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Rise and fall

In the wake of the global economy’s almost complete halt at the end of last year, macroeconomic data is now showing signs of improvement. In recent months, global stock markets posted some of the strongest rallies on record. The consensus view has rapidly shifted to a strong economic recovery and fears over deflation have been cast aside.

Maia is more sanguine. Although the impact of fiscal and monetary easing will be significant, the economic situation is still undoubtedly weak. Maia believes the consensus view is far too cavalier in ignoring the downside risks.

Gilt yields are still rising despite the Bank of England’s spectacular quantitative easing programme, and there is a danger that this alone could kill off any nascent recovery. There still remains a real risk that the UK will slip into a deflationary environment as the recession takes a firmer hold, jobs are lost and people start saving and clearing their debts rather than spending. The headline rate of inflation is falling rapidly and now stands at -1.2 per cent, the lowest level since the retail price index was initiated in 1948. On this measure deflation is already with us.

On the face of it falling prices might sound appealing – the real cost of living falls and we all seem richer. If prices fall in one sector, as a result of a huge increase in productivity from new technology for example, then falling prices can really be good.

Broader general deflation is usually bad, however. If prices are falling people tend to defer spending – why buy it today when it will be cheaper tomorrow? – and the economy comes to a standstill. This leads to job cuts which cause further spending cuts and a deflationary spiral downwards.

Deflation is particularly bad for those with debts and physical assets; property values will fall while the real value of the mortgage debt will increase. A house and mortgage does, however, provide significant protection against inflation. Therefore, many investors with a house and mortgage would be wise to pursue an investment strategy that offers a hedge against the risk of deflation, even if they believe this is the less likely outcome.

Long-dated government bonds offer the best protection against deflation as yields fall and prices rise. Recently, the yield curve has steepened as equity markets have rallied and risk appetite has increased. This means long-dated bonds now offer better value than they did a few months ago, making them a potentially attractive option for hedging the deflation risk. In contrast, equities and corporate bonds tend to perform poorly in a deflationary environment as earnings fall and default rates rise.

Despite the measures the authorities are now taking, from quantitative easing to Government spending programmes, there is still a risk the economy does not recover as fast as hoped. There is then the real danger that the authorities run out of tools to tackle the problem, which could lead to a Japanese-style “lost decade”. Although perhaps not the most likely outcome, the investment consequences of this scenario would be severe. Investors who choose to ignore the possibility of a global lost decade do so at their peril.

Jason Collins is a partner at Maia Capital


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