Inflation versus deflation: A guide for investors

Investors’ Insight Vontobel Asset Management

Inflation versus deflation: A guide for investors

Introduction

The monetary policy of all major central banks is focused on stimulus. Interest rates are at all-time lows of between 0% and 1%, and money supply aggregates are growing at a double-digit pace. Due to these conditions, many ­investors are concerned that inflation could soon jump sharply. However, there has not been a meaningful relationship between money supply growth and inflation for some time. More important for assessing monetary policy in terms of inflation is the so-called Taylor rule, which is currently indicating that the monetary policy ­ of major central banks is correct.

“There has not been a meaningful relationship between money supply growth

This study is structured as follows: Chapter 1 looks in detail at the basic causes of inflation and indicates our inflation forecast for the coming years.

Chapter 2 addresses the question of how investors should behave if they think that inflation will rise sharply. The chapter also discusses real – i.e. inflation-adjusted – yields for the major asset classes. The special role of gold will be discussed in a separate section.

Chapter 3 shows the performance of asset classes during deflationary periods.

Chapter 4 is a summary and also includes conclusions for investors.

and inflation for some time.”

In the coming years, inflation is therefore likely to stay lower than many people are expecting. However, should monetary policy turn out to be in error, the danger of inflation cannot be ruled out. Since 1900, commodities and to some extent equities have afforded the best inflation protection during inflationary periods. In contrast, gold is more for crisis protection than explicit protection against inflation.

Dr Thomas Steinemann, Chief Strategist of the Vontobel Group

Oliver Russbuelt, Senior Investment Strategist

Dr Walter Metzler, Senior Economist

September 2010 3

Chapter 1: What actually drives inflation?

The expansive monetary policy over the past two years has fuelled fears that a dramatic increase in inflation may be unavoidable. In actual fact, because of the global financial crisis, global interest rates and as a result bond yields have never been so low. In addition, central banks have implemented quantitative easing, which is a continuation of the lowering of interest rates by other means. To put it simply, quantitative easing is an expansion of the balance sheet of a central bank, in that the central bank buys securities and undertakes longer-term refinancing by printing money. As a result of the deep recession in 2009, core inflation (consumer price inflation without food and energy prices) in the industrialized nations is currently very low, which raises the question of what exactly it is that determines inflation.

In the 1970s, the dominant idea was the monetarist view that inflation was the result of too much money chasing too few goods. But in the 1980s the view of an empirical connection between money supply and inflation (see chart 1) was increasingly rebutted.

Chart 1: Inflation in the US has decoupled from money supply since 1980 Moving average 12% 10% 8% 6%

A leap in demand for liquidity during the financial crisis lies behind money supply growth The main reason why the US Federal Reserve increased the money supply was to satisfy the huge increase in demand for liquidity during the financial crisis.

Banks wanted to protect themselves against sudden outflows and reduce the risks on their balance sheets by holding more liquidity. However, since banks had lost trust in one another, they mainly sought out safe short-term ­investments, such as reserves held with the central bank.

Due to the extreme uncertainty unleashed by the crisis, not only banks but also companies and households wanted to hold more liquidity. If the central bank had not met this sharp increase in demand, interest rates would have risen considerably, which in turn would have exacerbated the economic crisis.

It is easy to recognize that the increased money supply was a response to greater demand in that banks have not raised their lending to companies and households since the financial crisis broke out, although they would have been able to do so, by virtue of their substantial reserves.

Neither did the general economy deploy the greater supply of liquidity to buy more goods and services. This can be seen in that the ratio between GNP and money supply – the velocity of money in circulation – has fallen since the start of the financial crisis.

4% 2% 0% –2% – 4% 1965

1970

1975

M1 money supply

1980

1985

1990

1995

2000

2005

2010

Inflation

Source: Datastream, Vontobel

This means that the money supply trend can no longer ­explain or forecast inflation. For example, growth in the US money supply from 1980 to 1995, a period in which inflation fell sharply, was in fact slightly higher than in the inflationary years of the 1970s. Conversely, monetary ­expansion slowed between 2005 and 2008, but inflation moved higher anyway. For these reasons the US Federal Reserve, the Bank of England and the Swiss National Bank no longer set money supply targets. Only the European Central Bank does so, with respect to the M3 money ­supply.

