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Fixed-Income Insights

Many market observers worry that today’s ultra-low inflation could signal falling prices ahead.

In Brief

  • Deflation concerns have seeped into some corners of the fixed-income market, as the United States and Europe report very low inflation figures.
  • The United States—While inflation remains well controlled, continued economic growth and solid consumer and business spending should keep deflation at bay.
  • Europe—While Europe may be more susceptible to falling prices than the United States, the Continent is seeing a fledgling economic recovery. Further, the European Central Bank appears determined to use a range of policy measures to combat deflation.
  • The key takeaway—With deflation a distant—or perhaps non-existent—threat, investors may be better served by focusing on strategies for two more likely outcomes: 1) low to moderate inflation or 2) a more significant rise in inflation.

With apologies to Sam Walton, could consumers and businesses start to encounter "Always Lower Prices" in the United States and the rest of the world? Deflation concerns recently have increased as a result of low levels of headline inflation, as evidenced by the 1.5% annual rate for the overall Consumer Price Index (CPI) reported by the Bureau of Labor Statistics in January. Also, the Federal Reserve's preferred measure of core inflation, the price index for Personal Consumption Expenditures (PCE), calculated by the Commerce Department, showed an annual increase of 1.1% for 2013. Both are significantly below the Fed's inflation target of 2.0%.

The worries extend outside the United States as well. Christine Lagarde, managing director of the International Monetary Fund (IMF), buttressed those concerns when she recently suggested that deflation is a major risk for the global economy.1

And although Japan is starting to heal from its two-decade bout with the deflation disease, Europe appears dangerously close, with January core goods price inflation at 0.2% year over year, according to Eurostat. Meanwhile, some peripheral European countries seem to have already succumbed, particularly Greece, which has logged negative headline inflation for the past 10 months.

United States: Not Turning Japanese
Japan's economic malaise over the past 20 years is testament to the impact of deflation, which prompts businesses and individuals to postpone purchases while awaiting lower prices. This creates a downward spiral in which demand declines, pushing prices and, eventually, wages lower still. At the same time, increasing debt costs combine with reduced growth to destroy the risk-taking backbone of capitalism. Japan's two-decade struggle to reverse the trend of falling prices is evidence that deflation is important to avoid and that its stranglehold on an economy is difficult to break.

However, the fact that the United States and the rest of the world have avoided Japan’s fate over the past several years suggests that deflation is not the next contagion. A comparison of rapid policy responses in the United States with slow and frequently misguided steps in Japan suggests clear differences in how the two countries approach both monetary and fiscal decisions. Cultural differences also may play a role: Japan's economy is characterized by high levels of consumer saving and a reliance on exports, while the United States features greater levels of spending and less dependence on exports. Japan's model seems designed to submit to, if not help promote, deflationary forces, while the current U.S. setup seems more predisposed to inflation-producing behavior.

Such cultural and policy differences may be the key contributors to the ultimate reason why deflation seems unlikely in the United States: continued growth. We at Lord Abbett expect U.S. gross domestic product to expand by 2.5% in 2014, with continued if not stronger growth anticipated for 2015. This argues heavily against the likelihood of deflation and suggests to some observers a return to more normal levels of inflation. Others worry that stronger growth may spur inflation to even higher levels. Ultimately, though, a well-established U.S. recovery supported by effective policy decisions and robust consumption seems to be building the momentum that should defeat deflationary fears.

Europe: A Sinking Feeling?
Europe, on the other hand, continues to struggle with growth and appears much more susceptible to deflation. Indeed, Europe may have been foremost in Lagarde's mind when the IMF head expressed her concern. High unemployment in Europe has reduced consumption and promoted household deleveraging, further reducing spending. Increasing levels of bad debt, whether recognized or ignored by banks, encourages deleveraging at financial institutions as well.

In a nightmare scenario, a deflationary environment that begins in a few peripheral countries could expand to the core of Europe. This outcome could have effects far beyond Europe—for example, lower demand could amplify problems in emerging markets that depend on Europe as an export market.

