It is very hard for most people to realize that the world has been – and still is – dealing with a global disinflationary wave. Central banks around the world are very worried that this disinflationary swoon will likely produce deflation. Japan shocked the world recently when they announced new allocations for their $1.2 trillion pension fund. The fund will allocate far less of its assets to Japanese Government Bonds (JGBs) and push greater allocations to equities both domestic as well as international. This move touched off global rallies in the equity markets.
Why do central banks fear deflation? Are trending lower prices really that bad? Deflation is just the opposite of inflation and has the effect of increasing the purchasing power of currency. Wouldn’t the gradual increase in purchasing power of a currency actually raise the standard of living for people who are on a flat income? If your dollar actually went further wouldn’t that be better?
Unfortunately, it is not better. Japan is the poster child of what the long-term effects of deflation can have on an economy. In 1989 the Japanese Nikkei 225 Index crested at 38,957. That same index recently traded above 17,000 for the first time since 2007. The harsh truth for Japanese investors is that 25 years after hitting an all-time high their asset prices are only 43% of where they peaked. Japan has showed the rest of the world the ugly underbelly of deflation. One of the ill effects of deflation is a destruction of consumer demand. When people think that prices will decline in the future they tend to put off purchases. Capital expenditures are subsequently delayed or cancelled because demand drops. Profits erode because of lower prices, so businesses suffer. Governments collect less tax revenue because of slower consumption and profits, yet public debt levels stay the same. In short, deflation is feared by central bankers because it can ruin economies.
The U.S. Federal Reserve began a grand experiment when they launched their asset purchase program now known as quantitative easing (QE). They expanded their balance sheet by over $3 trillion buying U.S. debt and mortgage obligations. The short-term results were mixed as asset prices rose nicely, but aggregate demand has still remained sluggish. Many expected such an aggressive move to produce inflation as the massive creation of dollars was pumped into the economy. However, that has not yet occurred. The Bank of England, Japan and now the European Central Bank have, or have indicated they will, institute their own QE asset purchases. Many more global central banks of developed countries are witnessing their own economies slowing as demand softens thus more adopt the QE experiment.
Nobody knows what the long-term effects of QE may be. It has never been attempted before to this magnitude. At this point, much of the currency created by the Fed’s QE purchases ironically sits on the Fed balance sheet in the form of deposits by member banks. The Fed pays them 25 basis points (one-quarter percent) to hold those excess reserves as deposits at the Fed. If the banks could safely loan those funds out they would, but the demand for loans has been sluggish to increase. What we have is plenty of “inflationary tinder” sitting in the economy waiting for a match to be struck. Many believe that the match needed to light the inflation fire is still years away.
Last week, I had the pleasure of listening to Alan Greenspan discuss the potential aftermath of global QE. Many will remember Dr. Greenspan as a very well respected former Fed Chairman who navigated through many economic catastrophes during his tenure. Mr. Greenspan took office as Chairman in August 1987 and was promptly tested by the Wall Street crash in October of the same year. Dr. Greenspan’s recent comments included his opinion that the months and years after the Fed stops QE will be very painful for the U.S. economy. He feels that it is only a matter of time before the inflation tinder ignites. He feels that it likely will not be a flame that the Fed will be able to easily control or extinguish. Dr. Greenspan watched his predecessor (Paul Volcker) fight the pain of inflation by raising interest rates to crippling levels back in the early 1980s. He notes that history shows how virtually every time the system is flooded with currency it eventually ends in a gust of inflation. It may take time to manifest itself, but it always has. His conclusion was that ownership of gold would be his suggestion for people to protect themselves from the “pain” that he believes is coming.
Remember that even though deflation is horrible, massive inflation is no walk in the park either. Inflation, which is the loss of purchasing power of a currency, lowers the standard of living of a country because prices rise much faster than incomes. After negotiating through the double-digit inflation experienced in the 1970s, the Fed is more confident that they can deal with inflation more easily than deflation.
The investment playbook for inflationary times is very different from what works in disinflationary or deflationary times. In times of deflation, bonds can be a very good investment as falling interest rates increases the value of bonds. However, in times of inflation, interest rates tend to rise and that has a negative headwind to bond prices. Why should an investor care? They should care because global central banks are intent on creating inflation. They have inflation targets to hit and they have seemingly unlimited tools to deploy. As long as deflation is a threat they will likely continue to flood the system with excess currency to counter the danger. Time has shown over and over that the Fed will actually keep monetary policy too easy for too long as they fear a relapse into recession and deflation. The result is likely to be a bigger-than-expected dose of inflation. This is essentially the conclusion of which Greenspan warns us.
The playbook for inflation hasn’t been dusted off much as the last time it was used was in 1982. That was the peak of inflation in the United States. That playbook reads that real assets may be one of the best ways to protect wealth and actually grow wealth in inflationary times. Real assets are those that you can touch and feel. Those that if you dropped on your foot would likely hurt. The Greenspan example of gold is just one. Others would include real estate, industrial metals, minerals, energy, etc. Inflation tends to cause the prices of these things to rise, which benefits the owners. Real assets used to be difficult for advisors to gain ownership of; however, now most can be traded on the major exchanges.
Recommending an increased allocation to real assets comes at a time when these assets are selling at multi-year lows. Many readers will dismiss my call to shed fixed income exposure, which gets hurt by inflation and to allocate funds to real assets, as the “ravings of a lunatic.” They will point to the current environment which is devoid of inflation and wonder why anyone would allocate assets to such a currently ugly asset class. I would suggest that even though the actions we advocate are somewhat counterintuitive, the eventual success of global central banks have the potential to reward those who heed our advice.
Our theory is simple. We believe that the actions and intent of global central banks will be pointed toward increasing inflation expectations. We believe that printing currency and historically easy monetary policy will eventually produce the aggregate demand needed to result in rising inflation. We believe that bonds now are incredibly overpriced as record investor demand seeks safety in the asset class. The expected returns are the lowest in history. The asset class that inflation would benefit is currently selling at multi-year lows and is being shunned by the investment community. We believe that the prudent advisor should consider allocating money away from bonds and increases the allocation to real assets.
We would acknowledge that the current economic conditions globally are deflationary. Our observation is that global central banks fully recognize this and are doing everything in their power to produce inflation. Money printing and deficit spending has always led to inflation, eventually. We expect it will do so once again. Just because you cannot see the effects of QE today doesn’t mean that it is not working. You don’t see the oak tree when the acorn is planted but the tree is growing. Central banks are notorious for over engineering monetary policy and will likely leave policy too easy for too long. Their ability to control inflation is questionable. We urge advisors to be ahead of the ball and consider allocating assets to areas where money is being pushed to and not pulled from. We think that real assets make sense in the environment to come. We think they are a natural hedge to the loss of purchasing power that the eventual inflation will bring.
Scott Colyer is CEO of Advisors Asset Management.
