DB Advisors: Deflation Fears Are Exaggerated
US government bonds: The next bubble is developing - Advantageous period now for institutional investors to hedge the inflation risks - Corporate bonds are very attractive in the currently uncertain market environment - Investors should strategically prepare the reallocation of assets into equities and real assets
Governments and central banks have been featuring a formerly unknown activity for some time: in the past four weeks, 14 countries have agreed to at least one fiscal package and 10 central banks have loosened their monetary policy. The undisputable dramatic downswing of the global economy since mid-2008 is raising the fear that the worldwide economy may be heading towards a deflationary situation - comparable to Japan in the 90ies or even the Great Depression in the last century. Essentially, there are many factors which speak against the development of such a deflation scenario and - just the opposite - investors should rather position themselves for an inflationary scenario in the future.
Massive macro-political measures supported by oil price decline
In light of the magnitude of the financial crisis following the insolvency of Lehman Brothers and the simultaneous collapse of important financial indicators, many central banks have reduced their interest rates very quickly, partially moving towards a zero-interest rate policy and the US central bank (Fed) has even progressed with a quantitative easing policy (additional liquidity generation through the purchase of securities). Furthermore, economic stimulus packages are launched around the globe, while their financing leads to a strongly increasing supply of government bonds. The discussion surrounding the medium- and long-term effects of these monetary and fiscal “experiments” is currently not held appropriately, in light of the momentum of the current downswing and the accompanying rapid decline of inflation rates. In addition to the expansive monetary and fiscal policies, a third factor comes into play, which is decisive when it comes to the stabilization of economic activities: the significant reduction of the oil price since the middle of last year (from 145 US Dollars per barrel to currently 40 US Dollars per barrel).
Bond market convinced of long-lasting recession
The momentum of the economic downswing in the past weeks and months has certainly reached a formerly unknown magnitude. However, it is oftentimes neglected, that the global economy was also at a very high level of expansion until July of 2008, linked to a rapid increase of the global inflation to 5%. Therefore, when analyzing the situation across the past years, a part of the downswing may be qualified as the normalization of former growth and not necessarily as the start of a long-lasting depression. Especially the returns of governments bonds no longer provide a safety buffer, if the economy, against all expectations, features signs of recovery in 2009. The returns of 10 year US government bonds were at 2.05% (currently 2.3%) in mid-January and thereby only somewhat above the historic low of 1.6% in November 1945. As soon as the Fed steps back from its willingness to purchase mortgage papers or also government bonds itself, there is the danger of a significant increase for capital market returns. Furthermore, the uncontrolled debt level of the US could provoke international investors to demand a higher risk premium - that is higher interest rates. A change in the long-term inflation expectations could also be a further cause for bursting the bubble in the government bond market.
Structural changes impact strategic allocation
A structural change as the result of the financial and economic crisis should be the increasing involvement of the governments. Partial nationalization in the banking and also the industrial sector, increasing budget deficits, less flexible job market conditions and increased protectionism have tended to result in lower productivity and therefore higher inflation rates in similar periods in the past. One secular trend should, however, continue in times after the crisis: the inequality between supply and demand for fossil fuels persists. This means that we expect, among other factors, an increasing oil price, which will in turn impact the inflation rates.
Corporate bonds attractive for total return investors
Corporate bonds with good credit rating appear very attractive under risk expectations. European corporate bonds are factoring in an annual default of 6% over the next 5 years in the meantime. The investor currently generally receives about 6.5% return and has the chance for additional capital gains upon a spread tightening to government bonds. Although we do not expect a significant recovery of the economy in 2009, we do assume a slight narrowing of the spread by at least 50 basis points. This should be the result of a falling illiquidity premium and a slight increase of the risk disposition. This process has already begun in the interbank market and represents an initial gleam of hope for the capital markets.
Invest into risk assets at midyear
In the medium term, institutional investors invested primarily in interest-bearing, nominal assets should consider the shift of values into real assets and equities. Even though the forecasts for corporate profits have been continuously reduced in the past five quarters, this process should continue in light of the global recession. However, this has already been discounted in the stock prices and many stock markets are valued at a price-earnings-ratio in single-digits. As soon as the expected negative corporate results in the ongoing reporting season as well as the announcement of profits for the first quarter of 2009 in April/Mai has been overcome, the interest rate measures in the recent past should have an impact following a delay of approximately one year. This would mean that the news during the second half of 2009 would slightly improve and equity positions should be developed in midyear. To what extent the expected increase of capital market interest rates may once again depress the forecasts in such as scenario can currently not be foreseen.
With regard to the term of the past ten years, the overall return of equity investments was actually negative. The investment, especially in government bonds, was considerably more profitable. This trend should not be prolonged by investors in light of the massive, global reflationing. The investment in producing capital, this means in companies with a solid financing structure, sustainable business models and cautious management should once again pay-off. Positive value creation of the companies has a real value in all types of inflationary environments.
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