Why investors shouldn’t worry about mild deflation in the year ahead
INVESTORS’ biggest enemy, inflation, is in retreat. Across developed economies, prices rose by a meagre 1 per cent over the second half of 2014. More up-to-date pricing indicators, like the Billion Prices Project, show a sharp fall in prices in 2015 so far (down about 1 per cent in the US versus the same time last year).
Much has been written about Europe’s slide into deflation; on our estimates, Spanish consumer prices fell by 3 per cent annualised in the final three months of 2014. Here in the UK, over the past six months, prices have declined by 0.6 per cent annualised after accounting for seasonal trends. On our estimates, consumer prices are now falling in 15 out of the 23 developed markets.
Inflation is falling in the developing world as well – the trend in inflation has declined from almost 8 per cent in 2011 to under 5 per cent now. And inflation looks likely to fall below 4 per cent – not seen since the 1960s.
This clearly has a lot to do with the collapse in oil prices. But the fall in commodities is broad-based and likely to continue. We think the “super-cycle” that saw commodity prices rise three-fold over 2002 to 2008 is now working in reverse as a result of increased supply and a peak in the Chinese investment cycle. More generally, growth is the most de-synchronised since the early 1990s. Economies like the US are powering ahead with big gains against a more sluggish global backdrop, resulting in ample spare capacity in the global economy.
This downward cycle in commodity prices means that even countries with relatively strong growth – like the US and UK – will also experience falling consumer prices through 2015, particularly as the recovery in wages has been disappointingly slow.
But should we worry about mild deflation? Not necessarily. History shows that continued mild deflation can occur alongside strong growth. During the mid to late nineteenth century in the UK this was certainly the case. Many agricultural and industrial processes were becoming mechanised, leading to greater productivity and labour capacity.
So what does this mean for investors?
Well first off, in real terms, the return from investment assets should be higher. On our calculations, a typical cash Isa taken out in each year since 2001 would have failed to beat inflation.
But most importantly, central banks will find it hard to raise interest rates at a time of collapsing inflation. An interest rate hike in the UK and US is becoming a dimmer prospect for 2015.
I think policymakers will need to see quite concrete evidence that inflation is picking up towards 2 per cent before pulling the trigger and raising rates. This wait-and-see approach is likely to support both bond and equity markets. And in continental Europe, deflation gives policymakers an added urgency to restart the aborted recovery, though investors remain unsure of what form quantitative easing might take.
With collapsing commodity prices and a much weaker euro, any bounce in European growth could make European stocks the contrarian investment of the year. Don’t write-off Europe just yet.
Shaun Port is chief investment officer at Nutmeg. www.nutmeg.com