We live in an abnormal world of falling consumer prices. The phenomenon is so rare that in the past 50 years, the US has seen year-on-year price declines in just two months – this January and March – if we leave out the 2009 depths of the financial crisis.
Fears of deflation have been increasing globally since last year, notably in Europe and Japan, and increasingly in China.
"The good news is we see the current phase of disinflation as transitory, caused primarily by the sharp fall in oil prices"
Normally, deflation is bad for equity investors as companies lose pricing power. This affects profit margins, which curbs their appetite for investment and growth. Also, consumers delay spending, hoping prices will fall further, which hurts demand.
The good news is we see the current phase of disinflation as transitory, caused primarily by the sharp fall in oil prices (which was led by excess supplies from the US rather than deteriorating global demand).
If anything, lower energy prices are benefitting consumers, giving them a higher disposable income to either spend or repay debt. This is supporting growth worldwide.
Global growth is accelerating
In fact, the world economy is set to accelerate for the fourth successive year. The US economy is, at last, achieving very healthy growth rates. Consensus estimates point to around 3 per cent growth this year, which would be the strongest pace since 2005.
Europe contributed more to the acceleration in global growth last year than any other region as the economy went from a full year recession in 2013 to modest growth in 2014. We believe it will build on this performance this year.
Finally, China’s targeted policy easing should help minimise default risks associated with the huge rise in debt levels, while supporting growth as authorities continue to pursue reforms to turn local consumers as the main drivers of the economy.
"The expected acceleration in growth in the US and Europe is supportive for riskier assets worldwide"
How should investors position themselves against this backdrop?
The expected acceleration in growth in the US and Europe is supportive for riskier assets worldwide, while China’s sustained stimulus offsets the headwind from slowing growth.
For Asia, the good news is inflation pressures in the region are muted and this allows authorities to maintain loose monetary policies intended to stimulate domestic demand.
Given excess capacity in the global economy and weak commodity prices, there appears to be little to suggest the trend for loose monetary and fiscal policy settings will reverse any time soon. This should allow for a modest acceleration in economic activity in Asia in 2015.
Developed market stocks preferred
Against this backdrop, developed market equities, particularly in Europe and Japan, and select Asian markets, remain our preferred investments. However, volatility is likely to increase as we head towards the first US interest rate hike since 2006. Also, one needs to be mindful of the upcoming event risks such as Greece’s debt renegotiations. Therefore, the key challenge is to construct a robust portfolio with the right balance.
Normally, investment grade bonds would be used to provide a ‘hedge’ within portfolios and reduce volatility. However, low bond yields mean this may be an expensive and risky hedge.
Higher volatility can create opportunities
Meanwhile, the ‘taper tantrum’ in 2013 showed any abrupt tightening of US monetary policy could push the correlation between equities and investment grade bonds higher (with both falling at the same time), reducing the effectiveness of the hedge.
Of course, we should not forget that higher volatility can create significant opportunities: investors can buy assets cheaper than they have been for some time or seize on opportunities to buy good assets which become relatively attractive against peers during such periods of dislocation.
Therefore, we would recommend that investors ensure their exposure to equities is not excessive to their risk tolerance, and that they use leverage judiciously.
"Given the historically low bond yields, a more diversified approach to income investing is recommended"
Income generation from a diversified group of assets remains one of our key investment themes for the fourth year running.
Given the historically low bond yields, a more diversified approach to income investing is recommended, and this includes buying high dividend-paying equities, particularly in Europe where yields and expected returns are higher.
The US dollar is likely to continue appreciating on growing monetary policy divergence as the US Federal Reserve starts to hike interest rates while the majority of the world remains in easing mode.
Against this backdrop, investors need to be very selective in terms of their non-USD bond allocations – good quality Indian rupee and Chinese yuan bonds fit the bill, given the attractive yields on offer relative to the limited risk of any currency depreciation. Stock investors should also hedge their currency exposure, notably in Europe and Japan (our preferred equity investment destinations) but also in Asia.
A version of this article was first published in Business Times on 23 April 2015
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