Within the US, we have a modest preference for small- and mid-cap stocks that underperformed significantly last year and we think are poised for a rebound. In our Factor Funds, we have substantial exposure to value strategies in Europe and Japan, while favoring quality-oriented growth styles in the US. From a sector perspective, consumer discretionary and energy are our biggest overweights globally. More broadly, we’re positioned to benefit from improving economic growth outside the US.
We’re underweight bonds, and we’ve positioned our exposure toward what we see as the best opportunities. Real—or inflation-adjusted—US yields remain higher than those of Europe and Japan, and we have preference for US TIPS. We’re maintaining active exposure to the US dollar versus all other currencies. We’re taking more interest-rate risk in the US and Australia and less in European bonds and Japanese government bonds. As we discuss later in the report, fears of deflation (or at least low inflation) are unlikely to dissipate anytime soon, so some bond or “bond-proxy” exposure is warranted. We’re close to the benchmark in our credit exposures.
The bloodbath for commodities continued during January, with massive underperformance by energy, materials and related industrial stocks. The weakness has been fueled by worries over slower growth and credit problems in China, the uncertain recovery in Europe, questions about Japan, and poor earnings and earnings guidance from natural resources– and infrastructure–related companies.
As we discussed last month, we think current oil prices are unsustainably low. The supply/demand adjustment could easily take a year, because inventory will continue to build, taking advantage of oil futures that are in contango. In other words, the prices of oil futures are higher than the expected future spot price of oil. In the meantime, panic and short-term overcapacity could cause prices to dip below $40–$45 per barrel. Despite this downside risk, we’re still overweight exploration and production stocks and long-term oil futures; we see them as attractive value opportunities. In our Factor Funds, we’re selling out-of-the-money put options on exploration and production companies to take advantage of the spike in implied volatility, which makes these options more valuable.
Looking beyond the energy sector, our expectation for higher market volatility seems to be playing out. Over the past couple of months, our Dynamic Asset Allocation team has modestly reduced its overweight in risk assets, including equities and high-yield bonds.
The more important question is: What should we do next?
Disappointing top-line global growth remains one of the key market concerns. There’s limited pricing power, commodities pricing is feeding deflationary pressures, and there are concerns about continued debt deleveraging. These factors contributed to a substantial decline in long-term implied inflation expectations. As fears of declining inflation resurfaced, financial assets that benefit from persistent low (or negative) inflation surged. Meanwhile, growth- and inflation-sensitive assets collapsed.
Compared with past low-inflation periods, the biggest difference this time is the concerted—and unconventional— efforts of central banks to stimulate 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. There’s not much consensus on when credit will improve, given adverse trends in China and the amount of questionable assets still on the books of European banks.
We think the probability of an outright deflationary period is extremely low, and that long-term investors should consider the value in economically sensitive assets that are responsive to rising inflation. But several factors could keep inflation low (as opposed to negative). In addition to the challenge of low nominal returns, investors should consider the added risks of the low-inflation environment. For example, it may complicate central banks’ eventual exit from quantitative easing, temper investments in capital and head count, and increase default risk by raising inflation-adjusted servicing costs.
So what does all of this mean for the investment outlook over the next one to three years? In our view, investors should continue to allocate the bulk of their “risk budget“ to assets sensitive to growth and renewed inflation (reflation). But it’s important to be thoughtful in positioning portfolios to take advantage of a possible lengthy period of low inflation; it’s vital to incorporate positions designed to reduce portfolio volatility and provide some offset to the possibility of a policy misstep or miscommunication.
The rest of this report will focus on identifying the most attractively valued reflation/growth trades. We’ll also share an approach to building a highly diversified basket of investments that would perform well in a low- (or negative-) inflation environment.
Benign and Destructive Deflation: What’s the Difference?
Deflation has come to be associated with devastating depressions, social unrest and collapsing asset prices. But history is a lot more nuanced: On one hand, deflation associated with collapsing demand or cutbacks in money supply has been lethal to the economy. But on the other hand, deflation associated with massive productivity gains or major technology advancements has boosted real economic growth. The current environment has elements of both scenarios, but seems to be closer to the benign variety.
We can look at inflation periods going way back in US history: more than 200 years, before it was even a nation. Most major inflation periods were driven by war expenditures (Display 1). The main exception was the inflation of the 1970s—now viewed as one of the great failures of macroeconomic policy. This period featured easy monetary policy, aggressive fiscal spending, a currency debased from the removal of the gold peg, sticky labor costs and an oil embargo.