Despite the currently strong increase in the US money supply due to quantitative easing, it does not necessarily follow that there will be a sharp increase in inflation.

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Inflation due to capacity utilization and monetary policy As money supply has increasingly been an unreliable indicator for inflation since the 1980s, experts have looked at the utilization of productive capacity to help explain the inflationary trend. This can be measured on the basis of capacity utilization in industry or using the output gap.

The output gap indicates by how much current economic production deviates from the potential. A positive output gap means an economy is overheating, while a negative output gap signals that utilization is too low.

How much inflation rises by during a phase of overheating depends on whether monetary policy is expansive or restrictive. To assess whether monetary policy is appro­ priate, the Taylor rule has become established as a benchmark. It states that interest rates should be based on (see box Taylor rule): 1. the output gap 2. the deviation of inflation from the central bank’s target 3. medium-term real interest rates and the current inflation rate

rates were too low, which pushed inflation up to 5%.

At the high point of the financial and economic crisis in the autumn of 2008, the Taylor rule actually indicated negative interest rates for the United States. But because a policy of negative interest rates cannot be implemented, the Fed turned to quantitative easing and brought about a sharp expansion of the money supply by buying securities, which acted like an additional interest rate cut. This action was in line with the Taylor rule and the dramatic circumstances at that time.

Chart 2: Output gap and inflation in the US Moving average 14% 12% 10% 8% 6% 4% 2% 0% –2% – 4% – 6% –8% 1970

1975

1980

Output Gap

1985

1990

1995

2000

2005

2010

Inflation

Source: Datastream, Vontobel

The Taylor rule shows that US interest rates in the 1970s were much too low, which explains why inflation was high (see chart 3). The decline in inflation in the 1980s was the result of the restrictive monetary policy of Paul Volcker, the Fed chairman at that time, as interest rates were much higher than the Taylor rule would ordain. In the 1990s monetary policy was correct for the most part, which explains the low inflation rate. From 2000 to 2004, interest Chart 3: USA: Taylor interest rate and actual interest rate Interest rates 25% 20% 15% 10% 5% 0% –5% 1970

1975

1980

Fed funds rate

1985

1990

Taylor rule

1995

2000

2005

2010

A degree of inflation risk in the US The Taylor rule is now indicating that the right interest rate would be about 1%, but the key rate is still 0.25%. In 12 months from now the Taylor rule recommends on the basis of our growth and inflation forecasts interest rates of 1.5%. We expect, however, that the Fed will hike its policy rate only as far as 0.75% in the next 12 months.

This implies a degree of inflationary risk, especially as the Fed is maintaining its quantitative easing for now. In addition, US fiscal policy is also highly expansive and will probably remain so.

In our main scenario we expect, over the medium term, a modest and below-average economic rebound. This will likely result in a more gradual shift of interest rates towards Taylor level. Thus inflation could rise to 3% or even 4% in the medium term, once deleveraging has been completed a few years from now. If the economic rebound is even stronger than expected, we believe inflation could reach 4% to 5%. There is also a danger that politicians could have an impact on monetary policy, keeping it expansive longer than is needed. In any case, we do not expect inflation to stay higher over a longer period, as the Fed would turn to a more restrictive monetary policy if there are clear signs of a sustained economic recovery.

in 12 months

Source: Datastream, Vontobel

The Taylor rule Taylor interest rate = real money market target interest rate + current inflation + 0.5 × (inflation – inflation target) + 0.5 × output gap Output gap =

actual GDP – potential GDP potential GDP

Potential GDP = GDP at full utilization of the capital stock and labour market The inflation target and the real money market target ­interest rate vary from one country to another. While

the inflation target reflects a country’s stability culture, the real money market interest rate depends largely on potential growth.

Assessing monetary policy using the interest rate instead of the money supply has the advantage that erratic shifts in the demand for money can be eliminated as a reason for wrong monetary policy. Friedman’s (mone­ tarist) money supply rule would probably have led to higher interest rates in the financial crisis because the massive increase in the demand for money could not have been satisfied.

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Chapter 2: What should investors do in times of inflation?

