Deflation: a temporary blip or longer-term threat?


The UK, like many other developed economies, has been experiencing periods of deflation, disinflation and ‘noflation’ leaving many uncertain when prices will normalise or grow again.

Last week’s Office for National Statistics data showed that the consumer prices index fell by 0.1 per cent in the year to April 2015, dropping year-on-year for first time since 1960, when prices fell by 0.6 per cent.

Although widely expected, many pass this deflation off as temporary, but is it really? And how should investors be positioned in this scenario?

JP Morgan Asset Management global market strategist David Stubbs thinks that deflation will not last long as the declines in energy prices, which were largely the cause for the drop, have already rebounded and “will soon fall out of the calculations”.

However, we are still in a deflationary environment and while waiting for the “gradual” interest rates hike expected from the Bank of England, he believes inflation will become positive, but not strong.

Henry Dixon, fund manager at Man GLG in charge of the GLG UK Income fund, very much expects to see an acceleration of GDP in the second half of the year meaning that investors should be focusing on “the twin spectre” of rising growth and inflation.

“I am always concerned when something has been written off, and inflation is definitely in that camp currently. In my view, when some of the short-term factors such as the fall in the oil price come out of the equation, it could overshoot the official target and climb back up near to 3 per cent by January.”

Standard Life Investments OECD economist James McCann thinks there are signs in the medium term of a pick-up in inflation with prices to become more sustainable.

“The disinflationary path has been overplayed. The growth in the global economy will be the catalyst to look for in the next year,” he says.

Paul Marson, chief investment officer at investment boutique Monogram Capital Management, disagrees, and thinks disinflation is instead going to continue and remain in the UK “for a long time”.

“You can see that typically about one-quarter of the UK CPI index is generally in deflation: right now we have 50 per cent of the CPI components in deflation. So we need £50bn plus of fiscal tightening to stabilise the net debt to GDP ratio. That, in itself, is a real headwind for the economy and is disinflationary,” he says.

In terms of investments, Stubbs thinks deflation has “obvious” implications on the gilt market.

“Even if the BoE is raising interest rates in the next couple of years we believe that gilts yields will not rise too much. Firstly because we think the interest rates rise will be very gradual, secondly because we don’t think inflation is going to get out of control, and thirdly because of what is going on around the world with a very low interest rate in Europe and Japan making our debt market look attractive to foreign investors.”

For Stubbs, gilts still represent “a decent value” for investors looking around the world at other fixed income instruments because interest rates “are even lower elsewhere”.

Axa Wealth head of investing Adrian Lowcock says the fall into deflation was expected and managers “have already aligned for this”.

Index-linked or inflation-linked bonds look attractive as inflation “will return” although it may take time to work through to significantly higher levels, he says.

He adds: “Equities are likely to continue to do well as interest rates are not likely to rise in a deflationary environment.”

However, many agree that with valuations higher, shares are not cheap so it is critical to be selective on stocks and sectors.

Premier Asset Management senior investment manager for multi-asset funds Simon Evan-Cook is not concerned by deflation as his stocks are “well protected”.

“In a deflationary environment, normally fund managers would opt for government bonds as the only secure asset and be selective on equities. However, we don’t like government bonds at the moment as they are threatened by inflation and too expensive.”

Marson thinks deflation is not just a UK story but is widespread around the world. He looks at the pipeline producer price deflation around the world and says in 34 countries, which account for 86 per cent of global output, 68 per cent have annual producer price inflation lower than zero.

“This deflation you are seeing in the UK is not UK only. You see a structural disinflationary picture around the world.”

China has an effect on commodity prices, he explains, the production of goods grows quicker than demand and the country’s fiscal policy continues tightening. “Those three things create a structurally disinflationary environment,” he says.

Tilney Bestinvest managing director Jason Hollands agrees with Marson that China is “exporting deflation pressures around the globe”.

In addition to that, there is also a “big mismatch” between supply and expected growth in demand for oil, which creates further uncertainties on the inflation outlook. Global oil demand will grow by just 1.3m barrels a day next year, way below the 2.89m level seen in 2010, according to the US Energy Information Administration.

Hollands says: “On balance therefore, while deflation looks like it will be temporary and in the near term inflation should rise, when you look through all of this, the inflation outlook is benign.”