At the spring equinox the financial markets are grappling with the twin, yet opposing, forces of inflation and deflation. One of these forces will wax, the other will wane.
The job of the investment strategist, like a nineteenth century detective writer (and a jolly good one at that), is to discover “who done it?” and why?
The ultimate denouement will have critically important implications for investors as we pick our way across the quick sands of this late stage in the economic cycle.
Market turmoil: getting to the bottom of it
At present all the economic headlines are being grabbed by the continuing rout in the US residential property market and, at the same time, by the record levels achieved by the futures price of a barrel of oil, a troy ounce of gold and any number of other hard and soft commodities.
However, from an investment perspective, it is important to bear in mind that rising commodity prices and falling house prices (and accompanying crisis in the credit markets) are the physical manifestations of two key opposing forces; inflation and deflation. Pick the right one and investors could walk off with the big prize, pick the wrong one and investors could end up, like Wilkie Collins’ character, Rosanna, plunging dramatically into the suffocating mud.
We have never held the view that today’s financial market issues have their source solely in the US subprime crisis, as regular readers of this publication will be well aware. Certainly, the point at which the US residential property market “went critical” was the point at which the “blue touch paper” was lit but today’s crisis, a global crisis, had its roots far more deeply embedded in economic policy measures taken for granted over the past fifteen years of relative prosperity but now, as is ever the case, returning to haunt us.
One the one hand, we have a US Federal Reserve rightly obsessing about the outlook for growth, cutting base rates aggressively and driving, by so doing, the dollar down to multi-year lows on the world’s foreign exchanges and Treasury Index Protected yields into negative territory! Does that really mean that investors are prepared to accept a guaranteed loss of real value in their capital for as long as five years merely for the certainty of avoiding the near-term inflationary pressures created by the Fed’s policy of benign neglect? – Stunning!
On the other hand, the Fed is right to pursue this policy. The tightening in credit conditions is no longer a localised affair. The deterioration in residential property prices is no longer a localised affair. Both events have crossed national frontiers and are unleashing very aggressive deflationary pressures, pressures that are already and will continue to drive global economic activity lower over the months ahead. The twin, and competitive, forces of inflation and deflation are causing havoc across the financial markets and helping to drive share prices back down towards and through the multi-year lows established at the end of January.
What we do know, because we saw a good example of it at the end of the twentieth century, was that those sectors which tend to lead into a period of pronounced volatility tend not to be those that lead when we emerge at the other end.
So we come to the crunch. For all the high profile concern regarding inflation, investors should be aware of the fact that inflation is, critically, a lagging variable and that the deflationary pressure associated with the credit crunch is a leading indicator.
What we are seeing in recent producer price inflation data is rising input prices being passed on, but not in full, at the factory gate. Higher prices are rapidly starting to curtail demand and margins are under relentless pressure. Falling demand places companies in an increasingly difficult position and illustrates quite clearly that demand / pull pressures are ebbing as the global economic tide goes out.
Importantly, central banks may be able to influence the price of credit but they cannot control its availability. Between 2004 and 2006 the supply of credit expanded aggressively at the same time as monetary policy was generally being tightened. Now monetary policy is being eased, particularly in the USA, but credit conditions have hit their tightest levels for eighteen years and whilst particularly severe in the US, conditions have tightened globally. If this isn’t a classic example of central bankers “pushing on a string” we don’t know what is!
Although the situation is particularly acute in the US, it is probably not far off being just as bad in Europe. The difference between the two regions is, of course, the differing mandates enjoyed by respective central banks. The Fed sees inflationary pressure but can cut base rates to provide the best possible foundation for future growth. The European Central Bank sees tighter credit conditions but is powerless to cut rates while near-term inflationary pressures intensify. Not for nothing are European bank balance sheets coming under significant pressure. Might it be appropriate to consider at what point credit conditions might be tougher in Europe than the US?
In Asia the problem is different again. Inflationary pressure is very much in evidence, but in many cases this is due to pegged exchange rates. The obvious way to relieve that inflation is to unpeg currencies rather than push base rates higher. As we know, this is a step too far for many in the region, including the Chinese.
Our position is that it will happen but that it might take time and in the meantime the pressure on the domestic economy will intensify. Note, however, that by unpegging exchange rates a country is virtually guaranteeing financial sector asset deflation. Tighter credit conditions would be the ultimate and inevitable consequence of such a move, adversely impacting future demand.
Think we’re wrong? Just look at the deteriorating global credit markets. Market operators sense asset deflation all around the world and credit default swap spreads (a standard measure of risk) have widened almost everywhere.
Conclusion
We are building up towards our next big call. Certainly the next few months are likely to be tough, characterised, we suspect, by still heightened levels of volatility and low levels of earnings visibility. However, we will be looking, during Q2 2008 to introduce risk back into investors’ portfolios (this is not the sort of comment normally attributed to the pathologically bearish!). Whilst we see inflationary pressure we view it as more a function of yesterday’s problem than tomorrow’s problem.
The global deterioration in the credit markets is a function of tomorrow’s problem, rising deflationary pressure. We believe that the sectors and strategies which win heading into periods of volatility are rarely those which lead on the way out. Readers will be well aware of our strong preference for large cap defensive strategies over the past nine months. That period is coming to a close. We see more opportunities presenting themselves from the asset deflation argument than in the ongoing inflation argument.
For a start we believe that investors should give serious consideration to reducing bond exposure (yields are either anticipating a serious deterioration in the global macro-economic environment, or they indicate that bonds are very expensive) and buying US equities over their European counterparts. Secondly, we are almost ready to start reducing exposure to defensive growth in favour, selectively, of the bombed out under-owned sectors of the market such as housebuilders.
We would add two words of caution. Firstly, Western macro economic activity is still trending downwards, led by severe pressure on the consumer. For this reason we continue to be very wary regarding apparent value on offer in the consumer facing sectors of the market. Secondly, accept that, for now, the banks might represent a “value trap” and that while the credit crisis rumbles on the “Moonstone” is likely to prove hard to track down.
By Jeremy Batstone-Carr, Director of Private Client Research at Charles Stanley