Ination versus deation: A guide for investors

Investors Insight Vontobel Asset Management

Introduction

The monetary policy of all major central banks is focused on stimulus. Interest rates are at all-time lows of between 0% and 1%, and money supply aggregates are growing at a double-digit pace. Due to these conditions, many investors are concerned that ination could soon jump sharply. However, there has not been a meaningful relationship between money supply growth and ination for some time. More important for assessing monetary policy in terms of ination is the so-called Taylor rule, which is currently indicating that the monetary policy of major central banks is correct.

This study is structured as follows: Chapter 1 looks in detail at the basic causes of ination and indicates our ination forecast for the coming years. Chapter 2 addresses the question of how investors should behave if they think that ination will rise sharply. The chapter also discusses real i.e. ination-adjusted yields for the major asset classes. The special role of gold will be discussed in a separate section. Chapter 3 shows the performance of asset classes during deationary periods.

There has not been a meaningful relationship between money supply growth and ination for some time.
In the coming years, ination is therefore likely to stay lower than many people are expecting. However, should monetary policy turn out to be in error, the danger of ination cannot be ruled out. Since 1900, commodities and to some extent equities have afforded the best ination protection during inationary periods. In contrast, gold is more for crisis protection than explicit protection against ination. Chapter 4 is a summary and also includes conclusions for investors.

Dr Thomas Steinemann, Chief Strategist of the Vontobel Group

Oliver Russbuelt, Senior Investment Strategist

Dr Walter Metzler, Senior Economist

September 2010
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Chapter 1: What actually drives ination?

The expansive monetary policy over the past two years has fuelled fears that a dramatic increase in ination may be unavoidable. In actual fact, because of the global nancial crisis, global interest rates and as a result bond yields have never been so low. In addition, central banks have implemented quantitative easing, which is a continuation of the lowering of interest rates by other means. To put it simply, quantitative easing is an expansion of the balance sheet of a central bank, in that the central bank buys securities and undertakes longer-term renancing by printing money. As a result of the deep recession in 2009, core ination (consumer price ination without food and energy prices) in the industrialized nations is currently very low, which raises the question of what exactly it is that determines ination. In the 1970s, the dominant idea was the monetarist view that ination was the result of too much money chasing too few goods. But in the 1980s the view of an empirical connection between money supply and ination (see chart 1) was increasingly rebutted.
Chart 1: Ination in the US has decoupled from money supply since 1980
Moving average
12% 10% 8% 6% 4% 2% 0% 2% 4% 1965 1970 1975 1980 1985 Ination 1990 1995 2000 2005 2010

A leap in demand for liquidity during the nancial crisis lies behind money supply growth The main reason why the US Federal Reserve increased the money supply was to satisfy the huge increase in demand for liquidity during the nancial crisis. Banks wanted to protect themselves against sudden outows and reduce the risks on their balance sheets by holding more liquidity. However, since banks had lost trust in one another, they mainly sought out safe short-term investments, such as reserves held with the central bank. Due to the extreme uncertainty unleashed by the crisis, not only banks but also companies and households wanted to hold more liquidity. If the central bank had not met this sharp increase in demand, interest rates would have risen considerably, which in turn would have exacerbated the economic crisis. It is easy to recognize that the increased money supply was a response to greater demand in that banks have not raised their lending to companies and households since the nancial crisis broke out, although they would have been able to do so, by virtue of their substantial reserves. Neither did the general economy deploy the greater supply of liquidity to buy more goods and services. This can be seen in that the ratio between GNP and money supply the velocity of money in circulation has fallen since the start of the nancial crisis. Ination due to capacity utilization and monetary policy As money supply has increasingly been an unreliable indicator for ination since the 1980s, experts have looked at the utilization of productive capacity to help explain the inationary trend. This can be measured on the basis of capacity utilization in industry or using the output gap. The output gap indicates by how much current economic production deviates from the potential. A positive output gap means an economy is overheating, while a negative output gap signals that utilization is too low. How much ination rises by during a phase of overheating depends on whether monetary policy is expansive or restrictive. To assess whether monetary policy is appropriate, the Taylor rule has become established as a benchmark. It states that interest rates should be based on (see box Taylor rule): 1. the output gap 2. the deviation of ination from the central banks target 3. medium-term real interest rates and the current ination rate

