• Text size      
  • Send this article to a friend
  • Print this article

Why deflation is a real risk despite the growth of the UK economy

INVESTMENT portfolios tend to be built around expectations of inflation - which figures show is falling faster than expected.

Too much inflation is bad, but moderate price rises favour shares over gilts or bonds. Few people expect prices to fall, other than temporarily. But some recent indications suggest deflation is now a risk.

Loading article content

How should investors react to the possibility of a radically different environment?

Few seem prepared for the change. Indeed, the suggestion of deflation might seem surprising when the UK economy is growing strongly.

Unemployment is also falling sharply, and there is now much less spare capacity in the economy to keep the lid on prices. Yet, there are worrying signals.

The most recent Bank of England quarterly report on inflation showed that wage growth has hit its lowest level on record. Average weekly earnings, excluding bonuses, are up just 0.6 per cent over the last year. The European Central Bank's Harmonised Index of Consumer Prices has gained just 0.4 per cent over the past year, compared to a 2 per cent target.

Self-employment, low paid jobs, and the willingness of older workers to accept lower pay, suggest wage pressures are now muted. The 14 per cent rise in the pound from its lows of early 2013 has also been a factor, as has intense supermarket competition. Discount retailing chains have moved mainstream, with additional deflationary pressure coming from the established major food retailers as they re-engineer business models.

But, the most worrying trends are in continental Europe. Not only are some peripheral countries now experiencing deflation, but investors have this month driven German ten year government bond yields down to 1 per cent.

This is putting a high value on safety and suggests little fear of inflation.

It also means that institutional investors may see little risk in holding cash deposits, given how little pick-up in income they would get from secure bonds. A recent survey suggested that investors are holding much higher levels of cash than normal.

The challenge of running a business in a deflationary sector has hit the big retail groups.

Tesco's shares now offer a high but risky dividend yield. It may now be tempting for companies such as Tesco and Morrisons to cut dividends to assist restructuring. While shares offer attractive dividend income, the risk of dividend cuts increases with deflation.

When headlines feature rising house prices, it is easy to dismiss the thought of deflation. But pockets of rising prices can live within a generalised deflationary environment. Indeed, increasing prices for essentials such as housing, adds to the downward pressure on spending in other areas.

It is these mixed signals that keep investors off guard. Many of the official statistics point to the deflation story, but the concept itself is so alien that it is dismissed by most commentators, policymakers and central banks.

In the deflation of the 1930s, gilts and monetary assets such as deposits did well. Savers collected a real return just by sitting on cash. And the countries that tried to break out of the deflationary spiral by leaving the gold standard were the first to recover. But in the eurozone, it is hard for member countries to break free from Germany's deflationary policies.

For investors, the deflation risk may initially be helpful. It increases the likelihood of strong stimulation and money printing.

But it may bring further competitive devaluations and dividend cuts, and even a break-up of the euro. It would be a new environment for most investors; the best protection may be a balanced portfolio, including bonds and shares.

Colin McLean is managing director of SVM Asset Management

Contextual targeting label: 
Finance

Commenting & Moderation

We moderate all comments on HeraldScotland on either a pre-moderated or post-moderated basis.
If you're a relatively new user then your comments will be reviewed before publication and if we know you well and trust you then your comments will be subject to moderation only if other users or the moderators believe you've broken the rules

Moderation is undertaken full-time 9am-6pm on weekdays, and on a part-time basis outwith those hours. Please be patient if your posts are not approved instantly.

256455