Why investors’ current pessimism is misplaced
In the recent film of Michael Lewis’s book The Big Short, no one wants to believe the US housing market is heading for a crash. Aside from a few who saw how unsustainable the subprime mortgage market had become, Wall Street would not stray from the perceived wisdom that because there had never been a housing market crash, the chances of one happening in 2007-08 were nigh on impossible.
Today, the problem is not blind optimism but a deep-seated pessimism across financial markets. Despite a resilient recovery from the global financial crisis, bearishness pervades. The doom-mongers argue that the world economy is suffering from a structural lack of demand and an accompanying lack of investment. This in turn is leading to low levels of growth, interest rates and inflation.
The two big mistakes investors are making
Some commentators have gone so far as to claim that inflation has been consigned to the history books. But what if they are wrong? If inflation is not dead, then investors are making two big mistakes and risk being left dangerously exposed when it returns.
The first error is that investors are bailing out of anything deemed to carry risk, even high-quality long-term investments, due to a fear that the world is now in a permanent state of stagnation and deflation.
Just look at the indiscriminate sell-off in anything connected to emerging markets; no account is being made for whether specific countries enjoy strong fundamentals. The view is that everything must go.
Investors’ second error is complacency towards US Treasuries. Because of the belief that inflation is now dead, there is an assumption that the “risk-free rate” will be a shelter from declining markets.
This is important, given the correlation between inflation, interest rates and bond prices. In simple terms, when inflation returns, the risk premium on bond yields will increase leading to a decline in US bond valuations.
If the Federal Reserve reacts by hiking rates this will further the move; if the Fed does nothing they risk losing credibility, which in itself would also increase the risk premium of longer date Treasuries.
If we are right, and inflation returns more quickly than anticipated, the market’s decision to buy supposedly risk-free Treasury bonds will compound the earlier error to bail out of riskier assets.
At first glance, the evidence in favour of the stagnation/deflation theory looks strong. For example, the widespread inflation that was predicted to result from the money-printing programs (quantitative easing) introduced by many western economies failed to materialise. This bearish assessment gained further weight because of the global fall in commodity prices, and in particular oil, which has fallen to lows not seen for more than a decade.
We believe this view is misguided; the evidence suggests that it would take a set of heroic assumptions to believe that headline inflation will remain at the current extremely low levels.
Our forecasts are ahead of the US Federal Reserve and, crucially, those priced in by financial markets. We believe headline CPI inflation in America will exceed 2 percent by the end of 2016 or early 2017.
Inflation could return quickly
There are a number of reasons to think that the market has got it wrong and that inflation could return far more quickly than most are anticipating. It is already running at high levels and above target in a number of emerging markets — from Malaysia to Russia, for example, as well as large swaths of Latin America. Bear in mind that emerging markets account for a significantly higher share of the global economy than they ever did previously.
Similarly, while the collapse in commodity prices has indeed hit headline inflation rates, the falls have masked the relative stability of core inflation. A recovery in oil prices and other commodities would quickly feed through to a boost in headline inflation.
Inflation on the way back in the US
In the US, still the largest driving force in the global economy, there are good reasons to think that inflation is on the way back too. The labor market is now essentially back to full employment, following several lean years in the wake of the global financial crisis. Ultimately, this should feed through to consumer spending, driving up prices.
What Are the Risks?
All investments involve risks, including possible loss of principal. Bond prices generally move in the opposite direction of interest rates. Thus, as the prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in developing markets, of which frontier markets are a subset, involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets.
If inflation does return more strongly than most anticipate, and the Fed responds as we predict, then Treasuries may not seem like such a haven after all. That might not be explosive enough for another Brad Pitt movie, but it would be potentially disastrous for investors who are caught out.
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Article prepared by Michael Hasenstab, Ph.D. Chief Investment Officer Templeton Global Macro (reproduced with permission)
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