Inflation or Deflation?
Inflation fell rapidly in every major economy during 2014 - see the graph below. In 2015 global inflation has temporarily stabilised at very low levels. What will happen next is the biggest question facing global investors.
Figure 1: Consumer price inflation in 5 large economies & Australia
The danger to the global economy that is posed by downward pressure on consumer and producer prices is a much larger and more enduring problem than a Greek exit from the Eurozone. The graph above shows global inflation levels in 5 major economies plus Australia since the beginning of 2008. The course of the GFC can be traced in this graph. It shows the three periods (shaded green) of rapidly falling prices in the GFC, which were only controlled by extreme government action.
Deflationary forces are stronger than commonly realised
To see how large the downward pressures on global prices are, ask yourself this: Where would inflation be in the absence of the massive programs of government spending and QE around the globe since late 2008?
25 trillion dollars of extra government debt has been accrued since 2008, in addition to 10 trillion dollars of central bank money creation (mostly QE). Inflation levels in the GFC have to be seen in the context of how much stimulus the global economy has received. When you consider that inflation in the major economies is close to zero after all that stimulus - the power of deflationary forces becomes clear.
Bulls and bears are sharply divided on how global inflation will evolve over the next two years. Fed Chairman Janet Yellen is an inflation bull. She believes that deflationary forces are sufficiently contained to allow the raising of US interest rates this year. Mohamed El Erian, the highly regarded ex-CEO of PIMCO, is an inflation bear. He said in April that he has moved all of his personal investments to cash because central bank action has pushed asset prices well above their fundamental values.
What happens if inflation continues to rise?
If global inflation rises from here, then the easy money policies that have so inflated asset prices, will be unwound and asset prices will suffer with that. If US inflation rises then the Fed will certainly start to raise $US interest rates this year. That will begin a rush for the exits in $US bond markets and all asset classes in emerging markets. The damage to commercial real estate and share markets will depend on how quickly the Fed raises rates. There is a real danger that the Fed goes too early and acts too aggressively in raising rates.
What happens if inflation falls?
If what follows from here is not rising inflation but instead a fourth episode of falling inflation in the GFC, then the global economy is in real trouble. The scope for additional government spending and depreciation of exchange rates against the dollar is limited. Much more QE will be needed - and will be forthcoming. That will put extra upward pressure on stocks, bonds and real estate and magnify the danger of bubbles inflating in those asset classes and then bursting; which would greatly damage already weak global economic confidence. Falling global inflation from this point is a dismal prospect, but one that investors cannot ignore.
How should investors prepare for either eventuality?
It is very unlikely that inflation will simply remain at its current low levels and neither rise nor fall - the opposed forces are too large. But we don’t know which way it will go. Commentators have strong views on what will happen, but strong convictions do not give anyone a crystal ball.
So, investors need to prepare for either eventuality - rising inflation or falling inflation. I think the asset classes that are best suited to either eventuality are infrastructure and bank hybrid notes.
Both infrastructure and bank hybrid notes have built in inflation protection. The revenues of infrastructure assets (airports, toll roads, electricity networks, etc.) are usually tied to inflation. Hybrid notes have coupons that float up and down with the level of short term interest rates.
Both infrastructure and hybrid notes are assets that generate relatively high yields compared to the amount of protection they will offer in any future (burst bubble) crisis. Infrastructure revenues hold up in an economic crisis because infrastructure usage is for the most part non-discretionary. Hybrid notes of the big banks receive the implicit government protection of the ‘too-big-to-fail’ status of the banks that issue them (see a previous article in this newsletter on the defensive qualities of hybrid notes, here).