On the flip side, major periods of US deflation were associated with declining money supply, a collapse in demand for goods and services, and productivity booms (Display 2). Real economic growth was actually positive in most of those periods.
Lessons from Japan’s Deflation Episode
Obviously, deflation isn’t a US-only phenomenon (Display 3). The most notable episode is the aftermath of the Japanese asset bubble that peaked in the first half of 1990. This episode led to a long period of deflation that started in the late 1990s. It’s a good example of a destructive deflation setting, and it’s part of the reason the market is obsessed with wage growth today.
The basic facts of Japanese deflation are well known. Bank of Japan governor Haruhiko Kuroda summarized them effectively in a speech at the Jackson Hole, Wyoming, symposium last August. We found a couple of his points particularly interesting and relevant for today’s policy discussion. When Japanese corporations were faced with poor pricing power, they tried to constrain labor cost growth by using part-time labor and negotiating wage cuts.
As a result, the rate of earnings growth trailed that of headline inflation (Display 4)
. This quelled overall demand and caused corporations to make more cutbacks in capital investment. In other words, corporations saved the extra profits from lower labor costs, instead of plowing them into growth-oriented investments. Kuroda called this the “paradox of thrift.”
The critical point to ponder today is whether we’ll see a thriftier environment or one with more consumption and reinvestment. Will the boost to multinational firms’ profits from weaker nondollar currencies translate into corporate spending or share buybacks? Will lower oil prices stimulate consumer-discretionary spending or instead translate into higher savings?
The answer to both questions comes down to how much confidence there is. At this point, improved US consumer and business confidence argues for spending over savings, and trends in the Japanese and European consumer sectors are modestly positive (Credit Sentiment, Display 5). On the other hand, bank lending in both Europe and Japan has yet to pick up, despite looser lending standards and growing demand (Display 5).
Declining Inflation Expectations
The amount of interest in the topic of deflation is certainly on the rise, even outside the investment world. Google searches for “deflation,” for instance, are now at an intensity that rivals the peak in November 2008 (Display 6)
. Interest in “inflation,” in contrast, has been declining steadily (Display 7)
The financial world echoes these trends. Near-term inflation expectations are extremely low (Display 8)
. This isn’t surprising, given the collapse in oil prices. But even though we can temper these forecasts because they’re linked to temporarily cheap oil, there are still ramifications. In Japan’s case, these short-term expectations may have held back corporate investment.
Longer-term expectations may be more of a concern. Since the middle of 2014, long-term implied inflation has been declining steadily (Display 9). The decline and the extremely low level may be telling us investors are skeptical that monetary policy, lower currencies and cheaper oil will be enough to stimulate growth.
Amid this backdrop, assets expected to flourish in an economic recovery have underperformed, and more defensive, income-generating investments have rallied (Display 10)
. Commodities, inflation-linked bonds, energy and related industrial equities have significantly underperformed (or had negative returns). On the flip side, bonds in almost every region of the world, interest-rate-sensitive cyclicals (consumer, financials), defensive equities (healthcare, utilities) and sectors benefiting from energy declines have all outperformed.
Technological Gains Erode Pricing Power but Support Volume Growth
There’s no shortage of narratives that support the slow-growth environment, including an aging population and declining labor participation, continued deleveraging, more government regulation, and income disparity. However, one element that intrigues us the most is the notion that technological innovation is bringing massive productivity increases to service industries, with greater productivity slowing nominal growth.
Past productivity gains were primarily concentrated within the technology industry itself or benefited manufacturing segments. A surge in productivity within services would affect a much bigger share of gross domestic product (GDP) and could put prolonged downward pressure on wages and prices. This isn’t dissimilar to the massive deflationary pressure that industrialization brought in the late 19th century. It caused skill mismatches in labor and distress for farmers and some craftsmen, but in the end it boosted overall growth and improved standards of living (Display 2).
In our view, technological evolution is eroding the pricing power of brands—most visibly in consumer services. Amazon.com’s business model has eaten into distribution margins for many firms. Another example—arguably—is among car services and taxis. Traditional car services have long been able to charge passengers a premium for their reputation of reliability and safety. In the taxi industry, competitors faced major entry barriers—regulation, certification and registration—that guaranteed a certain service quality for a premium.
