Inflation or deflation? That is the question for investors
As if their investment decisions are not difficult enough, fund managers have the added complication of deciding whether they are facing inflation or deflation.
Inflation is one of those metrics that grab the attention. In Germany, this has well-known historical roots, and explains the former Bundesbank’s, and now the ECB’s, determination to fight any increase in the basic rate.
The ECB has a fixed policy of ‘anchoring’ inflation at an averaged 2% across the eurozone.
Despite the ECB’s best efforts, inflation in the eurozone economies over the past year has trended up, reaching 3%, a three-year high and well above target.
In the global context, eurozone inflation remains one of the lowest, along with that of the US and Japan.
Everywhere else around the world, the inflation norm is more like 5% or more.
Within the eurozone, inflation develops differently from country to country, says Philippe Waechter, chief economist at Natixis Asset Management.
Comparing the Spanish, German or French inflation rate is impossible, he says, but he believes their inflation profiles are similar.
This means that although the eurozone countries have different inflation levels, the evolution of their respective inflation rates often follows a similar pattern and turning points occur simultaneously across the eurozone.
Inflation across most of Europe may be low, but it has been under pressure from rising commodity prices.
Waechter says this pressure is expected to ease in the short term, as a slowing global demand will restrain commodity, food and oil prices, and therefore also the inflation rate.
John Greenwood, chief economist at Invesco, agrees. Emerging market economies are seeing increased interest rates, tightened credit and reduced demand for their exports.
As a result, he says:“My expectation is for no further increases to the CPI over the next 12 to 24 months.” In the developed economies, the sovereign debt crisis will mean the extended deleveraging process will continue, which can have both inflationary and deflationary effects.
In the long run, Waechter believes the ECB is unlikely to change its inflation target of just under 2%.
However, he thinks the incoming president of the ECB, Mario Draghi, could be more flexible than his predecessor, Jean-Claude Trichet.
This would mean future ECB inflation rates could oscillate by +/-1% depending on economic circumstances.
Low inflation will mean low bond returns, Waechter says. He does not believe the ECB will significantly alter monetary policy, and says inflation in the short term will not affect asset allocations. Inflation also has no impact on how Natixis handles its corporate bond allocations.
Jon Mawby, lead portfolio manager at European Credit Management, a London-based fixed income specialist, says the elevated inflation levels in the developed world “should not feed through to a condition of permanently higher inflation as the underlying rise in price levels isn’t feeding through to wage price inflation”.
Corporate profitability is rising, unemployment levels remain stubbornly high and real wages flat to decreasing.
Inflation may continue to trend higher, but sluggish demand is causing central banks to fear deflation.
Increasing levels of unemployment, global austerity programmes, increasing price levels and rising volatility in economic data all serve to keep this demand level depressed.
Therefore, Mawby says: “Medium-term deflation is likely to continue to be more of a threat to developed economies than inflation.” But, in the long term, the use of quantitative easing (QE) by central banks since the early months of 2009, in a battle against weak demand, has “an uncertain outcome”.
Monica Defend, head of global asset allocation research, Pioneer Investments, says inflation expectation for the US and eurozone has risen gradually through this year but “we do not expect any second-round effects (via wage and salary inflation) to drive inflation any higher for an extended period of time”.
She adds that inflation will come back in line with the ECB target of 2% within three to six months, with some upside risks posed by the statistical effects coming from VAT hikes that took place, for example, in Italy.
In the US, too, Defend expects the headline inflation rate to gradually moderate toward the 2% threshold within three to six months.
The current global system of fiat money is as much of an experiment as the eurozone, says Mawby.
“In combination, the counter-cyclical monetary policy tools promoted so much by politicians and central bankers in the last 20 years are beginning to be, or are already, defunct and redundant.”
Ultimately, he says: “Global QE, zero or near zero interest rate policies and continuous stimulus pumped into a fiat monetary system has unknown consequences. However, it certainly has the potential to unhinge inflation expectations.”