As we discussed in the last chapter, we do not think that inflation will rise significantly in the foreseeable future.

However, this forecast is based on the assumptions that the central banks will not make any major error, that the exit strategy will be implemented at the right time and the deleveraging of the private sector will continue to take some time. Nevertheless, an inflationary scenario cannot be completely ruled out. We therefore conducted some research into which asset classes would generate positive returns during inflationary periods. We looked at the following asset classes in the US: cash, government bonds, corporate bonds, equities, commodities, gold and real estate for the period from 1900 to the present day. During this period there were six inflationary phases in which inflation rose more than 5% (see chart 4).

Chart 5: Average real returns in inflationary periods

In the six inflationary phases, the various asset classes posted the following average real returns (see chart 5).

years in which inflation peaked, the picture looks different (see chart 6). In these years equities performed poorly; only commodities generated positive real returns. For investors this means that even in periods of inflation they should not pursue a buy-and-hold strategy, but rather opt for a tactical investment strategy.

Buy-and-hold strategy no longer valid It is not surprising that government bonds post the worst performance, followed by gold, cash and corporate bonds, all of which generated negative real returns. In contrast, positive real returns came from real estate and commodities. Equities generated the best performance with an average inflation-adjusted return of around 4%, although stocks did not post a positive performance in each year during the inflationary periods. If we just look at

Real returns p. a.

4% 3% 2% 1% Corporate Bonds

0%

Equities

–1%

Commodities

Cash

Gold

–2% –3% – 4% – 5%

Source: Global Financial Data, Robert Shiller, Datastream, Vontobel

These results confirm overall, however, that for inflationary periods, real values such as commodities, stocks and real estate generate higher returns than nominal assets (see chart 5 and 6).

Chart 4: Six inflationary and two deflationary periods in the US since 1900 Inflation/Deflation

25%

WWI 1914 –1919

WWII 1939 –1947

20% 15%

Inflation

Vietnam war 1967–1970

Oil crises I and II 1973– 1981

Korean war 1950 –1951

10%

Stock market crash 1987–1990

5%

Deflation

0% – 5% –10% –15% 1900

Short but severe deflation 1920–1921 1910

1920

Great depression 1929–1933 1930

Source: Global Financial Data, Datastream, Vontobel

6

1940

Treasury Bonds

Real Estate

1950

1960

1970

1980

1990

2000

2010

tionary period from 1987 to 1990, however, gold posted a negative annual return of 7%, faring the worst of all ­a sset classes.

Chart 6: Average real returns in the years with the highest inflation rates Real returns p. a.

8% 6% 4% 2% 0% –2%

Real Estate

Gold

Equities

Cash

Corporate Bonds

Treasury Bonds

Commodities

– 4% – 6% – 8%

Source: Global Financial Data, Robert Shiller, Datastream, Vontobel

Gold provides protection at times of crisis rather than inflation It is remarkable that gold does not actually provide as good a protection against inflation as is often assumed.

In the six inflationary periods of the 20th century, gold posted a positive performance only once, between 1973 and 1981, when it returned a strong 15% annually. In all other inflationary periods, gold did not generate a positive return. It should be remembered, however, that until 1973 gold was not freely tradable and the price of gold was fixed. In addition, the private ownership of gold was prohibited at times.

The third and final gold price boom came after 2001, during another potentially deflationary phase following the bursting of the technology bubble. We therefore see that periods of rising gold prices come during times of both inflation and deflation. If not inflation, what could explain the price of gold? Chart 7 shows that the three periods of rising gold prices all took place when weak equity markets were moving sideways over an extended period of time.

In light of this, gold can be a good addition to a equity portfolio, but it is more a protection during periods of crisis than against inflation. Chart 8 shows that gold can generate comparable returns to stocks only if dividends are excluded. If they are included, we see that equities are clearly superior to gold.1 Chart 8 illustrates the significant contribution of dividends and cash flows to high returns.

Chart 8: Equities with and without dividends compared with gold An investor who invested 100 USD in the US equity market or in gold at the end of 1973 would now have…

Price chainlinked (1973 = 100) Price chainlinked (1973 = 100) 5000 4000

USD 3500.–

3000

Gold has had three periods since 1900 in which it has performed well. In the 1930s the value of gold went up by decree under the gold standard, which triggered the first period of higher gold prices, interestingly in a strongly deflationary period. After the Bretton Woods system was abandoned in 1973, the price of gold could move freely.

