The return of deflation

February 2010

In mid-2009, the world was worried about the imminent return of inflation. The reasoning was based upon the massive Government fiscal stimulus; ultra-low interest rates and buckets of cash entering the economy through quantitative easing.

Anticipating a strong V-shaped recovery and fuelled by cheap money, stockmarkets throughout the globe staged one of the biggest and fastest recoveries ever seen.

Following the rest of the world, the UK economy finally returned to growth in the fourth quarter of last year after the longest and deepest recession since records began more than half a century ago but at a far weaker rate than expected and behind other developed countries. It grew just 0.1%, lower than the 0.4% expected by economists and far lower than the Treasury forecasts.

As for inflation, the headline inflation figures for December exceeded Government forecasts and hit an annualised 2.9%, setting alarm bells ringing for a potential interest rate increase.

January 2010 started with an overwhelming consensus of optimism and enthusiasm for an improving economy – the majority of fund manager forecasts crossing our desks were claiming how the fundamentals support the market, whilst Investors Intelligence reported the smallest number of ‘bears’ among advisers since April 1987.

The data points to a technical recovery

The final month of 2009 produced a lot of positive data:

• GDP (Gross Domestic Product or output from the economy) is up and likely to continue in the short-term as inventory builds.

• Retail sales were up year on year – low interest rates have cut the cost of a mortgage and put money in consumers’ pockets (at least for those who have jobs).

• Production is up - the ISM manufacturing index in the USA in December was at its highest for four years.

But the weak link in the data is unemployment – it continues to rise and more jobs are going part-time.

According to David Rosenberg, chief economist at Gluskin Sheff, the US economy will need to create an additional 20 million jobs to get back to the previous employment population ratio peak of 63% in 2007. “That is a lot of jobs and unlikely to be achieved for at least a decade”, according to Edward Harrison on Creditwritedowns.com.

But spending habits are changing

So overall, economic activity is increasing which gives us a technical recovery, but certainly the US and UK economies are operating well below levels of the recent past; the output drop has been estimated at some 6%. People who have been made redundant or who are now working part-time don’t borrow and spend the way they used to, whilst the threat of redundancy is enough to cause significant belt-tightening.

This has considerable effects on a credit-orientated society where economic growth is dependent upon consumer spending.

The aftermath of a financial crisis

Two recently released studies on the subject of financial crises throw weight behind evidence of a changing financial environment in respect of consumer attitudes and behaviour.

In their highly acclaimed book ‘This time is different: eight centuries of financial folly’, Professors Carmen Reinhart and Kenneth Rogoff analyse the aftermath of financial crises.

This current one, they suggest, is even more significant because it is the first truly global financial crisis since the Second World War. They identified a number of key factors:

• Asset market collapses are deep and prolonged - housing falls on average 35% stretched out over 6 years, whilst stockmarkets collapse an average 55% over a downturn of 3.5 years.

• The real value of government debt explodes – on average a country’s outstanding debt nearly doubles within 3 years, once it exceeds 90% of GDP its economic growth rate slows by 1%.

• The average increase in the unemployment rate is 7%, which remains elevated for 5 years.

They conclude that the historical evidence suggests that banking crises are followed by a deleveraging of the private sector accompanied by substitution and escalation of public debt, which in turn slows economic growth. Furthermore, there is a significant increase in sovereign debt default.

The McKinsey Global Institute study ‘Debt and deleveraging: The global credit bubble and its economic consequences’ analyses current leverage in the total economy (private, corporate and public) and examined 32 examples of sustained deleveraging following a financial crisis. They concluded:

• Typical deleveraging begins two years after the beginning of the crisis (2008 in this case) and lasts for six to seven years.

• In about 50% of the cases, deleveraging caused significant belt-tightening and was a significant drag on GDP growth. In the remainder, deleveraging results in corporate and sovereign defaults or sharply higher inflation.

• The initial conditions are important because the size of the initial total debt determines the ability of a country to respond to a financial crisis. The following chart shows the size of 2009 debt.

Country	2009 Total debt (% of GDP)
India	129
Brazil	142
China	159
Canada	259
Germany	285
United States	300
United Kingdom	466
Japan	471

Source: McKinsey Global Institute

What is immediately noticeable here is that it is the emerging countries with the lower total debts that have fared better in the current crisis.

