Investors need to shake off fears of deflation and make some strategic and tactical adjustments, amid signs of reflation.
Fears of deflation have dogged markets for the past few years, but it may be time for investors to shake them off.
Morgan Stanley Wealth Management's Global Investment Committee (GIC), a group of seasoned investment professionals with whom I meet regularly to review the economic and political environment and asset allocation models for Wealth Management clients, believes deflation fears have gone too far and have become too embedded in both investor psyches and market structures.
Seeing signs of reflation at work, the GIC recently made some strategic and tactical adjustments to our asset allocation models. Our increased allocations to global equities, inflation-protection securities and simultaneous reduction of interest-rate-sensitive assets, such as real estate investment trusts, support such an outcome. We also still favor assets levered to rising oil prices—energy stocks and select master limited partnerships—and other commodities that should benefit from accelerating global growth.
Central bankers, much like investors, can sometimes fall into a rut. It shouldn't come as a surprise that, since the financial crisis, central bankers have made it their mission to fight deflation, as a broad drop in demand threatened to pull down prices and profits, in what economists feared would become a vicious spiral. After years of holding key interest rates near zero and aggressive monetary stimulus, central bankers still seem reluctant to declare success.
The GIC didn't see the glass as half empty at the beginning of the year; nor do we now. What we saw was a global monetary system that was adding significantly more stimulus to prevent deflation. We also anticipated gains on the demand side from a 50% drop in the price of oil and less fiscal austerity from the likes of Japan, Europe, China and India. Nearing the halfway mark, all that has changed is that these observations have become more of a consensus opinion—but in our view, still not fully priced into the market.
Central bankers may have finally added enough stimulus into the monetary system, just as lower oil prices and less fiscal restraint are helping to raise growth, and subsequently, inflation expectations. Such a shift could be a sea change for investors and financial markets, accelerating current trends that favor global equities and other securities levered to higher inflationary pressure coming from a low base.
Will these trends be short-lived, or have central banks finally slayed their deflation dragon? It's probably too early to tell. However, the current momentum should be strong enough to carry across several quarters and continue to affect returns for all of 2015.
The bottom line: Given the significant levels of debt that remain on household and government balance sheets, inflation is likely to remain lower than what we experienced in periods leading up to the financial crisis. However, deflation is a true tail-event outcome on which many markets have wagered heavily.
After seven years of fighting deflation, central bankers may have at least won a battle, with implications for asset prices over the next 6 to 12 months. We are positioned accordingly. Are you?