Why deflation is a real risk in the coming years

UK Real Bond Yields

So, what is going on? Either inflation is expected to collapse, or a new order has been established – one in which investors no longer expect to generate a real rate of return from the income component of bond investing. We somehow doubt the latter based upon our contacts with investors around the world but, equally, a total collapse of inflation suggests a dramatic slump in the already feeble rates of economic growth.

The problem is that central banks have manipulated interest rates to these crazily low figures and investors have followed them down. Now they have a problem. From this level returns are going to be tiny or negative but that is not the basis on which the investment world operates. Insurance companies, pension funds, bond funds, investment managers, savers and all the rest are operating on the expectation of real returns. Budgets are prepared on the basis of real returns. Actuarial forecasts are based on the premise of real returns.

Could inflation collapse? For many years central banks and others employed the concept of the Phillips Curve to assist in inflation forecasting. In simple terms this drew a link between levels of employment and wage growth and, by implication, inflation. If this was applicable today wage growth and inflation in the advanced world should be robust as average unemployment levels are generally low.

It seems, therefore, that the link, if indeed there ever was one, has broken down. Our view is that the economic “recovery” since the global financial crisis has been tenuous – based on lashings of artificially cheap money and the forced improvement in financial markets – not the genuine private-sector return to confidence that has typified the years following recessions over the last 50 or 60 years. We have previously reported that this “recovery” has been the weakest based on all the traditional measures – GDP growth, consumption, employment, labour productivity and investment.

Conclusion 

A bond yield of zero doesn’t look so bad if inflation is -2%, although putting your money under the mattress would yield the same return. If we were betting people, we would give this scenario a 50:50 chance over the next few years. But, by definition, that means we believe there is a 50% chance of inflation rising from current levels. Either prospect is not particularly inviting. 

This wire is an extract from the 2019 Q2 edition of Pyrford's 'Pyrspectives' 

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