The ups and downs of inflation

In early September, Mario Draghi, president of the European Central Bank (ECB), cut interest rates to a record low of 0.05 per cent and pledged to buy hundreds of billions of euros of private sector bonds in a dramatic move to save the eurozone from economic stagnation. This followed the targeted longer-term refinancing operations measures (LTROs) unveiled in June, which aimed to get banks lending.

A major reason for this intervention was to stave off the threat of deflation in the eurozone. Policymakers across the developed world have set a target of 2 per cent as the ideal rate of inflation, but the eurozone, hit by slower than expected economic growth and soft commodity prices, has rates closer to 0.3 per cent. And once deflation strikes it can be very hard to shift – in the mid 1990s Japan entered a deflationary spiral that has persisted to this day.

The general public are right to fear deflation and policymakers need to be vigilant in fighting it, says Brian Jacobsen, portfolio strategist at Wells Fargo Asset Management.

“You would think that lower prices are good, but it is not good when wages are falling even faster. And it is not good if you have debt, which is normally stated in nominal terms, so when inflation falls the debt burden goes up.” This can lead to a deflationary debt spiral, when debt burdens go up, bankruptcies increase and credit markets seize up, which creates all sorts of havoc, he warns.

However, Mr Jacobsen believes it is unlikely that the eurozone will dip into deflation. The contraction of credit, one of the major causes of the disinflationary environment, should begin to abate after the ECB begins its long-term refinancing operations. Instead he predicts the eurozone will turn from disinflation back to more normal levels of inflation over the next few months.

Much of the deflationary pressures have been driven by banks re-shoring their balance sheets and a decline in lending since 2009, but Mr Jacobsen believes some sectors are beginning to slowly increase lending. And the ECB’s moves have added to this momentum, particularly the LTRO initiatives announced in June.

“They should have done that sooner,” he says, “but they were trying to figure it out. A lot of monetary policy is experimental. They learned from the first time they tried the LTRO that there needed to be more strings attached this time.”

The ECB’s policy has provided some degree of commitment to tackle the decelerating inflation in the currency union, agrees Fadi Zaher, head of currencies and fixed income at Kleinwort Benson, but they must see it through. “In the future, the biggest risk is that the ECB does not follow through on their monetary expansion to change the course of direction for inflation in the euro area,” he warns.

Since March, Kleinwort Benson has been advising clients in multi-asset portfolios to increase government bonds to mitigate against the risk of falling inflation in the euro area, though this should change as long as the economic situation improves. “On a six to 12 month view, investors should rotate more into equities as we expect deflation risk to fade away with the quantitative easing by the ECB,” adds Mr Zaher.

Those who are saying the eurozone does not have inflation below zero and is therefore not technically in deflation are missing the point, says Sanjay Joshi, head of fixed income at London & Capital, as consumers and companies are already factoring it in. Retail spending is exceptionally weak in a number of countries as consumers wait for the next discount before they buy, while companies are not really accelerating on capital expenditure, which is a classic sign of a lack of demand and deflationary forces taking hold, he warns.

In addition, core countries such as France, Germany and the Netherlands, are seeing a lack of wage pressures because of the fear of unemployment and under employment.

Mr Joshi asks: “If deflation wasn’t here, why would the ECB be throwing not only the kitchen sink but the bathtub at the problem? They not only cut all interest rates but the deposit rate to -0.2 per cent and also announced a potential asset backed securities purchase programme. That all suggests there are serious concerns within the ECB council that we are already there and we need to counter it.”

The ECB is trying to force banks to increase lending and to try to create demand and increase economic growth, in the hope that this will eventually lead to higher inflation, but Mr Joshi warns this is a very long-term game and he harbours fears that it will end in failure.

The ECB does not have an easy job in balancing the demands and opinions of all the players across the eurozone and has to find some kind of consensus before it acts, he admits. “But the reality is that markets and economists have been telling them that deflation has been on the door for the last six months, and we have all been waiting for something to happen. The ECB waited far too long to act, which is why they tried to announce a great deal, and it isn’t clear that it has been well thought out.”

London and Capital has been taking advantage of the sovereign yield curve in its fixed income portfolios. “We have been long on duration in the bund market, we have been taking advantage of the narrowing of spreads between France and Germany, Italy and Germany and Spain and Germany,” says Mr Joshi.

The ultimate aim of the ECB is to try and reliquify and strengthen the banking system, he believes, and so rather than get involved in illiquid parts of the market, he is looking to take advantage of subordinated debt, the new contingent convertible bonds structure in the banking system, and the new issuances originating from the larger European banks.