M1 money supply

Source: Datastream, Vontobel

This means that the money supply trend can no longer explain or forecast ination. For example, growth in the US money supply from 1980 to 1995, a period in which ination fell sharply, was in fact slightly higher than in the inationary years of the 1970s. Conversely, monetary expansion slowed between 2005 and 2008, but ination moved higher anyway. For these reasons the US Federal Reserve, the Bank of England and the Swiss National Bank no longer set money supply targets. Only the European Central Bank does so, with respect to the M3 money supply. Despite the currently strong increase in the US money supply due to quantitative easing, it does not necessarily follow that there will be a sharp increase in ination.

Chart 2: Output gap and ination in the US

Moving average
14% 12% 10% 8% 6% 4% 2% 0% 2% 4% 6% 8% 1970 1975 Output Gap 1980 1985 Ination 1990 1995 2000 2005 2010

rates were too low, which pushed ination up to 5%. At the high point of the nancial and economic crisis in the autumn of 2008, the Taylor rule actually indicated negative interest rates for the United States. But because a policy of negative interest rates cannot be implemented, the Fed turned to quantitative easing and brought about a sharp expansion of the money supply by buying securities, which acted like an additional interest rate cut. This action was in line with the Taylor rule and the dramatic circumstances at that time. A degree of ination risk in the US The Taylor rule is now indicating that the right interest rate would be about 1%, but the key rate is still 0.25%. In 12 months from now the Taylor rule recommends on the basis of our growth and ination forecasts interest rates of 1.5%. We expect, however, that the Fed will hike its policy rate only as far as 0.75% in the next 12 months. This implies a degree of inationary risk, especially as the Fed is maintaining its quantitative easing for now. In addition, US scal policy is also highly expansive and will probably remain so. In our main scenario we expect, over the medium term, a modest and below-average economic rebound. This will likely result in a more gradual shift of interest rates towards Taylor level. Thus ination could rise to 3% or even 4% in the medium term, once deleveraging has been completed a few years from now. If the economic rebound is even stronger than expected, we believe ination could reach 4% to 5%. There is also a danger that politicians could have an impact on monetary policy, keeping it expansive longer than is needed. In any case, we do not expect ination to stay higher over a longer period, as the Fed would turn to a more restrictive monetary policy if there are clear signs of a sustained economic recovery.

Source: Datastream, Vontobel

The Taylor rule shows that US interest rates in the 1970s were much too low, which explains why ination was high (see chart 3). The decline in ination in the 1980s was the result of the restrictive monetary policy of Paul Volcker, the Fed chairman at that time, as interest rates were much higher than the Taylor rule would ordain. In the 1990s monetary policy was correct for the most part, which explains the low ination rate. From 2000 to 2004, interest
Chart 3: USA: Taylor interest rate and actual interest rate
Interest rates
25% 20% 15% 10% 5% 0% 5% 1970

1975

1980

1985

1990

1995

2000

2005

2010

Fed funds rate

Taylor rule

in 12 months

Source: Datastream, Vontobel

The Taylor rule Taylor interest rate = real money market target interest rate + current ination + 0.5 (ination ination target) + 0.5 output gap Output gap = actual GDP potential GDP potential GDP

Potential GDP = GDP at full utilization of the capital stock and labour market The ination target and the real money market target interest rate vary from one country to another. While

the ination target reects a countrys stability culture, the real money market interest rate depends largely on potential growth. Assessing monetary policy using the interest rate instead of the money supply has the advantage that erratic shifts in the demand for money can be eliminated as a reason for wrong monetary policy. Friedmans (monetarist) money supply rule would probably have led to higher interest rates in the nancial crisis because the massive increase in the demand for money could not have been satised.

Chapter 2: What should investors do in times of ination?

