Understanding the GFC

Navigating deflation and inflation

Hamilton Wealth Management

Melbourne, May 2016

Dr Sam Wylie

Principal Fellow, Melbourne Business School

Director, Windlestone Education

s.wylie@mbs.edu 0428 103 859

To receive Sam Wylie’s Finance Newsletter please connect with Sam

on LinkedIn or email info@windlestone.com.au

Introduction

Outline of talk

The global economic outlook: Bulls versus Bears

Evidence of global deflation

The fight against deflation

Why anti-deflation measures might overshoot into inflation

What should investors do?

Main points

Global deflation is the elephant in the room for investors

Defeating global deflation may take ‘extreme’ action by central

banks that is likely to overshoot into substantial inflation

Investors need to prepare for a slowing global economy, a

possible deflationary shock and extreme action that will follow it

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Evidence of global deflation: Actual inflation3

Bulls: Global economy heading back to normal

Bulls

US economy is picking up steam

-- Everything that was broken by the GFC is mended: Unemployment is

below 5%; the budget deficit has returned to normal, the banking

system is healthy; monetary policy is returning to normal,

-- Falling employment is finally causing wage growth (2.6% annual)

-- US growth will build global confidence

Global GDP growth is still ok

-- Global growth has been consistently above 3%

-- Green shoots of growth in Europe, especially Germany

-- Chinese and Indian Governments are determined to maintain growth

-- Inflationary expectations have not collapsed (no self-fulfilling

deflationary mind set)

Falling energy prices

-- Halving of the oil price is like a $1.7 trillion tax cut for global economy

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Bears: Deflation is a grave and growing threat

Bears

Quantitative easing

-- Additional QE and negative interest rates will be needed to preventconsumer price deflation

-- Extra QE will inflate asset price bubbles (stocks, property, bonds). Negative interest rates will damage the banking system

-- Bursting of bubbles has been the problem (Japanese stock and property

bubbles, US dot-com bubble, Global property bubbles)

Where is the ammunition to fight another crisis?

-- Government spending ?? (fiscal policy)

-- Cutting interest rates ?? (monetary policy)

-- Exchange rates ?? A zero sum game

-- Structural reform ?? Not easy

The low demand in the global economy may be permanent

-- Secular stagnation

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Is inflation the only way out of the GFC?

Explanations of slow growth

Secular stagnation Larry Summers, et al

-- Global demand has been falling relative to supply for decades, but was hidden before the GFC by growth in credit (which then caused the GFC)

-- The deficit is caused:

Demand side: demographic factors / globalization / concentration of wealth

Supply side: technological change / larger global work force

-- Real interest rates can’t get negative enough to stimulate investment

Debt overhang Carmen Reinhart and Ken Rogoff

-- Financial crises in which a massive credit growth leads to bad debts that lead a failed banking system are followed by 10-20 years of slow growth

-- Deleveraging by governments, corporates and households takes time

-- Growth is restored once debt runs down enough

We don’t know which explanation is correct

-- But . . . In both scenarios higher inflation will help a lot

-- High inflation means higher real interest rates (secular stagnation) and inflating away of debt (debt overhang)

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Evidence of global deflation: Expected inflation10

Australian wage growth11

Expected inflation: Commodity prices12

Expected inflation: Long term bond yields13

Expected inflation: Australian survey evidence16

The fight against deflation

What is being done to fight deflation

Quantitative easing

-- QE in the US, Japan, Eurozone and UK will soon amount to the

creation of $12 trillion of new money

-- QE is intended to increase consumer product prices, but actually has

increased financial asset prices (stock, bond and real estate prices)

Negative interest rates

-- Negative rates on the deposits of commercial banks in central banks

-- European Central Bank (-30 bps) and central banks of Switzerland (-

30bps), Sweden (-50 bps) and Japan (-10 bps) all charge commercial

banks for depositing funds in the central bank

-- This policy is intended to force commercial banks to turn the money

that is currently hoarded in the central bank into loans

‘Helicopter money’

-- Printing money and distributing it to households is really just another

form of Quantitative Easing

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QE and helicopter money18

Currency

Reserves

Other

LiabilitiesAssets

Central bank

Other

Treasury

bonds

Agency

bonds

Bonds &

Bills

Deposits

Equity

LiabilitiesAssets

Commercial

banks

Other

Loans

Currency

Reserves

Debt

Equity

LiabilitiesAssets

Households &

firms

Other

Currency

Deposits

Sector balance sheets

Treasury

bonds

Navigating deflation and inflation

Measures to defeat deflation will likely cause high

inflation in the long term

Deflation fighting measures are blunt instruments

Inflationary expectations must be shifted upwards, and there is

no fine-tuning of that shift

Central banks actually want significant inflation because it may

be the only way out of the GFC

-- High inflation will reduce the real amount of debt that is ‘over-hanging’

the world economy

-- High inflation permits negative real interest rates which are needed to

stimulate demand

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What should investors do?

Navigating the threat of deflation in the short-medium

term

Reduce net debt (debt – cash)

-- Deflation is the enemy of debtholders because the principal of the debt

increases in real terms

-- Higher cash holding will facilitate taking investment opportunities

Reduce overall investment risk by one or more notches

-- More defensive (less aggressive) asset allocation

-- Reduce leverage (as stated above)

Navigating the transition to inflation in the longer term

Asset classes that will deliver real returns in a deflationary

environment and an inflationary environment

Infrastructure investment

Variable rate notes and bonds

Bank hybrid notes

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Growth of debt

Source: AFR 6 May 2016

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