BOSTON (MarketWatch)—Neither an inflationist nor a deflationist be. That, to mangle one well-known quote, sums up the view of some investment professionals who are struggling to make sense of current market conditions.
“We are not currently forecasting a global deflationary environment, but rather an environment where subdued economic growth results in contained inflationary pressure,” said Jeff Witt, director of research at Private Asset Management, Inc. “This view is somewhat contrary to the markets bipolar assessment that we are either going into an inflationary or deflationary spiral.”
According to Witt, the extreme views on
inflation stem from the push and pull of various economic conditions prevalent in the global economy. “First, central banks around the world, most notably the Federal Reserve and the European Central Bank, have dramatically increased their balance sheets and the money supply in their respective economies—which is traditionally inflationary.”
The counter balance to this inflationary pressure, however, is the deleveraging in these economies, which Witt said, “results in excess liquidity not being circulated back into the economy and thus having relatively little inflationary impact.”
Another factor pointing to inflation is the rise of consumerism in several emerging markets, which, Witt said, “is driving up the demand for goods and commodities, especially energy and food, which again would be inflationary.”
But the increased consumption in those regions is being offset by austerity in larger, more developed markets, Witt said.>“Therefore, we believe that there is still some risk of deflation, but it will likely be regional and not global,” said Witt.
That being said, the risk of a global deflationary spiral cannot be ignored.
David Rosenberg, the chief economist for the Canadian money manager Gluskin Sheffis, spoke in February about an underlying trend of deflation that, along with other factors, spell trouble.
And this week, Robert Doll of BlackRock expressed concern that “the global risks of deflation are still present.”
Monitor the threat of deflation
Given the risk of deflation, Witt said one has “continually monitor for the threat.”
One way to monitor for global deflationary risk, said Witt, is to look at those investments that would likely
outperform in such an environment, most notably sovereign debt. “Recall that, all things equal, fixed-income becomes more valuable in a deflationary environment because future cash flows are no longer being discounted by inflation, thereby increasing the present value of the revenue stream,” said Witt. “Given the immense size of the Treasury market relative to the entire sovereign debt market, Treasuries can provide a good indication of the risk of a global deflationary spiral.”
At Witt’s investment firm, for instance, they check for a significant increase in demand for Treasuries, which, he said, results in pushing market rates down materially. “Note that this occurred in the height of the financial crisis in late 2008, where there was a real risk of a global deflationary spiral, in our opinion,” he said. “Recently rates have been moving lower, on concerns over the European sovereign debt crisis, but the contraction is nowhere near what we saw in 2008.”
is also monitoring the TIPS Spread, which is the interest differential between traditional Treasuries and TIPS, and is considered as a gauge of inflation expectation. “Here again we saw a significant downward move in the TIPS spread in late 2008, but this pattern has not re-emerged, and therefore, we are not currently forecasting a significant risk of global deflation,” said Witt.
What’s more, Witt said there are signs that the labor market in the U.S. is gradually improving. Plus, there’s been a general increase in unit labor costs among OECD, or Organization for Economic Cooperation and Development, countries. “Both of these economic improvements should further mitigate the risk that the world is falling into a deflationary spiral,” Witt said.
Equities over bonds if inflation
Given that his firm’s outlook calls for low inflation and gradual economic growth, Witt favors equity investments over fixed-income securities. “Should this outlook be
correct, we believe that market interest rates will gradually increase over the next few years, which will be a headwind for fixed-income securities,” said Witt. “Equities, which tend to outperform in a low interest rate environment, should be able to capitalize on the gradual economic improvement, however, we monitoring significant macroeconomic uncertainties, specifically in Europe.”
In addition, Witt said a “cyclical bias to a portfolio is warranted.”
Bonds and dividend-paying stocks if deflation
If we should fall into a deflationary environment, Witt said “debt becomes more attractive to investors; however, it becomes harder to service for borrowers.”
“If we were to see indications of a deflationary spiral, we would recommend increasing exposure to fixed-income investments, but would stay with investment-grade securities and would avoid TIPS and variable-rate debt.”
In addition, Witt said dividend-paying
stocks become more attractive since the dividend income stream is no longer being discounted by inflation. “Within equities, we would look for companies that have a history of paying and increasing their dividend and that have pricing power,” he said. “The latter is important to evaluate to insure that the deflationary environment will not inhibit the company’s ability to maintain and/or increase their dividends going forward.”
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