Consequently, in the inflationary period that followed it moved sharply higher in real terms. During the last infla-

scale)

10000

1000

100

10 Deflation 1 1900

1910

1920

S&P 500 Price Return

1930

soft Inflation/ Deflation

Inflation

1940

1950

1960

1970

1980

USD 1100.– USD 1050.–

1000 0 1973

1978

1983

S&P 500 Total Return

1988

1993

1998

S&P 500 Price Return

2003

2008

Gold price

Source: Global Financial Data, Datastream, Vontobel

So what does this mean for investors? Those who believe that inflation will rise sharply in the coming years could put their money into real assets such as commodities, real estate and equities. In contrast, nominal assets such as bonds or cash should be underweighted. It is worth bearing in mind, however, that commodities and hence gold are calculated in US dollars. Euro and Swiss franc investors must bear the exchange rate risk.

Chart 7: The three periods of rising gold prices Price (logarithm scale) PriceininUSD USD (logarithm

2000

1990

Gold price

Source: Global Financial Data, Datastream, Vontobel

2000

2010

Protection against inflation is also provided by inflationprotected bonds, which are mainly issued in US dollars (“TIPS” = Treasury Inflation-Protected Securities). These bonds are also issued in sterling and euros, but not in Swiss francs.

1 The

same is true of other commodities 7

Chapter 3: How to invest during deflationary periods?

in the EMU Interest rates 8% 6% 4% 2% 0%

Repo rate

Real returns p. a.

Taylor rule

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

–2% 2000

Chart 9: Real returns in deflationary periods

in 12 months

15%

Source: Datastream, Vontobel

10%

According to our estimates, the deflation risk is somewhat higher in Europe than in the US. Inflation has traditionally been lower in the eurozone than in the US due to a stronger culture of stability in Europe. Even though Europe’s monetary policy stance was also below the Taylor interest rate in the period from 2000 to 2008 (see chart 10), the divergence was smaller than in the US. Inflation was accordingly higher in this period than the European Central Bank (ECB) target but lower than in the US.

5%

0%

Equities Corporate Bonds

Cash

Treasury Bonds

Gold

Commodities

Real Estate

–5%

–10%

–15%

Source: Global Financial Data, Robert Shiller, Datastream, Vontobel

The deflation scenario is the inverse of the inflation scenario. Returns on real assets are significantly worse than on nominal assets, as deflationary periods in the past have regularly been linked to a recession. For investors this means they should give preference to bonds of sovereign and corporate issuers. Equities and commodities, on the other hand, should be underweighted.

Is what happened in Japan relevant for the West?

In Japan, the last 20 years have been marked by low inflation – at times even deflation – below-average economic growth and persistently low interest rates. This was attributable to the bursting of the Japanese real estate bubble in the 1980s. Japanese companies had mortgaged themselves heavily to buy large portfolios of land and property. The dramatic collapse in real estate prices from 1990 onwards forced them to reduce their debt and limited their investment activity accordingly. This phase, which is still ongoing at the present time because real estate prices have not yet stabilized, is known as deleveraging. Periods such as this are associated with weak overall demand in the economy and low inflation rates.

2 See

8

Chart 10: Taylor interest rate and actual key interest rate

1999

In contrast to a scenario of high inflation, some observers are forecasting deflation. We could enter a period of deflation if the global economy were to drop into a double dip recession. Although that is not our main scenario, we investigated how individual asset classes would behave in a period of deflation. Since 1900 there have been two basic deflationary periods in the United States (see chart 4).

The average real returns for these periods were as follows (see chart 9):

In the financial and economic crisis of 2008-2009 the Taylor rule likewise indicated negative key interest rates, but there was effectively no quantitative easing by the ECB. In the last two years the ECB has held key interest rates above the level indicated by the Taylor rule. This was one of the factors contributing to the sluggish economic recovery in the eurozone. While the Taylor rule currently recommends a somewhat higher key interest rate, our 12-month forecast for the repo rate remains unchanged and in our view continues to be appropriate.