As we discussed in the last chapter, we do not think that ination will rise signicantly in the foreseeable future. However, this forecast is based on the assumptions that the central banks will not make any major error, that the exit strategy will be implemented at the right time and the deleveraging of the private sector will continue to take some time. Nevertheless, an inationary scenario cannot be completely ruled out. We therefore conducted some research into which asset classes would generate positive returns during inationary periods. We looked at the following asset classes in the US: cash, government bonds, corporate bonds, equities, commodities, gold and real estate for the period from 1900 to the present day. During this period there were six inationary phases in which ination rose more than 5% (see chart 4). In the six inationary phases, the various asset classes posted the following average real returns (see chart 5). Buy-and-hold strategy no longer valid It is not surprising that government bonds post the worst performance, followed by gold, cash and corporate bonds, all of which generated negative real returns. In contrast, positive real returns came from real estate and commodities. Equities generated the best performance with an average ination-adjusted return of around 4%, although stocks did not post a positive performance in each year during the inationary periods. If we just look at

Chart 5: Average real returns in inationary periods

Real returns p. a.
4% 3% 2% 1% 0% Equities 1% 2% 3% 4% 5% Commodities Real Estate Corporate Bonds Cash Gold Treasury Bonds

Source: Global Financial Data, Robert Shiller, Datastream, Vontobel

years in which ination peaked, the picture looks different (see chart 6). In these years equities performed poorly; only commodities generated positive real returns. For investors this means that even in periods of ination they should not pursue a buy-and-hold strategy, but rather opt for a tactical investment strategy. These results conrm overall, however, that for inationary periods, real values such as commodities, stocks and real estate generate higher returns than nominal assets (see chart 5 and 6).

Chart 4: Six inationary and two deationary periods in the US since 1900
Ination/Deation

25% 20% 15% 10% Ination 5% 0% Deation 5% 10% 15% 1900

WWI 1914 1919

WWII 1939 1947

Vietnam war 19671970

Oil crises I and II 1973 1981 Stock market crash 19871990

Korean war 1950 1951

Short but severe deation 19201921 1910 1920 1930

Great depression 19291933 1940 1950 1960 1970 1980 1990 2000 2010

Source: Global Financial Data, Datastream, Vontobel

Chart 6: Average real returns in the years with the highest ination rates
Real returns p. a.
8% 6% 4% 2% 0% 2% 4% 6% 8% Commodities Real Estate Gold Equities Cash Corporate Bonds Treasury Bonds

tionary period from 1987 to 1990, however, gold posted a negative annual return of 7%, faring the worst of all asset classes. The third and nal gold price boom came after 2001, during another potentially deationary phase following the bursting of the technology bubble. We therefore see that periods of rising gold prices come during times of both ination and deation. If not ination, what could explain the price of gold? Chart 7 shows that the three periods of rising gold prices all took place when weak equity markets were moving sideways over an extended period of time. In light of this, gold can be a good addition to a equity portfolio, but it is more a protection during periods of crisis than against ination. Chart 8 shows that gold can generate comparable returns to stocks only if dividends are excluded. If they are included, we see that equities are clearly superior to gold.1 Chart 8 illustrates the signicant contribution of dividends and cash ows to high returns.
Chart 8: Equities with and without dividends compared with gold An investor who invested 100 USD in the US equity market or in gold at the end of 1973 would now have
Price chainlinked (1973 = 100)
5000 4000 3000

Source: Global Financial Data, Robert Shiller, Datastream, Vontobel

Gold provides protection at times of crisis rather than ination It is remarkable that gold does not actually provide as good a protection against ination as is often assumed. In the six inationary periods of the 20th century, gold posted a positive performance only once, between 1973 and 1981, when it returned a strong 15% annually. In all other inationary periods, gold did not generate a positive return. It should be remembered, however, that until 1973 gold was not freely tradable and the price of gold was xed. In addition, the private ownership of gold was prohibited at times. Gold has had three periods since 1900 in which it has performed well. In the 1930s the value of gold went up by decree under the gold standard, which triggered the rst period of higher gold prices, interestingly in a strongly deationary period. After the Bretton Woods system was abandoned in 1973, the price of gold could move freely. Consequently, in the inationary period that followed it moved sharply higher in real terms. During the last inaChart 7: The three periods of rising gold prices
Price in USD (logarithm scale)
10000

USD 3500.