Fortunately, European economic prospects appear to be better than the past several years. Eurozone GDP figures from Eurostat have at least been positive. Financing costs for peripheral countries have declined. From a policy perspective, the European Central Bank (ECB) has acted to reduce interest rates close to zero and may consider not only additional cuts but also a reduction in the deposit rate to below zero.

It seems less likely that the ECB would adopt the quantitative easing embraced by its U.S. counterpart. Quantitative easing would represent a logistically and politically complex option in Europe, given the number of countries whose debt might be purchased and the concern that purchases might be characterized as monetary financing of peripheral debt. Instead, the ECB could consider offering inexpensive funds to lend to households and businesses, similar to the United Kingdom's "Funding for Lending" program, which could increase domestic demand in the eurozone.

The key point here is that the worst of Europe's recession seems to be behind it, and there are deflation-preventing policy options available to the ECB. Equity and credit markets should respond favorably to improving growth and ECB actions, especially if the central bank's president, Mario Draghi, backs up his pledge to "do what it takes" to avoid the prospect and consequences of deflation.2 Aggressive action in Europe may even help emerging-market securities by supporting eurozone demand for exports from developing countries.

Investing Implications
What does all this mean for investors? Here are three approaches they could take, based on their expectations for the future direction of prices:

1) Low/moderate inflation—If inflation remains at current low levels, or even rises slightly, many fixed-income securities may not experience the significant adverse performance that is feared with higher inflation. Issues of shorter maturity and lower quality, as well as those tied to more economically sensitive companies, may have little reaction to a slight increase in inflation.

2) Accelerating inflation—Those investors who fear greater inflation may want a component of "inflation insurance" in their portfolios to protect against rising interest rates normally associated with rising inflation. Implicitly, such insurance should be cheaper now, in an environment when inflation seems well below historical norms and longer-term expectations.

Many investors consider Treasury Inflation-Protected Securities (TIPS) when seeking protection against rising inflation. However, five-year TIPS with negative yields of about -0.63% as of February 24, 2014, based on Bloomberg data, do not seem cheap, but surprisingly expensive, not to mention the adverse price performance that can be expected if interest rates rise. Commodities may be equally unattractive as a hedge against rising inflation because of the level of price volatility that is often unrelated to CPI inflation.

CPI swaps, on the other hand, seem to be an efficient hedge against rising inflation without introducing the influence of rising real interest rates or the unpredictable effects of changes in commodity supply and demand. These instruments reflect the movement in the headline CPI (including food and energy prices) and can appreciate in value if inflation expectations have increased since the swap was created and it is sold at a profit or there is a payment at maturity. If inflation expectations fall, the market value of the swap is likely to decline, which could lead to a loss.

And as one might expect in an environment of low inflation, CPI swaps have been influenced by recent lower levels of announced inflation. Based on the Deutsche Bank 5-Year CPI Swaps Index, five-year CPI swaps recently reflected expectations of about 2.14% inflation compared to expectations of 2.57% in February 2013.

Investors who seek inflation protection because they believe inflation expectations are likely to rise from current levels may want to consider a portfolio that includes CPI swaps, especially if they believe those expectations will return to or exceed the levels of early 2013. Investors with less aggressive expectations may be content to favor securities that are less sensitive to inflation and more sensitive to the economy, such as high-yield bonds or equities.

3) Deflation—Any investors believing that deflation is imminent should sell their gold and bitcoins, pay off all debts, and invest in high-quality bonds and companies that build bunkers. We're kidding, of course; but within this bit of humor is an unpleasant truth: investors' options will be distressingly limited if deflation takes hold.

 

1 Ian Katz, "Lagarde Cautions Davos on Global Deflation Risk," Bloomberg, January 26, 2014.
2 Claire Jones and Chris Giles, "ECB Poised for Battle to Ward Off Deflation," Financial Times, January 26, 2014.

 

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