It is also worth looking at high yield European corporate bonds, he says. “Clearly, if the banking system will be moving to support SMEs and larger corporates, we particularly want to focus on those high yields that have already reduced leverage and have the ability to utilise what the ECB and the banking system may do.”

Deflation in the eurozone is one of the larger economic risks out there, along with the geopolitical situation and emerging market credit excess, believes Eric Lascelles, chief economist at RBC Global Asset Management, but is unlikely and even if it happens it should be brief.

“Firstly you have the actions that the ECB is putting in place, but then you also have to consider just how rare deflation actually is,” he explains. “Outside of Japan there isn’t that much precedence for it. And you can argue Japan’s deflation was largely due to policy error.”

The ECB has been frustratingly slow to act and, until recently, far too orthodox in its actions, argues Mr Lascelles, though its “committee” nature made a bold and innovative approach virtually impossible, but it has eventually managed to calm the situation.

“Mario Draghi as the hero in the cape and the ECB swooping in and promising ever more stimulus will be helpful, partly in terms of money supply but much more in terms of the confidence it injects,” he says.

There is roughly a 30 per cent chance that the eurozone will slip into deflation, believes Subitha Subramaniam, chief economist at Sarasin & Partners, but she agrees negative rates of inflation would be unlikely to persist beyond the short term, as these would be countered by aggressive ECB action aimed at weakening the euro and increasing prices.

She explains that a strong euro and weak energy prices would put further downward pressure on inflation. “With no control over the level of oil prices, the ECB has realised how critical it is to keep the euro on a weakening trend. With this in mind, the ECB will do whatever it takes to ensure that the euro continues to depreciate,” adds Ms Subramaniam.

Other side of the coin

The outlook for long-term inflation is one of the key factors driving Sarasin’s thinking on strategic asset allocation, and the bank is worried that investors have not fully priced in the effect that ultra-loose monetary policies may have going forward.

“With central banks seemingly more focused on active demand management than inflation management, there is a real risk that monetary stimulus is kept in place for longer than needed by the economy.” This is particularly true in the US, she says, where labour markets appear healthy, growth momentum strong and pent up demand from capex is finally coming through.

Central banks have been deployed huge measures to counter deflationary pressures in recent years, says James Carrick, economist at Legal & General Investment Management (LGIM), and he is confident the worst of this cycle is now over. LGIM’s economic model says there is a 90 per cent chance that global inflation will be a rising trend as we head into 2015, though it does not indicate how strong this will be. The model does suggest that inflation in the eurozone is likely to remain too low for comfort, says Mr Carrick, but the US and UK should see higher levels.

“Ultimately, this means that a divergence in central bank policy is likely,” he says. “We have already seen a change towards more hawkish rhetoric from the Federal Reserve and Bank of England.” 

If the LGIM model proves correct he predicts this to become more pronounced, resulting in rate hikes in the US and UK, while the ECB continues easing.

“Over a medium to long-term basis you have to have in the back of your mind that the central banks have pumped so much money into the system to deal with the effects of the global financial crisis, that if that money ever starts to move it must surely be inflationary,” says James Knowles, head of fixed interest at Psigma Investment Management.

He does not believe there is a huge inflationary threat over the short to medium-term, but warns all the money in the system has to be treated correctly.

“The heavily indebted developed world sort of needs inflation because it has no way of paying off the accumulated debt,” explains Mr Knowles. “So governments and central banks will do their best to ensure that inflation remains positive. And there must be a risk that over the medium to long term the money that is stuck in the system gets loose.”

He suggests that investors should at least try to counter the risks of inflation by having some exposure to inflation-linked bonds. Although these do not present great value at the moment, they do offer some protection if inflation rises as well as steady, if unspectacular returns.

However, private clients need to understand that these instruments would not necessarily protect them if inflation really got out of hand. “If that happened the conventional market would get smashed and inflation-linked would get beaten up slightly less. It might be unlikely but clients need to understand that they would probably not get the protection that they were expecting.”

Traditional causes of inflation seem to offer little cause for concern in the immediate future, says Mr Knowles. “The energy revolution in the US means there won’t be upward pressure on oil and gas prices unless something like Iraq blows up. And there is sufficient supply of hard commodities to meet demand in the coming years.”

There are concerns about higher inflation in the US, admits Mr Jacobsen at Wells Fargo, but he is confident that the Fed has the necessary tools to combat any rise. “The question is whether or not they are willing and able to use them. If the Fed sees that the banks are beginning to expand credit much more rapidly than the economy can absorb, they have the ability and willingness to tweak the interest on reserves and use their regulatory muscle in order to keep inflation from getting out of control.”