic history for precedents. 

In the deflation of the 1930s, gilts and monetary assets such as deposits did well.  Savers collected a real return by just sitting on cash and the countries that tried to break out of the deflationary spiral were rewarded. Those that left the gold standard were the first to recover.

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