The financial world seems a more stable place as we enter 2014 than it has for several years. The intrinsic value of equities still appears reasonable, if no longer cheap, while government bonds still appear historically expensive. Not surprisingly, therefore, relative valuation arguments still favor equities. But as we near the end of quantitative easing and the extraordinarily easy monetary policy of recent years, we face new questions:
• Will monetary policy be tightened so slowly that the inflation genie will be let out of the bottle? Or is deflation the greater threat?
• What do we know about how asset prices perform in different inflationary environments?
• Can we realistically forecast inflation? Do we need to worry about what type of inflation we may get?
• Finally, can we build cost effective portfolios without having to accept an array of other risks?
The case for inflation
With some $8 trillion dollars on central banks' balance sheets, the fear is that these assets will be monetized before central banks can take the stimulus off the table. The more cynical may also believe that authorities see a degree of inflation as the least bad option to reduce the debt burden on the next generation. How rapidly bond yields rise to more normal levels, and how that affects equity markets, will be key. Central banks do have policy weapons to use. For example, if a central bank increases the reserve requirement, excess reserves then become required reserves.
The case for deflation
Currently, G7 inflation is decelerating against a backdrop of spare capacity. Unemployment remains elevated almost everywhere, suggesting that wage inflation should remain low, and commodity price inflation, in the face of low global growth, also remains subdued. Near term, we believe that deflationary forces dominate and inflation risks are still some way down the road. An ideal scenario of moderate growth, moderate fiscal deficits and moderate inflation would allow nominal gross domestic product to grow at a fast enough clip to bring debt ratios down.
Asset prices and inflation
The only recent period of high inflation in the developed economies was in the 1970s, and many of today's inflation-sensitive assets did not exist then. However, there does appear to be a monotonic inverse relationship between higher inflation and lower bond returns. With equities, moderate inflation or deflation has been associated with relatively buoyant returns. What appears to be important is whether inflation is accelerating or decelerating and not necessarily the absolute level.
Forecasting inflation
Inflation is hard to predict, and we must also consider whether it is accelerating or decelerating, whether it is
stagflation or demand-generated inflation, and whether it is exogenous or endogenous. Equities are unlikely to provide protection in a stagflationary environment, but may under demand-driven inflation. How we respond to inflation threats may also depend on where we are, with different choices for the U.S. than for many Asian countries or the U.K.
Building cost effective portfolios
There is no such thing as a single inflation protection portfolio, but there are assets that in the long-term have a good probability of matching or beating inflation, even if in the short-term they provide little or no protection. Stock dividends are paid out of nominal earnings and nominal earnings include both inflation and growth. Provided in the long-term we experience growth, nominal earnings should grow faster than inflation.
What else can we do?
We need to understand our sensitivity to changes in correlation, and consider assets and liabilities simultaneously. We need to understand the role of income in managing risk. The more that a fund's cash flow needs can be met from naturally arising income, the less risk there is that we will need to sell capital assets in a down market. And we need to understand the importance of managing down portfolio volatility, since volatility compounds the risk of having to sell assets in a falling market.
Conclusions
• Although equity valuations are not as attractive as they were a year ago, they still represent reasonable intrinsic value and they still look cheap relative to bonds.
• In the medium term, we may face significant risks from inflation or deflation.
• It is impossible to say today with any degree of certainty which is more likely.
• To structure our portfolios to withstand changes in inflation, we can:
o Measure the sensitivity of our liabilities to changes in interest rates and inflation;
o Measure the sensitivity of our assets to changes in correlation;
o Consider the impact of changing the size or make-up of our growth assets and how that may change the interaction between our assets and liabilities;
o Try to cover as much of our cash flow needs as possible to minimize the need to sell capital stock in a falling market.
Alan Brown is senior adviser at Schroders
