Strong deflationary forces have led the US and major central banks around the world to increase money supply aggressively, and we are convinced that investors are too sanguine about long-term inflation risks. Based on our analysis, we believe that we are currently at the beginning of a reflationary period instigated by quantitative easing and that global reflation will be the major topic for investors in the coming years. Investors should prepare for a scenario of accelerating inflation in the medium-term.
Policy makers around the world are attempting to break the vicious cycle of a deflationary depression. In their ambitious fight against the financial crisis almost all major central banks (US, Eurozone, UK, Switzerland, Japan) have started using unconventional methods to increase liquidity in the markets by expanding the money supply (quantitative easing). In terms of central bank actions, the focus has shifted from conventional interest tools to balance sheet expansion. This has happened through the purchase of government debt, quasisovereign debt, such as mortgage-backed securities and agency debt, and corporate bonds.
The Federal Reserve's (Fed) balance sheet has more than doubled since September 2008. Given all other commitment s that have be en announced, it could potentially double again and expand to over 30 percent of GDP (compared to a “normal 6 percent of GDP”).
The Bank of England (BoE) has been in the forefront of quantitative easing, with the Asset Purchase Facility (APF) announced on 19 January 2009. In the meantime the BoE has increased the programme to £175 billion (€147 billion; $210 billion). The Swiss National Bank (SNB) has already expanded its monetary base aggressively by more than 80 percent. In addition, the SNB announced a currency intervention on 12 March 2009 and is officially buying foreign cur rency. The European Central Bankhas announced the purchase of €60 billion of covered bonds and has provided commercial banks with unlimited amounts of liquidity in its refinancing operations.
CENTRAL BANKS WILL BE SLOW TO EXIT
While discussions about possible exits of quantitative easing have started, we believe that central banks will likely not be able to withdraw the monetary stimulus rapidly without putting the tenuous recovery at risk. On 18 March 2009, the Fed announced an additional $1.15 trillion of spending on government bonds, mortgage-backed securities and agency debt. These measures are more permanent-looking and even Ben Bernanke confirmed that the Fed would only dispose of small portions of these assets in the near term.
A credible monetary policy is crucial to prevent rising inflation expectations. These days central banks are cooperating closely with governments in the fight against depression and to restore financial market stability. We suspect that central bank officials and financial markets underestimate the political forces they are going to face once the recovery sets in. Hence, the independence of central banks is questionable and inflation expectations might begin to drift.
The most frequently voiced argument against accelerating inflation in the foreseeable future is that the global recession has created a huge gap between actual and potential output and thus considerable spare capacity has been created that will take years to be absorbed. However, even economists and analysts that believe in the Phillips Curve relationship agree that any real-time estimates of the output gap are highly uncertain due to data revisions. For example, during and after the mid-1970s recession, the Fed believed the output gap to be substantially larger than it actually was. The reason for this was that it overestimated potential output, which later turned out to be much lower than initially thought. In addition, empirical analysis shows that output gaps only have a weak influence on inflation.
A further argument against rising inflation in the current environment is that the additional liquidity from central banks (monetary base) merely neutralises the fall in the money supply caused by the global deleveraging in the banking system. We agree that the huge increase in the monetary base – so far – has been partially offset by the collapse of the money multipliers. However, based on the latest more positive quarterly reports of major US banks we see the first “green shoots” of a positive nature. As a result, it would be wrong to expect that the multiplier will remain at current panic levels over the next 12 to 24 months.
MONETARY AND FISCAL POLICY WILL HOWEVER RESULT IN RISING INFLATIONARY PRESSURE
In addition, central banks are not alone in their battle against a deflationary depression. Governments all over the world have announced large fiscal stimulus programmes, equivalent to about 4.3 percent of global GDP, to offset the decline in private demand. This year the US budget deficit will reach 12.3 percent of GDP and not even the US government expects a trend reversal. With record levels of government debt to be issued in the next two years we expect rising pressure on central banks from governments to support the fiscal policy with ongoing expansionary monetary policy.
While expanding money supply and increasing fiscal (deficit) spending are necessary and efficient ways to fight deflation/depression in the short term, we strongly believe that the current macroeconomic policy will result in accelerating inflation in the coming years.
IMPLICATIONS FOR PORTFOLIO ALLOCATION
The key question for investors is how to position a portfolio for a period of accelerating inflation rates and low trend growth.
We would recommend that investors avoid the “bond trap”. Long duration fixed coupon bonds will suffer considerably in a high-inflation environment. Inflation linked bonds, like Treasury Inflation-Protected Securities (TIPS) in the US or Inflation-Linked Gilts (ILG) in the UK, are designed to cut out the inflation risk to investors.
The picture for public equity will be mixed: where inflation can be passed on to the consumer, equities will do relatively well. Other sectors will underperform. Periods of high inflation/deflation are often associated with higher macroeconomic volatility. As a consequence, real risk premiums tend to increase in such periods. This is the main reason why equities in general do not provide good inflation protection.
We consider private equity to be the best relative value play within the overall equity asset class, as private equity's qualities of active ownership and strong incentives to adapt quickly in a changing environment offer the greatest competitive advantage.
ATTRACTIVE ASSET CLASSES IN DIFFERENT ECONOMIC ENVIRONMENTS
Infrastructure assets are characterised by having their tariffs adjusted annually by a pre-specified spread over a defined inflation rate – mostly measured by the consumer price index (CPI). In addition to these inflation-linked revenues, low operating cost and high EBITDAmargins provide a “safe haven” in an inflationary environment.
Real estate returns have historically shown the ability to provide protection against rising inflation as rental income is commonly indexed to changes in the CPI. In the US, for example, commercial real estate landlords can adjust rental rates annually and pass on up to 100 percent of the change in the CPI.
And finally, natural resources have historically also outperformed in an inflationary environment. Between January 1973 and December 1981, US inflation averaged 9.1% per annum. The S&P GSCI Commodities Index, which tracks oil, metals and food futures, generated 14.4% per annum over the same time period while equities underperformed, returning 0.9% per annum. Furthermore, production cuts by commodity producers and the current monetary and fiscal measures are sowing the seeds for interesting demand-supply adjustments that will favour commodities in coming years.
This material has been prepared solely for purposes of illustration and discussion. Under no circumstances should the information contained herein be used or considered as investment advice, as an offer to sell, or solicitation of an offer to buy any security. The information is in summary form for convenience of presentation, it is not complete and it should not be relied upon as such.