By Daniel Hunter
"Equity investors have every right to be afraid" of deflation, according to Peter Elston, Global Investment Strategist at Seneca Investment Managers.
Mr Elston warned that the looming spectre of deflation could prove disastrous for equity markets.
He said: “Equity markets hate high inflation, but their fear of negative inflation is even greater — just look at the disastrous performance of the Japanese stock market over the past two-and-half decades.”
Meanwhile, the World Bank this week cut its forecasts for global economic growth in 2015 amid concerns about the faltering performance of many of the world’s leading economies, the poor confidence of both businesses and consumers, and the limited ability of central banks to cut interest rates any further to provide assistance.
“We are certainly set to remain in a low-inflation environment,” Elston added. “And while I am still hopeful that the UK can avoid deflation, there is now the possibility of these headwinds pushing us into negative inflation territory.”
If those fears are realised, investors across all asset classes will need to reassess their portfolios, Elston warned.
Equities
“Equity investors have every reason to be afraid of deflation,” Elston said. As prices fall, real interest rates rise, the real value of debt held by the private sector increases, while the revenues corporations earn fall as customers hold back spending in anticipation of cheaper prices later on. In the worst-case scenario, this can cause a deflationary spiral with disastrous effects.
Bonds
“Deflation is generally better news for bond prices,” Elston explained. The fixed coupon payments that bonds typically offer become more valuable in real terms during a period of deflation. At the same time, falling interest rates lead to falling bond yields and higher capital returns.
However, Elston warned that the effect of deflation on bond markets would, in practice, be difficult to predict, since central banks would be likely to respond to a serious deflationary threat with a renewed programme of quantitative easing.
He added: "The most reliable leading indicator of recession I know is an inverted or negative yield curve. We're not there yet, but we're heading there quickly. Since inflation is already low, a recession would be very dangerous. It is time for the government and central bank to act preemptively."
Other asset classes
Deflation would also have an impact on other asset classes. Previous rounds of quantitative easing have, for example, been associated with a sharp rise in the gold price, which is seen as a hedge against the inflation of the monetary base associated with QE.
On the other hand, the increasing real cost of servicing debt could hit the property markets, as would the inability of struggling companies to cope with the cost of commercial property.
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