How the next global crisis will be different for investors

The fear of deflation

Every year the Montreal-based Bank Credit Analyst prints a conversation between one of its long-time subscribers, Mr X, and the editors - a conversation about the main economic events and influences which will shape the world economy over the coming 12 months. The views of BCA editors are always interesting, for they take a longer-term view of world economic events than any other group I know. But this particular exercise is especially interesting this year, for it highlights the great transition that the world is making from an environment of inflation to one of deflation.

It is not, of course, certain yet, but it does appear that the great inflation of the second half of the 20th century is over - the greatest inflation that, for example, this country has known since the Middle Ages. What comes next? Is it a century of stable prices or one of slowly falling prices like the 19th century? A world of stable prices might enable a century of great prosperity, but the transition from one monetary environment to another might be botched.

Alan Greenspan, head of the US Federal Reserve Board, put an interesting perspective on this in a speech at the weekend. He said that just as even moderate rates of inflation hampered economic performance, so moderate rates of deflation could also damage it. "Deflation, like inflation, would distort resource allocation and interfere with the economy's ability to reach its full potential." But deflation carried further risks, for as nominal interest rates could not go below zero, a world of falling prices could lead to high real interest rates.

The BCA editors start from the position that deflation is the key force shaping the investment outlook this year. Mr X is worried: might the Asian crisis trigger a global financial crisis, he asks?

Yes, is the reply, mainly because the cause of it, over-investment in manufacturing capacity, puts a powerful deflationary force on the whole of the world. Cheaper exports from the region will boost spending power in the main economies but their exports will be squeezed by this competition. The BCA people reckon that global economic growth will slow from around 4 per cent last year to perhaps 2.5 per cent this; by comparison, in 1990-91 the global slowdown was from 4 per cent to 2 per cent.

If that is right, the world is facing in aggregate almost as sharp a slowdown as it did in the early 1990s recession. One effect (see left- hand chart) will be for inflation, already below the level of the 1960s, to fall even further. "Once world economic growth is back on track, say by mid-1999, inflation will be so low that it will no longer figure in investors' plans."

This, the BCA team argues, will have an important effect on investment strategy, for bonds and equities will tend to move in opposite directions. For the last 30 years, in an inflationary environment, bonds and equities have tended to move in the same direction: when one goes up so does the other. That was because most shocks were monetary and inflationary: what was bad news for bonds was also bad news for companies. But in a deflationary world most shocks will be economic in nature. This affects companies but not bonds. So bonds will play a more important role in portfolios, for they will provide diversification. This negative correlation between bonds and equities has been evident in Japan for several years.

So far, falling inflation has been very positive for share prices (the middle graph shows the 20-year bull run), just as rising inflation during the 1970s was bad for shares. But shares are, they believe, over-valued and equities will perform poorly. Bonds, by contrast, will do well. Once world growth is re-established, the long-term bull market in equities can resume.

All this is based on the presumption of the BCA editors that the outlook will most likely be non-inflationary rather than deflationary. They think that is most likely, but acknowledge the danger that the world is walking on a tightrope. Mr X worries that there are similarities with the 1930s. BCA reckons that this is possible, but only as a worst-case scenario.

The conversation then moves to the world economy, where the main features are a slowdown in the US and UK with growth at about 2 per cent; actual recession in Japan (40 per cent of its exports go to Asia); and continental Europe battling into a strong headwind of corporate restructuring against a background of continuing weak domestic demand. As you can see in the right-hand graph, retail sales on the Continent have been flat or negative since 1991. The only large economy to grow above trend will be Canada, with about 3 per cent growth.

The practical impact on this for investment? The view, as summed by Mr X, is generally negative on equities, and particularly for emerging market equities. The UK, Italy and maybe Germany will do best among the major markets, while the US market will "skate though" only on the back of a sharp fall in bond yields. "Once the deflation scare is over, the long wave will come into play again."

Currencies and commodities? Good for the dollar, bad for the yen - a fall to 150 could easily occur. Will the euro self-destruct? The BCA editors think on balance not, though it will be possible to make a no- cost bet against it by staying in the German mark. Since the euro will initially be perceived as a weak currency, the Swiss franc and the pound will have "safe haven" status and will tend to rise. Commodities: general weakness, including weakness in the gold market until the deflation scare is over.

Finally the conversation turns to risks. The BCA team note five big risks to the world economy: Asia-centred global recession; trade protection returning; stock market crash and deflationary spiral; EMU faltering; and dollar collapse as inflation returns.

The first three might run together, for if turmoil in Asia pushes the world into recession, there will be great protectionist pressure, which in turn might lead to a global (as opposed to just an Asian) stock market crash. EMU faltering, on the other hand, is a one-off. The problem is that financial markets are assuming EMU will occur on schedule and so failure, or even delay, would be very disruptive. As for the dollar collapse, that risk is at the other end of the spectrum, with Japan in particular suddenly repatriating its assets: maybe not so likely, but worth acknowledging.

Given this little list of uncertainties, Mr X has decided that he may this year need to drop by before next December in case things start moving rather too fast.