What if we were to see deflation?

Concerns in Europe have centred around low growth and the spectre of deflation. This worry has been heightened by the latest headline inflation print for Europe which was -0.2% yoy. Our central case is that we will not see deflation in the Eurozone as a whole in 2015 (UBS CPI forecasts are 0.3% in 2015 and 1.3% for the Eurozone). For headline inflation the only country where we forecast negative CPI for 2015 is in Spain. We would also make a distinction between an environment in which the source of deflation is exogenous and endogenous. At the moment the headline inflation numbers globally are being driven down strongly by the price of oil. This is thought to be largely due to oversupply rather than a lack of demand, hence is a “good” type of deflation. Stripping out energy, food and tobacco Eurozone inflation in November was +0.7%. We are still far from a deflationary spiral in Europe.

But setting aside our central case for a moment, what would we do if we were to see deflation?
If deflation is not global there is always the choice of moving investments where there is no deflation. A fund domiciled outside the deflation zone can simply withdraw investments from the affected country. For the investor in the deflation zone it is likely that their currency will weaken as capital flees, hence moving investment out of the deflation region will get an FX boost relative to their domestic currency. However if the period of deflation is prolonged it may be difficult to time the repatriation of the return on those foreign assets.

Previously we have shown that the best hedge against inflation, or deflation, is to have an explicitly inflation-linked security such as an inflation-linked bond or swap . Inflation-linked bonds are geared towards being long inflation, and although it would be possible to short an inflation-linked bond this would not work as a deflation hedge because many inflation-linked bonds have a deflation floor. This is because the principal at maturity will never fall below par value. A simpler solution is to enter into an inflation swap receiving a fixed rate and paying a rate linked to inflation. As swaps are synthetic there is also more flexibility in terms of duration and notional than selecting from a limited supply of government issued inflation- linked bonds.

In the early stages of deflation markets are likely to be very volatile and investors would probably hide at the safest end of the fixed income scale in cash or cash-like instruments. A deflationary environment is one of the few where cash is attractive because instead of losing value over time cash becomes more valuable in real terms.

Another way of thinking about this is in terms of opportunity cost: low inflation is likely to be coupled with low growth, hence the yield curve will be low and flat which means the opportunity cost of holding cash rather than government bonds will be small. Money market funds and the cash-like assets that they typically hold would therefore be attractive: this would include high quality commercial paper, short-dated government bonds, high quality floating debt and high quality corporate credit with a short duration.

After markets have settled down following the initial deflationary shock riskier instruments such as longer-duration and lower-quality credit and equity are likely to become more acceptable. However the prospect of deflation is particularly worrying for equities which tend to de-rate aggressively during periods of deflation or very high inflation (as shown in Figure 2 above). For Europe the “optimal” inflation rate which gives the best equity ratings is between 1% and 2%.

Unfortunately history is a poor guide to deflation in Europe as can be seen from the scarcity of data points where yoy CPI was negative – all five negative CPI data points were in 2009.
If we want more extensive periods of deflation the only example we have is Japan which, following equity and property bubbles inflated by easily available credit during the 1980s, suffered two decades during which growth and asset prices faltered and the country repeatedly dipped into periods of deflation.

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