The Macro Environment
IN PRINT ARCHIVE CIR Summer 1999
|The Macro Environment|
|Inflation or Deflation--Which Will Affect Global Investments?|
Global stocks don't exist in a vacuum, but are impacted by the local and global macro economic enviroment. A key element of this is the potential for a return to inflationary times. Conversely, concerns are now being raised about the possibility of a deflationary scenario. Here our speakers debate the possibility and impact of various pricing scenarios. Nicholas Carn,senior vice-president, Alliance Capital Management, London.
Price deflation in and of itself is not really that significant. The reason is obvious if we think about it. The two businesses which have the greatest degree of price deflation in the last few years are computers and telecoms. They are also the two businesses which have had the highest growth in profits and employment and share of overall activity. The issue for us as investors isn't price deflation per se, it's whether we get a combination of falling prices and falling activity.
We don't believe that we are heading for global depression. A long-term perspective of U.K. consumer price shows that for much of the period, prices went up and down but they fluctuated around zero inflation (see chart page 43). When the first atomic bomb was exploded, the overall price level wasn't that much different from the middle of the 17th century. So the big inflation, the rise in prices of some 25 or 30 times since the end of World War II, really stands out.
Falling consumer prices, one route to a depression that people discuss, are actually extremely rare. Japanese prices fell again last year but not by very much. We saw falling prices in Germany in 1986. Commodity prices have been weak but then commodity prices have been falling relative to wages really for thousands of years. That is why cars are more affordable for more people now than they were 30 years ago.
Another concern is that the causality between the financial markets and the economy has been reversed temporarily. It is not that the stock market is good because the economy is good, rather that the economy is good because the stock market has been good. There has certainly been an element of that in the current economic expansion.
A third route to depression is that the people you sold to go bust and that upsets your economic expansion. We did see this last year. U.S. manufacturing industry was weak given the Asian crisis but the big upsetwas that cheaper microwave ovens is bad news for the American microwave manufacturer but it's very good news for everyone who buys microwave ovens. They then have a higher disposable income. If you've got a properly functioning job market, then they will expending more on something else and you can redeploy the labour in that way. That's exactly what happened and why the U.S. was strong in spite of a weak manufacturing sector. Rory MacLeod, leader, global fixed income and currency team, Baring Asset Management, London.
In the long run in the world economy, demographics are key. Demographic growth accelerated rapidly in the 18th and 19th century; it stopped about 25 years ago basically as women have seized control of the reproductive systems. The result is that temporarily the world's working population will be in a sweet spot because there aren't a lot of old people and there aren't a lot of children. Therefore, the working population will be growing relative to non-workers. We are looking at a long period of stable prices and rising prosperity.
A stable price environment is inherently stable and it's good for all assets. Mild episodes of deflation and inflation are usually connected with changes in commodity prices. Since the main characteristic of capitalism is using economies of scale to turn raw materials into investment and consumer goods, it isn't surprising that there is a tendency towards mild falling price levels in capitalism.
There is one environment in which governments don't need to get involved and that is in a time of price stability. There is no call for society to become more involved in business activity to achieve price stability. On the other side of price stability is destabilizing inflation. It is initially good for asset prices because real interest rates are falling and economic growth rates are rising. Stocks with pricing power do well and real assets do well. But as inflation continues to rise, growth slows. Real investment returns fall and there's a flight towards real assets. You don't want to be a bond dealer at this point. In the middle stands price stability. This is a period when risk taking is rewarded. All assets do well; stocks do best. Corporate bonds are preferred to government bonds because in a stable environment, investors can price default risk and the best job of all is to be a fund manager.
We've been in a period for the last 17 years when destabilizing inflation has been giving way to stable prices. As governments returned us to stable price level and interest rates fell, bonds did well and stocks did well basically due to expanding price earnings multiple. The earlier years were more spectacular because yield levels were higher at that time. This is not a typical historical experience. In the long run, bonds cannot provide returns of this sort. In the very long run, bonds have returned about 3.5% over inflation. The index of U.S. equities relative to bonds shows that U.S. equities outperform bonds by that 3.25%. It is surely no coincidence that this is the same as the U.S. growth rate over the same period. Now how do we get to lower returns from where we are now? Maurice Levi, professor of international Finance, University of British Columbia, Vancouver.
Ultimately inflation is a choice variable. It is determined by government policy and most particularly by government monetary policy. We all think that we are living in an environment of near zero inflation. Just to prove that government policy is important, if we were living in Russia, Brazil or Indonesia, we would have seen rampant inflation.
It just so happens that it is low inflation in a world of dollars or currencies that are more or less linked to the dollar through exchange rates that have not fluctuated a great deal. I suggest that since it is ultimately an indigenous variable that's going to be determined by government policy and monetary policy, we have to decide whether in fact we're heading for a period of deflation or inflation.
We really have to ask what the government is likely to do and in a sense, what is in the government's interest. Government works in the interest of the electorate, at least in the very long run.
Let's talk a little bit, in the shorter term, about the politics of inflation versus deflation. We are not going to experience major deflation.
Deflation typically comes with serious consequences. In fact, our own governor of the Bank of Canada has made it very clear that he's quite frightened about deflation. If you speak of deflation, consumers defer spending and if you defer spending, why buy a house if it's cheaper next year. If they don't buy, then there will be deflation which will encourage even more people to defer their spending and thus you have a positive feedback only in this case in a downward direction. So we don't want deflation.
There is an oversupply of goods and services that has been behind disinflation as I like to call it. Disinflation just meaning lower rates of inflation, not necessarily deflation. A major factor clearly has been the economic liberalization which is going on around the world. At least a billion workers working for approximately $4 a day, compared to $100 a day that you would be paying to a Western worker, clearly will bring down the inflation rate. Ultimately though, this is going to turn itself around, as those workers become consumers.