Market Comment January 8th 2010

Dr Sushil Wadhwani, the former member of the UK Monetary Policy Committee, now running his own hedge fund firm, had some interesting observations on the outlook for inflation and markets in an article in the Financial Times. He highlighted the fact that market opinion about the threat of inflation/deflation is likely to oscillate from one side to another for some time, a theme that I have also highlighted before.

In his experience central bankers are puzzled by the "inflation angst" that concern investors, as all they see are the downside risks to inflation, including growing unemployment and falling core inflation in many countries. As Dubai and Greece have demonstrated, many over-indebted borrowers have yet to adjust to the new climate, “a feature that typically holds back growth and inflation for several years after the bursting of a bubble”.

The current inflation/deflation debate is “a textbook illustration of the true uncertainty that confronts investors”, Wadhwani says. The truth is that the outlook for inflation is unknown. As Keynes observed: "The outstanding fact is the extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made."

This has important implications for investors. As policymakers tread a tightrope while facing significant upside and downside risks to inflation, they will have to be exceptionally skilful and lucky to avoid none of these risks materialising. That means the probability of "price stability" in the developed world over the next five years is lower than it has been for some time.

“Looking ahead" concludes Wadhwani "we would expect financial markets to act in a schizophrenic fashion, alternating between worrying about deflation and inflation risks”. This is what occurred in Japan during the last decade, where the oscillations in bond yields were considerable. The 10-year yield fell from about 1.5 per cent in early 2002 to 0.5 per cent in mid-2003, before jumping back to almost 2.0 per cent over the following year. By the nature of bond prices, small changes in yields when yields are already very low can produce spectacular price movements, up and down.

In Wadhwani’s opinion, macroeconomic uncertainty is likely to be corrosive of the medium-term performance of equity markets. Since 1915, the US stock market has, on average, fared much better during periods of price stability than during either "inflation" or "deflation" episodes. In this period “the Dow Jones Industrial Average delivered average monthly rises of 0.86 per cent in times of stability, compared with 0.05 per cent a month with inflation above 5 per cent and minus 0.03 per cent during periods of significant deflation (with prices falling by more than 2.5 per cent per year)”.

"In an environment where markets are likely to oscillate between different views of inflation and macroeconomic uncertainty is likely to erode medium-term performance, we would suggest that medium-term allocations to equities should be below normal. Indeed, this should be an environment where, on average, some "alternative" strategies should outperform, as a more agile investment approach that switches allocations with the ebbs and flows of inflation expectations could be profitable".

Comment: It seems entirely plausible to me that the markets will indeed perform as Wadhwani suggests, and therefore that flexible thinking may be needed to ride the volatile but sideways trending market movements that this implies. He also makes the point that in the short-term, the next few months are highly likely to produce “an intensifying inflation scare", with economic growth likely to be higher than forecast – the point that Bill Miller and others have also been making.