Don’t fret too much about deflation – the next crisis will be different

“Don’t panic!”

That’s a two-word summary of an argument put out by Capital Economics yesterday.

In essence, it says, despite some sluggish data in recent months and the panic over China, things just aren’t as bad as many are saying.

And surprising as it may seem, I rather agree…

Everything is awful – isn’t it?

The International Monetary Fund (IMF) says things are looking gloomy. Global growth is stalling and this year will see the worst growth since the global financial crisis and the recession of 2009. At 3.1%, growth is weaker than the IMF thought likely in the spring.

Although the problem lies more with emerging economies (now into their fifth years of slowdown) than with developed ones, the IMF recommends that the US Federal Reserve hangs on for “firmer signs of inflation” before it thinks about raising interest rates – another excuse for Janet Yellen to hold off.

There aren’t many sure things in finance. But here’s one: if you’re on the same side of a trade as the IMF, you cannot call yourself a contrarian.

This isn’t to say that growth is going to be spectacular this year, not by any means. It’s more about tone.

We’ve got Larry Summers back in the FT this morning, calling for governments to “do more” to stimulate the economy and save us from “secular stagnation” and the “zero-bound” of rock-bottom interest rates.

A lot of the same big names who had no inkling of the pending financial crisis back in the halcyon days before 2007 are now telling us that things are awful and we need a ton more government spending or experimental monetary policy to get us out of the hole.

Without wanting to get complacent, that makes me question the whole premise of the ‘new normal’.

Successful active investing doesn’t necessarily lie in spotting where things are going. It lies in spotting where the market has priced in an outcome that is too extreme.

For value investors, it’s spotting where the market has decided a company is going to go bankrupt, and prices it accordingly, even when the value of the underlying assets makes clear that there’s money to be had even in the worst-case scenario.

For contrarians (basically a subset of value investing), it’s about getting a feel for what the consensus believes, and where they might be wrong.

What could go right?

What are the risks to the prevailing air of gloom? Well, for a start, things might just not be as bad as markets fear.

For example, notes Capital Economics, “consumer indicators are holding up well in advanced economies, suggesting that households are spending their windfall from lower oil prices”.

Meanwhile, the consultancy also thinks “the true rate of growth in China has stabilised (at a low level) since the beginning of the year, and is likely to rebound in the coming months”.

So here’s a different potential scenario, from the ‘new normal’ or ‘secular stagnation’ idea: maybe the slide in commodity prices is largely good news.

That shouldn’t be as unusual a point of view as it apparently is. It’s hard to see how the same pundits who thought that soaring oil prices were recessionary now see collapsing oil prices as recessionary too.

Whether the extra money in consumers’ pockets goes on paying down debt or spending more doesn’t really matter. Consumers who are benefitting from a little more breathing space will have a greater tendency to consume.

And if China is doing better than people think, then maybe the pain for emerging markets and the commodity sector is on the verge of ending – or maybe it already has.

In fact, maybe the main thing we’re going to have to worry about economically is that the Federal Reserve and other central banks get ‘behind the curve’. Instead of doing too little, they do too much, based on a panicky sense that the world is on the cusp of a brutal deflationary collapse.

I’m not saying that there’s nothing to worry about. The political side of things is looking very sticky at the moment. Relationships between Russia and the West are deteriorating again. China is another player on that front whose intentions and ambitions are not entirely clear. And the retreat from globalisation continues apace, which is something else that investors will have to incorporate into their future planning.

But the next disaster we are heading for will not be the same one that we saw in 2008. And the danger is that – as always – those in power and those in the markets spend so much time fretting about the accident behind them that they don’t see the looming hazards ahead of them – until it’s too late.

How are you meant to invest in this environment? Well, you can take a more active approach (in tomorrow’s issue of MoneyWeek, we look at a number of sectors likely to benefit from any rebound in sentiment, including gold miners, and an intriguing way to play any emerging-market rally).

Or if you don’t fancy being that active, you can take what I like to think of as a ‘passive but intelligent’ approach – constructing a diversified portfolio with broad exposure to the best-value areas so that you benefit from the most promising long-term sectors while smoothing out the ups and downs. We’ve put together a step-by-step strategy that aims to do just this – if you haven’t already heard about it, find out more here.


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