Inflation Expectations Tumbled: What Now? by Vadim Zlotnikov, AllianceBernstein
The bloodbath in commodities has driven a major decline in long-term inflation expectations, leaving inflation-sensitive assets cheap. But approaching the opportunity requires some nuance.
Inflation Expectations Have Collapsed
It’s not surprising that near-term inflation expectations are extremely low, given the collapse in oil prices. What may be more of a concern is the steady decline in longer-term implied inflation expectations since mid-2014 (Display). This decline in expected inflation to very low levels may represent investor skepticism that monetary policy, lower currencies and cheaper oil will be enough to stimulate economic growth.
Assets that benefit from persistent low or negative inflation rates surged as inflation expectations fell. Bonds in almost every region of the world, interest-rate-sensitive cyclical stocks (consumer, financials), defensive equities (healthcare, utilities) and sectors benefiting from energy declines all outperformed.
Meanwhile, assets that typically benefit from economic recoveries fared poorly. Commodities, inflation-linked bonds, energy and related industrial equities significantly underperformed or posted negative returns. As a result, investments that are responsive to rising inflation look very attractive today.
Let’s run through the inflation terminology first. There’s deflation, when price levels are falling; disinflation, when prices rise but at slower rates; and reflation, when prices rise at an accelerating rate. Because it’s impossible to precisely time the transition between these environments, there’s an element of risk to inflation positioning.
Historical Perspective on Low-Inflation Periods
Compared with past low-inflation periods, the biggest difference in this cycle is the concerted—and unconventional—effort of central banks to encourage credit creation. So far, bank lending has improved in the US, Australia and Canada, but it’s still depressed in Europe and Japan, which together account for the majority of global bank credit.
This raises some questions. Will the current low-inflation trend create more thrift, as happened in Japan with reduced demand and cutbacks in business capital investment in the late 1990s? Or will the environment be relatively benign, with more consumption and reinvestment? Will higher profits for multinational firms from a strong dollar translate into corporate spending or share buybacks? Will lower oil prices stimulate consumer discretionary spending or simply translate into higher savings?
The answers to these questions, in many ways, come down to confidence. At this point, US consumer and business confidence is improved, which argues for spending over savings. Trends in the Japanese and European consumer sectors are modestly positive. But things aren’t completely rosy: for example, bank lending in both Europe and Japan has yet to pick up, despite looser lending standards and growing demand.
The Disinflation/Reflation Barbell
In our view, a period of outright deflation is unlikely, so it makes sense for long-term investors to consider the value that’s available in economically sensitive assets that tend to be responsive to reflation. From strictly an opportunity standpoint, it seems to make sense to allocate the bulk of a risk budget to these types of assets.
But there are other considerations. It’s not clear exactly when inflation will rebound, and it could remain low for a while. A low-inflation environment tends to produce low nominal investment returns. It could also complicate central banks’ eventual exit from quantitative easing policies. It might also temper business investments in capital and headcount, as well as increasing corporate default risk by making debt servicing more expensive in inflation-adjusted terms.
So, it’s possible that investors could endure a substantial amount of pain from investing in inflation-sensitive assets until inflation picks back up, and many investors need a source of income in the meantime. That’s why we think it makes more sense to reduce risk by balancing reflation-sensitive investments with defensive, income-generating exposures that tend to fare better in a disinflation or deflation environment. We can think of it as a disinflation/reflation barbell strategy.
Evaluating what those disinflation investments should be is a bit of a challenge, given that every period of declining inflation is different, but as the Display below highlights, we think there are a number of strategies that could fit the bill when building disinflation/reflation barbell positions.
In our view, this position would likely be driven by growth in the US and stabilization in international markets, and assets aligned with these themes should form the bulk of the strategy. But it would also include diversifying assets to help reduce volatility and generate returns in case slow economic growth and low inflation last longer than anticipated.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.
Vadim Zlotnikov is Chief Market Strategist and Co-Head of Multi-Asset Solutions at AllianceBernstein.