Low inflation is a good thing - right?
In recent years the gathering of Economists and Central Bankers in Jackson Hole, Wyoming has captured the attention of global investors. It was here in 2010 and 2012 that Ben Bernanke (US Federal Reserve) announced extraordinary monetary measures that became generically known as Quantitative Easing (QE).
This year attention was focused on Janet Yellen and her comments with regard to the labour market and the possible timing of the first interest rate hike in the US since 2006. However, Yellen was upstaged by comments from her European counterpart at the ECB, Mario Draghi.
Investors believe that Draghi has now brought forward the timetable for the start of a QE program in the Eurozone. Draghi at Jackson Hole expressed his concern with regard to the most recent reading for inflation expectations (which at previous press conferences following ECB meetings he had suggested were well anchored). The ECB’s mandate is a straightforward one: “inflation below but close to 2% over the medium term”. Inflation is presently 0.3%. The trend of the graph below causes significant concern for the ECB.
Why is the focus of the ECB solely on inflation? This is partly as a result of the ECB being modelled on the Bundesbank and the German experience of hyperinflation in the 1920’s. In addition, economic thinking in developed countries over recent decades has suggested that a country benefits most when inflation is low and stable. This monetary thinking in conjunction with the exporting of disinflationary pressures from China and improved productivity levels (with greater introduction of technology in the work place) ensured that inflation was unusually stable over the last 30 years. Extremes of inflation are a novelty for many of today’s investors.
In a low inflation environment savers suffer with the low bank deposit interest rates, employees are unable to negotiate wage increases and debtors struggle with the real value of their debt load maintained. As most developed economies post the credit crisis have ongoing high debt loads this places a limit on the amount of fiscal stimulus that can be applied by respective Governments. Low inflation does allow credit worthy corporations and individuals to borrow at low interest rate levels, banks are able to cheaply fund their balance sheet and creditors hold the real value of their lending.
The greatest risk for investors is that inflation moves from low levels to negative levels (deflation). Japan has spent the last 25 years trying to extricate itself from a deflationary spiral. Deflation postpones consumer spending today in the belief that the product or service will be cheaper tomorrow i.e. a reduction in aggregate demand and a subsequent collapse of a substantial part of the economy. It is deflation that alarms Draghi and it is a justifiable fear which may force the ECB, to introduce measures such as government bond buying, funding for lending programs and most worryingly for the Irish saver, negative deposit rates. Expect Mario Draghi to continue to upstage Janet Yellen in the next few months.
We believe we are entering a low return environment where equities, in spite of some concerns regarding valuations, remain the asset class of choice. It is on this basis that we continue to invest in a portfolio of high quality, low volatility equities that represent businesses with pricing power.