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.
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.
In the eurozone, however, it is hard for an individual member to break free from Germany’s deflationary policies. Inflation will stay low while Germany persists in running a current account surplus and does not recycle this into the periphery.
If nominal GDP falls, the debt burden will rise on a shrinking base. Wealth taxes, rather than a bailout of the banking sector, might be the only solution. Without a break-up of the eurozone, the ECB may need to be much more stimulative.
The challenge for investors in assessing the risks is ‘availability bias’. Headlines remind us of a housing bubble, and it is difficult to reconcile this with the inflation indices.
Yet localised inflation in an asset class may not find its way into generalised inflation. It may even exacerbate deflationary pressures, as rising housing costs leave renters and borrowers with less spare cash.
Investors may have time to adjust. Analysts are optimistic about the prospects for reflation and it may take time for a new environment to bite on company profitability. Before this happens, investors might do better to consider the likely policy response.
Analysts might be slow to factor in deflation but politicians know it could harm their chances of re-election. So an unprecedented policy response seems likely, which should benefit financial assets.
It is hard to boost the real economy without leakage into stock markets and property. Equities may not peak until governments and central banks run out of imaginative ways to stimulate.