Macro: Inflation, deflation and recession - part I

Since the Global Financial Crisis (GFC) we've made a number of macro-driven calls that have driven our stock selections, quite successfully as it happened.

Our China crash protection portfolio has performed well, as have our model portfolios. We also anticipated the rush to yield and got to buy some great blue chips stocks at very cheap prices; and we steered members clear of the mining crash.

Not bad. But in one area we utterly failed. The policy response to the GFC was to roll the printing presses and throw free money at the banks. To us, that meant inflation, and possibly lots of it. We were wrong. Deflation rather than inflation now appears a bigger risk. Although with banks sitting on mountains of cash that could quickly be released, there remains the possibility of inflation, too.

For investors, this presents a dilemma. Preparing your portfolio for either inflation or deflation is reasonably straightforward. Preparing it for both is like trying to make an omelette and a pancake from the same egg.

Nevertheless, we're going to give it a crack. Whether it's deflation or inflation, you can bet a local recession isn't far behind. Here, we'll offer some background to the risks posed by inflation and deflation. Next week we'll unveil a portfolio of stocks to protect you against these risks.

What is deflation?

Deflation is the opposite of inflation. Instead of prices going up, they go down. Under deflation, you can buy more with the same amount of money over time. Under inflation, you can buy less. A little inflation is good because it encourages spending. Too much is bad, which is why central banks have inflation targets (not to high, not too low). But any kind of deflation is really, really bad.

Once people expect prices to fall they withhold spending, knowing that future prices will be lower. That pushes down consumption, output falls, prices and wages fall, workers are laid off, more people default on their debts and a deflationary spiral ensues.

Deflation is a big problem. Interest rates can be increased to lower inflation but you can't pay people to borrow money to overcome deflation. And even if you could, it doesn't follow that people would actually spend the money they've been paid to borrow. Once people have it in their heads that prices will continue to fall, the costs of changing that belief quickly mount.

Japan has endured two decades of deflation. During that time the government debt-to-GDP ratio has increased from about 65% to over 220%. Much of that increase was due to failed stimulus measures. Only now is the country emerging from deflation. And if you think this has no bearing on stocks, think again: the Nikkei 225 index hit a high in 1989. Almost 26 years later the Nikkei is almost half what it was then. Deflation is bad for stocks.

Is deflation a real threat in the west?

Yes. The Eurozone, the US and UK have target inflation rates of 2%. In Australia, our target rate is 2.5%. Each has an actual rate of inflation below target. In Sweden and Israel, and those countries most affected by the Eurozone crisis – Greece, Spain and Italy – inflation is at zero or below. Even in China, where the government targets a 4% inflation rate, the actual rate is half that. This is a real threat.

There's another problem that amplifies the risk. The policy response to the GFC effectively bailed out the banks at taxpayers' expense. The private debt that should have been written off was transferred to the public balance sheet and the businesses that failed did not die, as capitalism supposedly dictates.

The result is that government debt as a percentage of GDP in many countries is at historically high levels, so high in fact that the only way to pay it back is to inflate at least some of it away. Trouble is, much of that debt is inflation-resistant through financial products like Treasury Inflation Protected Securities, making it harder for governments to devalue what they owe by inducing inflation.

Countries like the United States, Japan and the Eurozone are going to have to grow their way out of trouble. Right now, financial markets appear willing to purchase almost any government bond but who can say that will always be the case? Furthermore, governments are already devoting a substantial portion of their budgets to repay the interest on the huge debt, reducing the capacity to embark on fiscal stimulus. The policy options to counter emerging deflation are limited.

Why is inflation still possible?

Since the GFC the US Federal Reserve Quantitative Easing program has increased the bank's balance sheet from under US$1tn to over US$4tn. The European Central Bank recently increased its monthly QE program from €13bn to €60bn, while the Bank of England and Bank of Japan are also busy creating money out of thin air. Ordinarily, this would lead to rampant inflation. This time it hasn't because most of the money created remains parked in bank vaults.

Banks haven't lent out this money as intended. Having sniffed the wind, they realised there wasn't much appetite to borrow and repaired their balance sheets instead. Eventually, that money will make its way into the real economy and boost aggregate demand, at which point the prospect of inflation increases.

One more point: Whilst the conventional measure of inflation – the consumer price index - is near-record lows, this index does not include asset prices, which have sky-rocketed over the past few years. Asset price inflation is already with us; consumer price inflation could yet make an appearance.

What effects would either have on my portfolio?

It depends on what assets you hold. In an inflationary environment the purchasing power of cash is eaten away. Those allocating a high percentage of their portfolio to bonds and cash would suffer. The best protection against inflation, and recessions, is to invest in high quality shares with the ability to grow in value over time, regardless of the level of economic activity.

Luckily, that same approach also applies to the threat of deflation. The popularity of bonds over the past few years suggests that markets place a greater weight on the risk of deflation than inflation. As for your portfolio, dealing with either threat boils down to appropriate asset allocation and selecting stocks that can survive and prosper under both conditions. That's what we'll cover next Friday. Watch out for it.