2000 1000 0 1973 USD 1100. USD 1050. 1978 1983 1988 1993 1998 2003 2008

S&P 500 Total Return

S&P 500 Price Return

Gold price

Source: Global Financial Data, Datastream, Vontobel

1000

100

So what does this mean for investors? Those who believe that ination will rise sharply in the coming years could put their money into real assets such as commodities, real estate and equities. In contrast, nominal assets such as bonds or cash should be underweighted. It is worth bearing in mind, however, that commodities and hence gold are calculated in US dollars. Euro and Swiss franc investors must bear the exchange rate risk. Protection against ination is also provided by inationprotected bonds, which are mainly issued in US dollars (TIPS = Treasury Ination-Protected Securities). These bonds are also issued in sterling and euros, but not in Swiss francs.
1 The

10 soft Ination/ Deation 1990 2000 2010

Deation 1 1900 1910 1920 1930 1940 1950 1960

Ination 1970 1980

S&P 500 Price Return

Gold price

Source: Global Financial Data, Datastream, Vontobel

same is true of other commodities 7

Chapter 3: How to invest during deationary periods?

In contrast to a scenario of high ination, some observers are forecasting deation. We could enter a period of deation if the global economy were to drop into a double dip recession. Although that is not our main scenario, we investigated how individual asset classes would behave in a period of deation. Since 1900 there have been two basic deationary periods in the United States (see chart 4). The average real returns for these periods were as follows (see chart 9):
Chart 9: Real returns in deationary periods
Real returns p. a.
15%

Chart 10: Taylor interest rate and actual key interest rate in the EMU
Interest rates
8% 6% 4% 2% 0% 2% 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Repo rate

Taylor rule

in 12 months

Source: Datastream, Vontobel

10%

5% Commodities

0% Corporate Bonds 5% Cash Treasury Bonds Gold Real Estate

Equities

10%

According to our estimates, the deation risk is somewhat higher in Europe than in the US. Ination has traditionally been lower in the eurozone than in the US due to a stronger culture of stability in Europe. Even though Europes monetary policy stance was also below the Taylor interest rate in the period from 2000 to 2008 (see chart 10), the divergence was smaller than in the US. Ination was accordingly higher in this period than the European Central Bank (ECB) target but lower than in the US. In the nancial and economic crisis of 2008-2009 the Taylor rule likewise indicated negative key interest rates, but there was effectively no quantitative easing by the ECB. In the last two years the ECB has held key interest rates above the level indicated by the Taylor rule. This was one of the factors contributing to the sluggish economic recovery in the eurozone. While the Taylor rule currently recommends a somewhat higher key interest rate, our 12-month forecast for the repo rate remains unchanged and in our view continues to be appropriate.

15%

Source: Global Financial Data, Robert Shiller, Datastream, Vontobel

The deation scenario is the inverse of the ination scenario. Returns on real assets are signicantly worse than on nominal assets, as deationary periods in the past have regularly been linked to a recession. For investors this means they should give preference to bonds of sovereign and corporate issuers. Equities and commodities, on the other hand, should be underweighted.

