The biggest risk to economies around the world in 2010 is a growth double dip. Further out, investors remain rightly concerned about hedging tail risks, particularly the risk of inflation or deflation. Worries about these two tail risks have increased as investors have become more concerned with sovereign risk, both in terms of national and local government debt. This has raised the specter of both inflation (if politicians choose to cure debt via inflation) and deflation (if interest rates were to spike in anticipation of inflation and cause the economy to slump).
How likely is either scenario?
According to North American Economist Ethan Harris, outside of energy prices, inflation is likely to remain weak and on a gradual downward trend in both the US and globally. One of the most regular features of the business cycle is that inflation falls in the early stages of recoveries. This is because spare capacity is always high coming out of recessions, with high unemployment, vacant offices and apartments, and under utilized factories. After a big recession the spare capacity is even greater, extending the period of disinflation. Sustained deflation is only likely if the US follows the Japan scenario and fails to heal the wounds of the capital markets crisis. Thus, if there is a series of shocks to the economy or a major policy mistake such as premature fiscal tightening, then the wounds will fester and inflation will continue to fall. In Japan, two recessions with only a very brief recovery in between were enough to cause deflation.
A sharp rise in inflation is extremely unlikely in the next two years, but thereafter the risk is twofold. First, because of the solid economic recovery combined with another big boom in commodity prices. Second, politicians interfere with financial authorities and prevent them from exiting its extraordinary policy ease in a timely manner. Once the economy and banking system are fully functioning it is important for the governments to drain all the excess liquidity out of the banking system. A sharp rise in inflation is extremely unlikely in the next two years.
How to position for inflation or deflation?
The best examples of deflation are the US in the 1930s and Japan in the past two decades. A quick look at US returns during the 1930s shows that investors very worried about deflation should bias their portfolios in the following way:
- Bonds over equities, real estate and commodities
- Growth stocks over value stocks
The best example of inflation is the 1970s. A quick look at returns during the 1970s shows that investors who are very worried about inflation should bias their portfolios in the following way:
- Small cap stocks over large cap stocks
- Value over growth stocks
- Commodities and real estate over equities and bonds
