|The inflation versus deflation riddle |
By Tony Jackson
While the markets may be slightly less jumpy at the moment, one great uncertainty remains: whether we face inflation or deflation. From a purely selfish perspective, investors should, on balance, prefer the latter.
This is because inflation transfers wealth from lenders to borrowers, while deflation does the opposite. There is ultimately no good hedge against inflation. But whatever damage deflation might do to society, investors – in their capacity as lenders – may profit by it.
We need not look to economists to answer our starting question, since they disagree on it. We should be particularly wary of those who tell us that inflation is a problem solved. In any discipline, a decade of unusually benign outcomes will be taken by practitioners as a tribute to their expertise.
If not economics, let us try history. The latest investment yearbook from Credit Suisse charts UK prices – in approximate terms – since the 13th century. Inflation and deflation roughly balanced out until the 20th century, when inflation streaked ahead.
That can be refined slightly. A century ago, it would have been rational to regard inflation as a byproduct of war. Thus, the absolute price level reached at the end of the Napoleonic war in 1815 was not reached again in the UK until the early stages of the first world war. The final level of that war, in turn, was not seen again until early in the second world war.
Then it all went wrong. The final level of the second world war has not been seen again either, but that is because prices have never again been that low. Nor are they likely to be, having risen 35-fold since.
Let us set aside the competing explanations for that. The question is whether inflation is now permanent.
Not necessarily. In the decade 2000-09, UK prices rose less than in any decade since the 1930s. And in 2009 prices actually fell – the first case of deflation in a calendar year since 1933.
So the jury is still out. Now, back to the question of defending against either outcome.
The academic authors of the Credit Suisse study, Dimson, Marsh and Staunton (DMS for short) give the historical context. Their data on real returns over 112 years in 19 countries give a total of 2,128 country years. They have arranged those years in a spectrum from extremes of deflation to inflation, and measured the real returns on asset classes in each.
Unsurprisingly, real returns on bonds are highest during extreme deflation, and fall consistently thereafter – going negative when inflation reaches about 5 per cent. Equities are less simple.
Contrary to the view still common among investment professionals, real equity returns are highest – above 10 per cent on average – from the deflationary extreme until inflation reaches about 2 per cent. Then they start dropping, going negative at about 8 per cent.
At the inflationary extreme, equities return minus 12 per cent, while bonds are down by twice that. Conversely, at the deflationary extreme real bond returns of 20 per cent are twice the level for equities.
But we should beware of taking this at face value. Both stocks and bonds are paper promises, contingent on the solvency of the issuer.
The return on bonds since 1900 represents an average of good times and bad, in terms of government solvency. Today we are towards the bad end of the range.
Real yields on German or US Treasuries are negative, but are sharply positive for Spain and Italy because of default risk. Deflation, which pushes up the real cost of bond repayments, would make that risk more acute again.
Similarly, the expected return on equities doubtless contains an element of inflation risk. But as the DMS team point out, the overall risk premium covers a lot of other risks too.
This is neatly illustrated from the German hyperinflation of 1922-23, when equities maintained their real value while other paper promises became worthless. As inflation ran off the scale, shares in manufacturers and miners were snapped up on the premise that they had assets and cash flows abroad. That is, they were a currency hedge.
What about gold? While the best available bet against inflation, it is not a hedge in the sense of holding its real value unchanged. Again, there are too many other things going on. The real gold price in sterling is much higher in today’s low inflation than it was in the high-inflation 1970s.
There are, of course, index-linked government bonds, which today either give negative returns or are subject to default risk. There are also all kinds of fancy inflation hedges on sale from the investment banks.
But in the long run, faced with either inflation or deflation, you are on your own.