Is deflation the real threat?

If the global economy is slipping towards deflation, then recovery in the West may not be assured, notes Akash Prakash

The biggest surprise in the global economy over the past five years has been the near-total absence of inflation.

Despite the unprecedented monetary adventurism and all the money-printing, forward guidance and quantitative easing, inflation has mostly surprised on the downside.

With the notable absence of Japan -- where the policy response has been radical, but it’s not clear whether it is sustainable -- in every other large developed economy, inflation has undershot central bank targets and the direction of change has been consistently downward.

This comment is applicable to both core and headline inflation numbers.

Two per cent inflation, the target for most major central banks, seems to be a tall order.

If we are to move into a more disinflationary period, then historically such a major change in the inflationary environment has always been preceded by a certain number of sensitive prices falling in advance of the general price indices.

If we examine the situation today, we find that metals prices are falling, the deflator for world trade is in negative territory, export and import prices in the US are declining, and producer prices in both the US and Europe are at zero (according to GaveKal Capital).

Many macroeconomic forecasters have built predictive models on inflation, all of which highlight intense downward pressure on prices.

These leading indicators do seem to highlight that it is not a trivial probability that we are facing the possibility of a deflationary shock hitting the developed world.

Far from worrying about the debasement of fiat money and buying gold and other hard assets to protect purchasing power, investors have now begun to worry about a possible Japanification of the developed world.

In a post-bubble environment with high levels of debt, deflation leads to an increase in real debt levels and the pain of trying to de-leverage.

By raising real rates, it will also eventually suppress demand and economic activity.

While outright deflation must be avoided at all costs, even excessively low inflation has negative consequences.

Low inflation can occur for a variety of reasons, and not all are negative. It could be because of a surge in productivity, whereby unit labour costs decline, prices rise more slowly than wages, and real incomes rise.

Low inflation might reflect a large output gap, the result of growth below trend for many years.

It might also reflect a positive terms-of-trade effect.

A big drop in energy prices, as a case in point, will feel like a tax cut for energy consumers -- prices would fall relative to wages. Low inflation can also reflect shifts in relative prices and wages around the world.

This bout of disinflation, however, seems to trace its roots to being an unintended consequence of monetary stimulus.

Unconventional monetary stimulus works through two primary channels: asset prices and the exchange rate.

It is the second effect that may have forced inflation down globally, not so much in the countries adopting the unconventional stimulus but in those that have not gone down this path.

For, these countries have had to endure rising nominal exchange rates, thereby driving down import prices and curtailing the pricing power of domestic producers.

The countries using unconventional monetary policies have effectively exported disinflationary pressures globally.

This unexpectedly low inflation creates a dilemma for central bankers. Falling unemployment rates may warrant an early rate hike, while lower inflation may point to a delay in raising rates.

In all likelihood, central bankers will err on the side of caution and delay rate hikes. No one wants deflationary tendencies to set in, since they lead to an increase in real interest rates and a rise in debt servicing costs, and are corrosive for the real economy.

In a truly deflationary environment – with no expectations of rising wages or prices -- households and companies will have no incentive to spend, which will likely delay the onset of a sustainable recovery.

Without the revival of an investment cycle in the private sector, there is no way that the economies in the West will be able to attain escape velocity and grow sustainably without the crutches of central bank support.

It presents a dilemma even for investors.

If we are going down the road of deflation, we need to focus our asset allocation on buying those assets that have a negative correlation with the inflation rate. Historically, this asset has always been long dated, high-quality government bonds.

Yet it is also this very asset class that screens as being very expensive and almost in bubble territory.

Most investors have been very clear that they need to move out of bonds and into equities.

This may be a wrong move if we are truly moving into a deflationary set-up.

Cash will be king, and leverage must be avoided at all costs.

The option of having cash is invaluable at such times.

The US dollar will strengthen and commodities and gold tend to do poorly.

The worst hit will be stocks and sectors with leverage, and financial institutions could once again come under intense pressure.

Quality will once again be fashionable, with investors willing to pay up for pristine balance sheets, pricing power, dividends and cash flow.

Let us hope we are not going down the road to deflation, which could turn the investment environment on its head and rekindle fears of excess debt and de-leveraging.

The writer is at Amansa Capital