Is what happened in Japan relevant for the West? In Japan, the last 20 years have been marked by low ination at times even deation below-average economic growth and persistently low interest rates. This was attributable to the bursting of the Japanese real estate bubble in the 1980s. Japanese companies had mortgaged themselves heavily to buy large portfolios of land and property. The dramatic collapse in real estate prices from 1990 onwards forced them to reduce their debt and limited their investment activity accordingly. This phase, which is still ongoing at the present time because real estate prices have not yet stabilized, is known as deleveraging. Periods such as this are associated with weak overall demand in the economy and low ination rates.
2 See

Even an accommodative monetary policy like that pursued for a long time by the Bank of Japan does not lead to high ination. But why is that? While the private sector is deleveraging, there is little demand for new loans. As a result, the increase in the money supply by the central bank does not ow into the economy and consequently has no inationary effect. This effect cannot be inferred for the current situation in the western economies, particularly not for the US. As US real estate prices have already begun to stabilize unlike in Japan the deleveraging phase is only likely to last between three and ve years.2

Vontobel Asset Management From the nancial crisis to the debt crisis: Effects on the economy and nancial markets, March 2010

Since scal policy is now being tightened in many eurozone countries due to the debt crisis, economic policy is generally on the restrictive side. While our main scenario

does not foresee a return to recession and hence deation, growth will remain below-average and ination will rise only marginally to around 2%.

Virtuous Switzerland Switzerland has followed the Taylor rule most closely in the last ten years. In the nancial crisis the Swiss National Bank (SNB) also practised quantitative easing, as the negative Taylor interest rate indicated. Switzerlands key interest rate is currently slightly below the Taylor interest rate. The Taylor rule recommends raising interest rates to 1.5% over the next 12 months, based on our economic and ination forecasts. We continue to expect the key interest rate to remain at 0.35% in this period, however. This is because the strong upward pressure on the Swiss franc will persist. The SNB sees real appreciation in the Swiss franc of 3% the same effect as an interest rate increase of 1%. To offset the current negative effect of the strong Swiss franc, interest rates may be some 1.5% lower than if the Taylor rule were strictly applied. Both currently and in the next

12 months, Swiss monetary policy can be considered generally appropriate, meaning that there is no major ination risk in Switzerland for the foreseeable future.

Chart 11: Switzerland: Taylor interest rate and actual key interest rate
Interest rates
14% 12% 10% 8% 6% 4% 2% 0% 2% 2000 2004 2006 2008 2002 1990 1980 1984 1994 1988 1996 1998 1986 1982 1992 2010

CHF 3 month Libor

Taylor rule

in 12 months

Source: Datastream, Vontobel

Chapter 4: Summary and conclusions for investors

The correlation between money supply growth and ination has widened considerably in recent decades. The Taylor rule is therefore a more important measure of future ination. It implies that central banks are currently pursuing appropriate non-inationary policies.

We do not expect any substantial increase in ination in the years ahead

In addition, the deleveraging of private households and corporates triggered by the real estate crisis will continue for some years. We do not expect any substantial increase in ination in the years ahead. However, if central banks keep their key interest rates low for too long as measured by the Taylor rule ination is likely to accelerate. Investors who expect ination in the future are well advised to overweight real asset classes such as commodities, real estate and equities. If their take on the future is more one of deation, then sovereign and corporate bonds should be favoured. Our analysis of inationary periods shows, however, that the performance of asset classes is not homogeneous. Although equities generally provide good real returns in inationary phases, they perform less well in the years with the very highest ination rates. Based on this reasoning we would recommend a differentiated approach rather than a pure buy-and-hold strategy for inationary and deationary periods. Investors therefore may have no other option than to make tactical asset allocation decisions themselves or to delegate them to a professional asset manager.

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Disclaimer Although Vontobel Group believes that the information provided in this document is based on reliable sources, it cannot assume responsibility for the quality, correctness, timeliness or completeness of the information contained in this report. This document is for information purposes only and nothing contained in this document should constitute a solicitation, or offer, or recommendation, to buy or sell any investment instruments, to effect any transactions, or to conclude any legal act of any kind whatsoever. This document has been produced by the organizational unit Asset Management of Bank Vontobel AG. It is explicitly not the result of a nancial analysis and therefore the Directives on the Independence of Financial Research of the Swiss Bankers Association is not applicable. All estimates and opinions expressed in this brochure are the authors and reect the estimates and opinions of Bank Vontobel. No part of this material may be reproduced or duplicated in any form, by any means, or redistributed, without acknowledgement of source and prior written consent from Bank Vontobel AG.

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