The looming spectre of deflation could prove disastrous for equity markets.
Equity markets hate high inflation, but their fear of negative inflation is even greater – just look at the disastrous performance of the Japanese stock market over the past two-and-half decades.
My warning follows the announcement this week that inflation in the UK, as measured by the Consumer Price Index, fell to just 0.5% in December. This is the joint lowest level since records began.
Meanwhile, the World Bank this week cut its forecasts for global economic growth in 2015 amid concerns about the faltering performance of many of the world’s leading economies, the poor confidence of both businesses and consumers, and the limited ability of central banks to cut interest rates any further to provide assistance.
In my opinion we are certainly set to remain in a low-inflation environment. And while I am still hopeful that the UK can avoid deflation, there is now the possibility of these headwinds pushing us into negative inflation territory.
If those fears are realised, investors across all asset classes will need to reassess their portfolios.
Equity investors have every reason to be afraid of deflation. As prices fall, real interest rates rise, the real value of debt held by the private sector increases, while the revenues corporations earn fall as customers hold back spending in anticipation of cheaper prices later on. In the worst-case scenario, this can cause a deflationary spiral with disastrous effects.
Deflation is generally better news for bond prices. The fixed coupon payments that bonds typically offer become more valuable in real terms during a period of deflation. At the same time, falling interest rates lead to falling bond yields and higher capital returns.
However, the effect of deflation on bond markets would, in practice, be difficult to predict, since central banks would be likely to respond to a serious deflationary threat with a renewed programme of quantitative easing.
The most reliable leading indicator of recession I know is an inverted or negative yield curve. We’re not there yet, but we’re heading there quickly. Since inflation is already low, a recession would be very dangerous. It is time for the government and central bank to act preemptively.
Other asset classes
Deflation would also have an impact on other asset classes. Previous rounds of quantitative easing have, for example, been associated with a sharp rise in the gold price, which is seen as a hedge against the inflation of the monetary base associated with quantitative easing.
On the other hand, the increasing real cost of servicing debt could hit the property markets, as would the inability of struggling companies to cope with the cost of commercial property.
The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca Investment Managers and do not constitute investment advice. Whilst Seneca Investment Managers has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.
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