Should investors be worried about deflation?

Inflation is starting to surprise on the downside, so are central banks able to keep prices in positive territory?

As Japan battles to spend its way out of a deflationary funk spanning decades, could falling inflation in other developed nations become the next big threat?

Inflation in the UK and United States has been tracking downwards, while the European Central Bank, worried about the onset of deflation, halved its repo rate to a record 0.25 per cent in November.

HSBC Group chief economist Stephen King highlights the potential of falling inflation rates to threaten fragile economies.

He says the UK, US and Japan’s quantitative easing programmes have significantly lowered their currencies, boosting inflation, but this has led to “disinflationary” pressure on other countries as it pushes up the relative value of their currencies.

King says: “Normally, this would not be a problem but with the effect of monetary policy on the real economy not working as well as it might, and with growing protectionism, one country’s monetary stimulus is increasingly another’s ball and chain.

“If unconventional policies work primarily through the exchange rate, they serve primarily to export rather than cure disinflationary pressures.” 

While King does not predict a descent in to outright deflation, he says there is a chance that inflation will stay overly low or sink further over the next couple of years.

Standard Life Investments global thematic strategist Frances Hudson says the threat of deflation is starting to come up in conversation.

She says: “The central banks do not really have a toolkit for deflation, in that the whole monetary system is set up to control inflation.”

Hudson says the eurozone is much closer to succumbing to deflation than the United States and the UK. She says Standard Life has started favouring eurozone sovereign bonds as European inflation rates fall toward zero and real yield rises.

She says while deflation is “not imminent, it is rising on people’s radars. It is becoming more of a concern and the kind of things people are watching is whether banks are going to start lending. 

“Because any bank faces exactly the same thing: if there was going to be a deflationary environment you would sit on your money, because it is going to be worth more.”

Hudson adds credit growth has been slowing in the US and the eurozone, driven by regulatory changes and increased capital requirements as banks pull back from financing crossborder activity and lending to small and medium-sized businesses.

She says: “We are in an awkward stage where people do not really know which way they are going.”

ETF Securities research director Martin Arnold believes commodity shocks that could push economies into deflation are unlikely.

He argues recovery is building in both developed and emerging economies. He says after exceptional growing seasons last year, prices for agricultural commodities are already low and likely to rise rather than fall. He think oil prices are also unlikely to drop much further, despite Opec being a “toothless tiger” in keeping members honest on quotas.

Arnold adds: “We do not really see the threat of deflation at the moment.”

Chelsea Financial Services managing director Darius McDermott says deflation is an “interesting question” for those running money.

He says: “If you are in the deflationary camp, fixed income would look better, but if you are in the other camp you would want very little fixed income exposure or short duration bonds.”

But Fidelity Worldwide Investment head of tactical asset allocation Trevor Greetham sees things differently.

He says there are three main drivers pushing down inflation: the structural slowdown in China lowering global demand, which then compounds an overcapacity in the commodities space; and lastly the spare capacity in most developed economies, especially the US. 

Greetham describes this as a “back to the 90s” scenario which is not in itself too frightening. 

He explains that about 20 years ago Japan was in the position China takes today, with slowing industrial demand creating deflationary pressures for the rest of the world and contributing to the era’s equity bull market.

Greetham says: “We see similar dynamics today. A property bust in America and Europe has again created spare capacity in labour markets. Meanwhile, commodity production capacity continues to come on stream and there is a possibility that Iran will ramp up exports of crude oil.”

Greetham believes that will translate to poor performance in commodities and emerging markets, while developed world equities should give better returns.

Fidelity’s multi-asset portfolios have been positioned accordingly with overweights in US and Japanese stocks, which tend to benefit from a strong dollar.

Unlike most other asset managers, the multi-asset team is underweight European equities. It is also overweight European government and corporate bonds.

Greetham says the team has an underweight position in European equities given the fact that countries in southern Europe such as Spain, France or Greece, would be unable to devalue their currencies to combat deflation. He believes if this would spark another euro crisis.

He says: “There are parts of the world where deflation would be really toxic, which would be the eurozone periphery. We are relatively underweight on European equities because we’re concerned about this.

“Next time you get a global slowdown, Europe will get it in the neck.”