Deflation an unimagined world for investors

Experience drives what we recognise and forecast, but deflation is unfamiliar territory. Investors base analysis on what they know and understand; periods of stable or rising prices. But that is not the pattern now; Europe’s inflation outlook is steadily being revised down, but getting little attention. Even if the deflation risk is recognised, the problem is that no-one really knows where to start. How can falling prices be factored into financial planning and stock selection?

Moderate inflation is certainly a comfort zone for markets. But, this bias to anchor onto 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 under-shooting 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 under-shooting 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 ECB’s 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%. This conceals actual deflation in some of the peripheral nations of Europe.

In the UK, the CPI is a comparable benchmark, and has moved to a new four year low. But 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 own 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 1930’s, gilts and monetary assets such as deposits did well. Savers collected a real return just by sitting on cash. And the countries that tried to break out of the deflationary spiral were rewarded. Those that left the gold standard first were the first to recover. But, in the Eurozone, it is hard for any individual member to break free from Germany’s deflationary policies. While Germany persists in running a current account surplus and does not recycle that into the periphery, inflation will stay low. If nominal GDP falls, the debt burden will rise on a shrinking base. Wealth taxes, rather than bailing out the bank sector, may then be the only solution. Without a break up of the Euro, 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. Indeed, it may even exacerbate deflationary pressures, as rising housing costs leave renters and borrowers with less free cash. The paradox is a challenge for our thought processes.

But, investors may have time to adjust. Analysts remain persistently optimistic on the prospects for reflation, and it may take time for a new environment to bite on company profitability. Before that, investors might be better to consider the likely policy response. Analysts may be slow to factor in deflation, but politicians know that it could prevent 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 stockmarkets and property. Equities may not peak till governments and central banks run out of imaginative ways to stimulate.

A version of this article was published in the Behavioural Finance series in Citywire Wealth Manager on May 1 2014.

Disclosure: The opinions expressed in this article are my own, and may not represent the views of any firm or entity with which I am affiliated. The information presented in this article has been obtained from sources believed to be reliable, however, I make no representation as to their accuracy or completeness and accepts no liability for loss arising from the use of the material. Articles and information do not represent investment advice.

Image credit; Craig Murphy, Creative Commons some rights reserved.

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