The D-Process

The evidence suggests the economic recovery looks extremely weak and dependent upon continued government fiscal stimulus. There is little or no likelihood of a return to strong consumer spending and sufficient economic growth for job creation. Last June we wrote of the prospect of inflation picking up, yet today the signs point to the makings of a depression, shaped like a series of W’s consisting of short and uneven business cycles as governments embark on ‘stop-go’ policies of quantitative easing.

This would suggest that the overriding secular force currently at play in the West is the D-process - deleveraging and deflation.

Lessons from Japan

Japan was the economic miracle of the 1970s and 1980s, but uncontrolled credit expansion and eventual financial crisis burst the bubble in the early 1990s. The heavily indebted private sector began a prolonged period of deleveraging.

Despite massive government spending, near zero interest rates, their own quantitative easing and many heralded expected recoveries, the Japanese economy currently remains mired in deflation. Economic growth for the past 20 years has averaged only 1% per annum. Japan now has the greatest total debt as a percentage of GDP of any country (with the UK a close second).

Japan’s experience could point to where we may follow. However, there are two notable differences – Japan continued to be a highly successful manufacturer, successfully exporting to Western markets through the period. Second, the population have become a nation of savers and are the biggest purchasers of government debt. Both points contrast sharply with the UK, where consumer spending makes up nearly two-thirds of the economy and the personal saving ratio is still exceptionally low.

Rising sovereign debt worries

In the absence of sustainable, robust economic growth and clear and realistic plans for government debt reduction, the outlook looks decidedly difficult.

The recent stockmarket anxiety is based upon warnings of credit rating downgrading to countries on the periphery of Europe – Greece, Portugal, Italy, Spain and Ireland. Unless dramatic measures are taken to control spending, the perceived risk of default increases, driving up yields.

Professors Reinhart and Rogoff made the statement: “Once debt becomes excessive, countries do not grow their way out of the problem, they must go through the pain of debt repayment and saving”. (As Japan found out).

Where does this leave investors?

According to David Rosenberg of Gluskin Sheff, at current levels the S&P is priced for 4% real economic growth for 2010. Typically, by the time the market reaches such a rebound, the economy is well into its third year of recovery and creating jobs. Furthermore, the market is now four times overvalued on a reported profit basis – as it was during the tech bubble.

Our view is that the 2009 stockmarket rally from March was a strong ‘bear-market rally’ that is not being supported by a required robust and sustainable return to long-term economic growth. The outlook for major stockmarkets is as bad as it can be – it is quite conceivable that this year could re-test the March low of 3,447.

For clients who are currently invested in equities, we suggest that this would be an appropriate time to review your portfolio with a view to reducing your exposure to equities and taking a more defensive approach.

Where capital preservation remains the key objective, short-dated gilts are top of our list to achieve this. These are typically up to five years to maturity.

Alternatively, cash deposits and highly-rated money market funds would be appropriate where short-dated gilts are not available.

Where income is required, investment grade corporate bond funds offer a reasonable yield with less downside risk to capital than equities or high-yield bonds.

For those who wish to take a more dynamic and aggressive approach but with a deflationary theme, we are paying close attention to a recently launched fund from Eclectica Asset Management. This is an ‘absolute return fund’ managed by Hugh Hendry, a fund manager who holds similar ‘contrarian’ investment views to our own.

If you wish to discuss any issues or your portfolio please do not hesitate to contact me.

Steve Wilson BA(Hons) CertPFS, Certs CII(MP & ER)
Managing Partner
steve.wilson@2hwealthcare.co.uk

References:
FT.Com – various
Professors Carmen Reinhart and Kenneth Rogoff – ‘This time is different: eight centuries of financial folly’
The McKinsey Global Institute - ‘Debt and deleveraging: The global credit bubble and its economic consequences’
Edward Harrison – www.creditwritedowns.com
David A. Rosenberg – Chief economist and strategist Gluskin Sheff & Associate

The above represent the views of the author and are not necessarily the views of all the partners of 2hwealthcare LLP. The content is for your general information and is not intended to address your particular requirements. It does not represent specific personal advice.