It is some months now since developed nations embarked on a co-ordinated programme of increasing money supplies. The effects so far have been mostly seen in more stable European bond yields, and to some extent, in buoyant US equities and commodities. But longer term, the jury is still out on the impact that these measures are likely to have on global financial markets.
Three possible outcomes exist: deflation where prices fall and the real cost of borrowing goes up; reflation where prices stabilise and interest rates return to normal levels; and inflation where prices rise quickly and cause economic disruption, as central banks are forced to raise interest rates aggressively. Each outcome is very different, and this makes long-term investment tricky. It’s important to understand the differences.
First, deflation. With central banks now resorting to highly unconventional monetary policies and growth showing little sign of recovery, there is a risk that central banks have lost the battle against deflation. Under these circumstances a preference for bonds over equities makes sense. Equities only perform during deflations when growth makes an occasional re-appearance. Commodities are volatile and gold only performs when accompanied by financial chaos or massive monetary stimulus to counter it.
This is not an environment for taking leverage or excessive borrowing as falling prices leads to layoffs, and increasing numbers of people unable to service their loans. Investors should hold long-dated G7 bonds as these rise when inflation falls. Short-term USD bonds in emerging markets (countries with low debt levels) will also be attractive, as the policy response in G7 will be more money printing and lower interest rates.
If G7 central banks fail to deliver a revival, bonds denominated in local currencies in emerging markets will also become good value as recession and deflation will take on more global characteristics.
Second, reflation. If central banks have done enough to quell deflation, then it is most likely that the dominant theme will be the gradual recovery of growth, and an increase in pricing power that will improve corporate profitability and earnings growth.
Interest rates can slowly return to normal levels. Under these circumstances a skew in asset allocation towards equities is preferable as price stability, growth and the recovery phase of economic growth cycles is normally associated with equity performance.
Avoiding longer-dated bonds makes sense, except in countries that quickly increase interest rates to normal levels.
Thirds, inflation. If central banks have acted with undue haste and created egregious amounts of new money, then there is a serious risk of a breakout of inflation if rapid GDP growth returns much quicker than expected. This will be negative for bonds, eventually negative for equities and only positive for commodities and real assets.
Obviously you can’t have all three, all at once. Without central bank stimulus measures, deflation will probably define the rest of the decade. With co-ordinated central bank quantitative easing measures, it’s more likely that we’ll get reflation – but this isn’t guaranteed. This is almost everyone’s baseline forecast and it relies on banks being cleaned up quickly and returned to healthy lending practices (the US is almost there).
But the lessons of the 1930s should not be forgotten. Japan left the gold standard, printed money like crazy and ended up with massive inflation. Reflation can turn to inflation very quickly. Vigilance and doing your investment homework is probably more important today than it has been for a very long time.