Even an accommodative monetary policy like that pursued for a long time by the Bank of Japan does not lead to high inflation. But why is that? While the private sector is deleveraging, there is little demand for new loans.

As a result, the increase in the money supply by the central bank does not flow into the economy and consequently has no inflationary effect. This effect cannot be inferred for the current situation in the western economies, particularly not for the US. As US real estate prices have already begun to stabilize – unlike in Japan – the deleveraging phase is only likely to last between three and five years.2

Vontobel Asset Management “From the financial crisis to the debt crisis: Effects on the economy and financial markets”, March 2010

Since fiscal policy is now being tightened in many eurozone countries due to the debt crisis, economic policy is generally on the restrictive side. While our main scenario

Virtuous Switzerland Switzerland has followed the Taylor rule most closely in the last ten years. In the financial crisis the Swiss National Bank (SNB) also practised quantitative easing, as the negative Taylor interest rate indicated.

does not foresee a return to recession and hence deflation, growth will remain below-average and inflation will rise only marginally to around 2%.

12 months, Swiss monetary policy can be considered generally appropriate, meaning that there is no major inflation risk in Switzerland for the foreseeable future.

Chart 11: Switzerland: Taylor interest rate and actual key interest rate Interest rates 14% 12% 10% 8% 6% 4% 2% 0%

CHF 3 month Libor

Taylor rule

2010

2008

2006

2002

2004

1998

2000

1996

1992

1994

1990

1986

1988

1982

1984

– 2% 1980

Switzerland’s key interest rate is currently slightly below the Taylor interest rate. The Taylor rule recommends raising interest rates to 1.5% over the next 12 months, based on our economic and inflation forecasts. We continue to expect the key interest rate to remain at 0.35% in this period, however. This is because the strong upward pressure on the Swiss franc will persist. The SNB sees real appreciation in the Swiss franc of 3% – the same effect as an interest rate increase of 1%. To offset the current negative effect of the strong Swiss franc, interest rates may be some 1.5% lower than if the Taylor rule were strictly applied. Both currently and in the next

in 12 months

Source: Datastream, Vontobel

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Chapter 4: Summary and conclusions for investors

The correlation between money supply growth and inflation has widened considerably in recent decades. The ­Taylor rule is therefore a more important measure of future inflation. It implies that central banks are currently pursuing appropriate non-inflationary policies.

“We do not expect any substantial ­increase in in­flation in the years ahead” In addition, the deleveraging of private households and corporates triggered by the real estate crisis will continue for some years. We do not expect any substantial increase in in­flation in the years ahead. However, if central banks keep their key interest rates low for too long – as measured by the Taylor rule – inflation is likely to accelerate.

Investors who expect inflation in the future are well ­advised to overweight real asset classes such as commo­ dities, real estate and equities. If their take on the future is more one of deflation, then sovereign and corporate bonds should be favoured. Our analysis of inflationary ­periods shows, however, that the performance of asset classes is not homogeneous. Although equities generally provide good real returns in inflationary phases, they perform less well in the years with the very highest inflation rates. Based on this reasoning we would recommend a differentiated approach rather than a pure buy-and-hold strategy for inflationary and deflationary periods. Investors therefore may have no other option than to make tactical asset allocation decisions themselves or to delegate them to a professional asset manager.

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Disclaimer Although Vontobel Group believes that the information provided in this document is based on reliable sources, it cannot assume responsibility for the quality, correctness, timeliness or completeness of the information contained in this report.

This document is for information purposes only and nothing contained in this document should constitute a solicitation, or offer, or r­ ecommendation, to buy or sell any investment instruments, to effect any transactions, or to conclude any legal act of any kind whatsoever.

This document has been produced by the organizational unit Asset Management of Bank Vontobel AG. It is explicitly not the result of a financial analysis and therefore the “Directives on the Independence of Financial Research” of the Swiss Bankers Association is not applicable. All estimates and opinions expressed in this brochure are the authors’ and reflect the estimates and opinions of Bank Vontobel. No part of this material may be reproduced or duplicated in any form, by any means, or redistributed, without acknowledgement of source and prior written consent from Bank Vontobel AG.

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