Then, along came Uber. With its mobile application, the company has effectively assembled a group of low-cost service providers and—this is a key point—underwritten the implicit service guarantees from those providers. Before location-based services like Uber developed, it would have been hard for competitors to use price to gain share against premium car-services firms. Now, there’s price deflation in this arena…and it may be permanent. A similar trend is playing out with companies like Angie’s List, Handy and Airbnb—companies that take on reputational risk by effectively policing the independent contractors they collaborate with.
A bigger question is whether the disinflationary impact of technology will spread to “knowledge” workers and reduce their brand equity, too. We’re seeing huge growth in low-cost legal services, telemedicine, massive open online courses (MOOCs, which offer online higher education), robo-advisors and remote software development. In each of these cases, the potential for success is heavily linked to the ability of the aggregator to build a reputation, which it can then use to underprice traditional service providers and gain market share. There’s been a lot of debate and research on this topic, but the long-term impact on lower inflation and investors is still very much unresolved.
Technological advances have improved productivity and challenged the brand equity of entrenched suppliers across many industries. It has also had a very positive impact on sales volume growth: recent innovations have made customized and personalized goods and services possible. Today, in almost every industry, there’s an opportunity to deliver “unique” service (custom music playlists, completely customized personal computers and cars, personalized medicine, and 3D printing are examples). Eventually, companies will be able to meet demand all along the price continuum with a customized offering for each price level. This will drive up sales-volume growth while creating opportunities for small-business startups that haven’t fulfilled their growth promise yet (Display 11).
Barbell Limits Deflation-Related Drawdown While Capturing Upside
Because there’s uncertainty over when inflation will rebound, we think it makes sense to keep exposure to investments that perform effectively in low- or negative-inflation environments.
Evaluating what those investments should be is a bit of a research challenge. Every period of declining inflation is different, and there’s not a lot of data on periods with low and declining inflation expectations, such as the one we saw recently. The correlations between changes in inflation and the performance of stocks and bonds have changed significantly over time (Display 12). This seems to make intuitive sense, because inflation rising from 10% is a very different environment from inflation rising from 1%. Since 2002, the correlation between changes in inflation and equity returns has actually turned positive. Reflation is interpreted as being positive for margin sustainability and growth, rather than indicative of destructively higher rates.
Over the last 20 years of low inflation, average correlations of inflation with various sectors and risk premiums are low, but generally in line with intuition (Displays 13 and 14)
. Commodities and high-risk/cyclical stocks tend to do well when inflation is rising, while carry strategies and defensive dividend-paying stocks fare well when inflation declines. Of course, those are average correlations, and each inflation period has its nuances. The only constant is to buy what’s inflating (or that has pricing power) and sell whatever is deflating.
How does the current period align with the deflation drivers we discussed earlier: declining money supply, falling end demand or a shock to productivity or technology? We see some elements of declining demand and productivity/technology shocks. And if there’s a major policy mistake, we could see a declining money supply. A low-inflation environment like the one we’re in today argues for the use of leverage, but there’s a wrinkle. The handoff of responsibility for providing liquidity from the US Fed to the Bank of Japan and European Central Bank could be volatile, and that could create short-term funding issues. So, we prefer structured products where the duration of funding is roughly similar to the duration of the assets or investments.
Display 15, highlights some of the strategies we view as particularly attractive for a disinflation/reflation barbell positioning. This trade would likely be driven by growth in the US and stabilization in international markets, which should form the bulk of a portfolio, as well as diversifiers to reduce volatility and generate returns if slow growth and low inflation last longer.
The discussion of declining inflation and its eventual revival is one of investing’s tried and true “mean reversion” strategies. The uncertainty isn’t whether reversion will happen, but when it will happen. To successfully implement these strategies, investors have to be willing to wait—and endure some pain.
For instance, shorting expensive companies that are overearning or going against the grain of highly crowded, “common-sense” investment trades can be extremely painful, sometimes for extended periods. But investors who have the luxury of time to wait should be able to enjoy strong returns over the next decade from assets and strategies that perform strongly in environments of rising inflation, money supply growth and currency devaluations.
Most investors also need to generate steady income from their investments, and they struggle to find sources of secular growth and reflation. They need a more balanced approach, and since defensive, income-generating assets are expensive, finding that balance takes some creativity. Our take has been that exposure to fixed-income carry and value trades, private credit, and even thematic equity growth strategies can offer powerful diversification as we wait for an inflection point in credit growth.