The root cause of this renewed deflationary risk is the same as in 2008: a balance-sheet recession – then in the private sector, but now in the public sector. An ultra-accommodating monetary and fiscal policy mix had raised hopes of things improving thanks to economic growth. Sadly, this economic impetus is cruelly lacking today in both Europe and the USA. The markets have been signalling that economies will be unable to cope with any onset of either monetary or fiscal tightening at a time when the ECB is keen to combat inflation by hiking interest rates, when the Fed wants to stabilise its balance sheet, and when several countries in the developed world find themselves forced into rebalancing their public finances through draconian spending cuts. The signal from the markets is unmistakably clear: pushing official interest rates back up prematurely towards their historical averages of 3% and pruning budget deficits to less than 3% of GDP far too quickly will run the risk of wreaking significant damage on economic growth in the developed world.
A similar state of affairs as in 2008 The problem posed by balance-sheet recession has been dragging on since 2007 when excess debts accumulated over several decades hit their peak. As the problem is still some way from being solved, financial markets will persist in carefully scrutinising possible solutions put forward by authorities. Unless there are clear and decisive solutions, unlike policymakers' unconvincing and half-hearted proposals to resolve the debt crisis on the euro-zone's periphery, the markets will persevere with their defensive stance.
Today, the markets are factoring in a risk premium for haphazard and disjointed reduction of the debt mountain that is almost as high as it was in late 2008. Any solution to Europe's debt crisis allowing some lowering of this risk premium would have to involve a series of measures. These could include a systematic process of transferring liquidity from creditor countries to those in distress, an ECB resolved to buy up assets and prepared to print money if need be, or even more severe hair-cuts than those announced for Greece's debt, with this approach incidentally being extended to encompass overindebted US households as well.
All the evidence at present suggests that the forthright political will to devise a lasting and credible solution is lacking. There is no denying that capital is still being stripped out of debt-laden balance sheets, such as those in Italy or Portugal, and transferred to the elite club of those with healthy finances, such as Switzerland or Brazil.
From an investor's perspective, forces associated with the balance-sheet recession are exerting a much more powerful influence than all other valuation metrics. For instance, even though P/E ratios on stock markets do seem to suggest plenty of buying opportunities, caution remains the watchword in a climate where the risk of deflation may materialise. In this respect, the painful example of Japan is etched into every investor's mind: asset pricing in a deflationary world will tend to move close to book value (i.e. a price-to-book ratio of 1X) whereas, in Europe's case for example, the ratio is still running at around 1.3X.
In a world of deflation, assets perceived as being 'solid', i.e. backed by sound balance sheets, will continue to outperform more cyclical assets and those underpinned by less sturdy balance sheets, i.e. riskier assets. These risk assets will, however, swing dramatically upwards if and whenever new measures to reflate the economy are announced. In Europe, banks and utility companies are primarily those that fall into this latter category.
Gold: climbing to new peaks In circumstances where the risk of deflation still looms large, cash remains an excellent asset. By definition, gold ought not to be, but the bullion price looks set to continue on its uptrend for four main reasons:
- the markets are expecting a fresh round of reflationary measures from monetary authorities which will cause currencies to depreciate – mainly the US dollar today – thereby automatically feeding through into a rise in the gold price;
- gold is not backed by any balance sheet;
- real interest rates are negative;
- gold can be regarded as a 'currency', but one that it is impossible to print more of.
Moreover, if the gold standard were to be implemented once again, as was the case up to 1971 when one ounce was worth 35 dollars, today, considering the expansion in the money supply over the last 40 years, gold would be valued at between 5,000 and 10,000 dollars an ounce. It seems more likely however that, once gold reaches a price of some 2,500-3,500 dollars an ounce, investors will begin to cast a more favourable eye over financial assets.
Good-quality sovereign bonds should also continue to do well. Our proprietary forecasting model points towards yields on 10-year US Treasuries extending their downtrend into the third quarter of this year before picking up again by the year-end, then setting off back downwards up to the outset of Q2 2012. Moreover, Bunds should continue to benefit from their safe-haven status.
Top-grade corporate bonds also look to have plenty of appeal as credit spreads appear to have stretched unjustifiably wider over the last few weeks. A few high-yield bonds also look attractive.
The big-cap appeal Equity markets also look to offer some handsome buying opportunities for investors geared to longer-term investment goals. Prospects are bright for large-cap blue-chip companies with healthy balance sheets, such as the likes of Nestlé or Procter & Gamble. In order to establish exposure to equity markets under a scenario of renewed reflationary measures, investors should take best advantage by broadening their exposure to markets traded in weak currencies (such as the US dollar), but hedging their exchange-rate exposures in the strongest currencies (like the Swiss franc).
Nevertheless, if risk-asset markets stick at current levels, we are quite unlikely to see a third round of quantitative easing on a par with either QE1 or QE2 being pushed through imminently in the USA. Inflationary expectations for 5 years ahead have not yet returned to their lows seen in late 2010, which had prompted the Fed to launch QE2. Investors, therefore, seem to have few options but to continue favouring the assets cited above over the coming weeks, biding their time for some significant monetary measures to be taken.
