There is a constant fear I hear when talking to financial advisers. No one can understand why the trillions of pounds, dollars and euros that have been pumped into the global economy by central banks over the past five years have not caused a big jump in prices. Perhaps this will eventually happen, although there is little sign of it so far, even though, in the UK, we are finally seeing decent economic growth.
The UK inflation rate is now close to a five-year low. The US has also seen a sharp fall in inflation recently, thanks to the falling oil price and strengthening dollar, which makes imports cheaper for Americans to buy. We have also seen renewed fears of deflation in the eurozone and Japan.
There has been a lot of gloomy talk about what it means for the global economy, if even the countries with decent recoveries seem to be struggling to generate much inflation. The question for investors is: what will this “lowflation” world mean for future returns?
Of course, the honest answer is that nobody knows. However, two big lessons seem clear.
The first is that stocks can do perfectly well in a lowflationary environment. Using the newer target measure of inflation, the CPI, we can only go back to 1988 but since then we find the FTSE All Share has produced an average return of almost 2.5 per cent a year when inflation was between 1 and 2 per cent. That is less than when inflation was a bit higher. But it is not too shabby: when you use the RPI to take the numbers back to 1960, the returns are higher but the pattern is similar.
I do have some concerns about the UK stock market short term. I worry our recovery will be held back by slow growth across the Channel or, quite possibly, another eurozone recession. I also worry the UK market will be buffeted by political fears around the May general election. Compared with those two concerns, the possibility that inflation will stay stubbornly below 2 per cent ranks pretty low.
But below 0.5 per cent is another story. It is not happening here but is in many countries in the Eurozone where, on average, inflation is just 0.4 per cent. The longer that continues, the more you worry, because the closer you get to actual deflation: falling prices.
A persistent deflation scenario would be bad news for financial markets, and particularly for economies and companies carrying a lot of debt, as falling prices means the real value of debt and debt payments keeps going up.
That is one of many reasons why having little or no inflation tends to be bad for company earnings and stocks, making it harder to raise your turnover or boost profits.
So, you might say, steer clear of European stocks out of fear of deflation. But deflation itself is pretty rare. If you look at all the available data for all countries since 1950, you find inflation in those economies has been positive nearly 95 per cent of the time.
If you stay out of stocks on the mere hint of deflation, you miss out on the returns you would get if and when inflation moves out of the danger zone – below 0.5 per cent – and European stocks start to look like a better bet. Given how gloomy people are about the eurozone, it might not take much.
That is why I would always recommend keeping diversified, with a large chunk of your assets in global stocks and a large part in bonds. Bonds are the classic hedge against deflation because they offer a guaranteed cash return even when prices are falling. But precisely for that reason, it does not make sense to have all your assets in bonds when inflation is still positive and the yield available on those bonds is negative once you take that inflation into account.
That is the second big implication of global inflation still being so low. It means long-term interest rates are also likely to stay low for even longer than we thought – even after the Bank of England finally increases the short-term policy rate it can directly control.
On balance, I still think interest rates are going up in the UK and US in 2015. However, not for the first time in this strange post-financial crisis world, it looks like they are not going up as fast as we previously thought. Neither is inflation.
Stephanie Flanders is chief market strategist for UK & Europe, J.P. Morgan Asset Management