Asset Allocation: Investing in Low, Really Low, Inflationary Environme
When inflation is non-existent the investment paradigm changes, and investors have to rethink strategies in a world of price stability. BT's Craig Stobo explains the implications.
Sunday, February 7th 1999, 12:00AM
Portfolio construction has, for many years been based on the belief that equity and bond markets are inversely correlated. When one goes up the other goes down. However, for the past year both markets have risen, thus raising a conundrum for advisers and investors. In this article BT Funds Management chief investment officer Craig Stobo (pictured) discusses the implications of this changed relationship for asset allocation, and raises a theory explaining why both markets are moving in tandem.
Prices for commodities are falling to lows not seen since the 1960s and 1970s.Consumer price inflation in the major developed economies of Europe and the US is benign. In Japan deflationary pressures are still evident across most sectors, including assets such as property despite the large price falls that have already occurred in the 1990s to date. Central banks have won the war against inflation after instituting hawkish monetary policy regimes in the 1980s and 1990s, aided by the waves of deflationary pressures generated by Asia’s excess manufacturing capacity.
This represents a relatively new backdrop for those investors whose experience of markets was affected by the financial market deregulation and asset price boom of the inflationary 1970s and 1980s. During that period, to generalise, investors’ expectations of economic cycles included a traditional monetary response to any unbalanced economic growth which subsequently affected the discounting of company earnings. Or more simply put, interest rates were raised to quell inflationary pressures, and stock prices fell. This negative correlation between interest rates and the equity market served as a useful framework for making stock selection and asset allocation decisions in that period.
However, when inflation is non-existent, perhaps the investment paradigm changes, and investors have to rethink strategies in a world of price stability.
Gibson in his 1930 Treatise on Money tries to explain this phenomenon where interest rates (bond yields) are correlated with the economy’s general price level, and the correlation between bond yields and stock prices becomes positive not negative. It has become known as Gibsons Paradox, because no one is entirely sure why this relationship has held true for long periods when prices are stable. One possible explanation is that the equity risk premium is correlated with inflation. When inflation rises, so does uncertainty about future corporate earnings. Stock prices fall. When inflation approaches zero, the equity risk premium is at a minimum. From that point corporate profits are positively correlated with the general level of prices and therefore bond yields.
Clearly as inflation expectations fall (itself a function of stable current prices) interest rates can fall further. I don’t believe that many investors are currently investing based on a 0.4 per cent headline inflation for the March 1998 year. Yet that is what the Reserve Bank is forecasting. Household inflation expectations are much higher than this. The latter explains why investors are currently struggling to come to terms with 5 per cent bank deposit rates and are scrambling for yield. If inflation expectations fell to forecasts, current rates would be seen to be very attractive.
Similarly a downward shift in inflation expectations would require similar directional changes to long term corporate earnings growth expectations, which previously have had to incorporate an element of inflationary risk when discounting returns.
Although Gibsons Paradox was bypassed as an explanatory tool in the inflationary decades of the 1970s and 1980s for obvious reasons, it may be that his observation of a positive correlation between stocks and interest rates is becoming more insightful in the late 1990s. Arguably Japan is already experiencing this relationship. Stock prices have been falling for most of the decade as have interest rates and the general level of prices. Similarly the gyrations in global stock markets in the March and September quarters last year were also periods of similar directional moves in global bond yields as investors alternated between risky and riskless assets. In other words stock and bonds have become portfolio complements rather than substitutes.
For investors then the issue is reasonably clear. If inflation expectations closely approximate price stability then the investment environment is different, and requires a strategic rethink of exposure levels to bonds and equities in portfolio construction and the allocation process between them. Arguably bond exposures are still too low in many portfolios.
Craig H Stobo is chief investment officer at BT Funds Management.
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