September started with a bang. The FTSE 100 ended higher on Friday, but that was its only gain for the week. And the S&P 500 saw its worst weekly loss since July.
The recent market rally has been driven partly by relief that the world hasn’t ended yet, but also by faith that the world’s governments have the ability to reflate the global economy. To choose inflation, rather than deflation.
But they might have a tougher fight on their hands than they appreciate. The big fight between inflation and deflation hasn’t been won yet, not by a long chalk. We suspect that in the long run, inflation will be the final destination. But for now, deflation may well start to worry investors again. As it does, the sorts of assets that have been rising during the recent rally will be rejected in favour of more deflation-proof ones.
So what would that mean for your investments?
The current slump will end with a nasty bout of inflation
Deflation isn’t an issue in Britain at the moment, mainly because sterling had such a catastrophic fall before everyone started getting excited about risky assets again. But many countries are now seeing prices fall on an annual basis (for our purposes here, we’ll talk about deflation as meaning falling prices rather than the stricter definition of a declining money supply). The consumer price index in the US was down 2.1% year-on-year in July, for example, while eurozone prices are falling at 0.7% a year.
We suspect the final destination of the current slump is with a nasty bout of inflation. Because in the end, central bankers and governments will do whatever it takes to get out of this slump, even if that involves destroying their currencies and causing sovereign defaults.
But this might be a tougher job than they expect. For one thing, as John Mauldin points out in his weekly Investors Insight email newsletter, wages in the US are falling. Falling wages do not make for an inflationary environment, and while unemployment is still rising, there’s not much scope for employees to get any kind of traction in terms of asking for wage rises. The level of strike action in the US, for example, is at a more than 60-year low.
A surge in commodity prices might push up inflation figures. But the problem with high commodity prices is that in this kind of environment, they act like a tax. If people have no ability to demand higher wages to pay those higher food and energy bills, then the money comes straight out of their disposable income.
So while we believe that Western central banks will keep working hard to avoid deflation – with enough stimulus and money-printing to bankrupt their countries if necessary – there will be plenty of moments when ‘victory’ seems in doubt. And we could be heading for one of those times right now.
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What this means for your investments
What does this mean for your investments? Government debt could easily rally as people get more worried about deflation. But the trouble with government debt is that central banks are now key buyers in those markets. All you need is for Mervyn King or Ben Bernanke to turn around and say the wrong thing to the wrong journalist and next thing you know, yields are surging and prices are falling. Second-guessing the government isn’t an easy way to make money.
Corporate bonds are more interesting. Not the high-yield junk, the investment grade, relatively safe stuff. It’s not the most exciting asset class, but if you’ve already bought into it, and are holding a fund such as the M&G or Invesco Perpetual Corporate Bond funds, we’d feel comfortable sticking with it for now. They yield enough to make it worthwhile and if the market does start to fret about deflation, these sorts of funds will become all the more attractive.
As for stocks, it has to be defensives. Deflation is bad news for companies – an over-indebted populace simply can’t spend as much money, so profits are going to take a hit whichever way you look at it. So you want companies that have the balance sheet strength to ride out a storm and whose business is resilient throughout all stages of the economic cycle. The good news is that defensives are also cheap and offer attractive dividend yields compared to the rest of the stock market.
Gold should be seen as another currency
Lastly, how does gold fit into this equation? Well, as Mauldin points out (and as we’ve mentioned many times before), a rising gold price doesn’t have to be all about fear of inflation. It’s as much about the threat of governments undermining their own currencies in their attempts to beat deflation. “What it may be saying is that paper currencies are a problem. Gold is going up not only in dollar terms, but in euros, pounds, yen, and more. My view is that gold should be seen as a neutral currency.”
That makes sense to us. And gold certainly had an exciting week last week, with the price spiking up to near $1,000 an ounce. I’ll leave it to my colleague Dominic Frisby to update you on gold in more detail later this week, but I know he’s pretty excited right now. At the start of last week, Dominic released a report on his favourite gold stocks and already some of them have started to see some solid gains.
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