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Debt and deflation leave investors all at sea

With more volatility certain in Western markets, Japan and Vietnam offer more value

14 November 2015

9:00 AM

14 November 2015

9:00 AM

Just two forces will determine how the ‘storm-tossed barque’ of your portfolio fares in the choppy waters ahead. One of them is deflation, for which China’s shock currency devaluation in August marked the global starting gun. The other is inflation, which our central banks have been doggedly pursuing for seven years to no obvious effect, other than to lift the prices of sundry financial assets.

So first, the bad news. Seven years of almost completely ineffectual quantitative easing have made stocks, bonds and property all horribly expensive. That interest rates have been driven down towards zero in the process hasn’t helped. Unfortunately, QE has utterly failed to lift western economies out of their collective funk. And QE has also failed to trigger strong private demand or inflation. The credibility of central bankers is now on a par with faith in the management board at Volkswagen after its emissions scandal.

You may be wondering why our central banks are so determined to create inflation when most of them have a sworn obligation to defend against it. The answer lies in their clients, the governments of the developed world — governments that are sitting nervously atop a gigantic powder-keg of already unpayable debt. Without inflation, they face insolvency.

Rather extraordinarily, the printing of trillions of dollars, pounds and euros that QE represents has failed to ignite that inflationary spark. Independent analyst Russell Napier believes that this failure of central banks to inflate means that they will soon be replaced in this task by governments themselves. An awkward by-product of explicit government intervention will be the reintroduction of capital controls. And you thought deflation was bad?


So China’s obvious economic slowdown and the autumnal decline of its stock market come with grave implications for the West. Equity markets closer to home have been wrestling with these implications. Future volatility seems assured.

Another problem facing western markets is how — if ever — central banks can start to normalise interest rates. It is distinctly unnatural to have base rate squatting at 0.5 per cent. Janet Yellen at the US Federal Reserve had an opportunity to begin this process in the US in September but she bottled it, citing unstable foreign markets.

Anyone with a global portfolio will appreciate that emerging markets are experiencing an annus horribilis. Commodity exporters in particular are being squeezed on two sides. Commodity prices are in free-fall even as the real value of exporter nations’ borrowings rises in line with a stronger US dollar. Emerging-market debt defaults seem inevitable. Our current global monetary system — an uneasy mix of floating exchange rates and emerging market currencies pegged to the dollar — is clearly unfit for purpose, but as Russell Napier also points out, that’s because it was never actually designed at all. Expect further volatility from foreign exchange markets, especially in emerging economies.

But the news isn’t all bad. Happily, there are pockets of value out there in the financial markets. Japan is one of the more compelling. Having experienced two decades of deflation long before the rest of us, the Japanese have learnt how to cope with a new financial order. Their stock market is cheap compared with its western peers. Fully 40 per cent of Japanese listed companies trade with a price to book value (the ratio of market capitalisation to replacement cost, if you like) of less than one. And Bank of Japan Governor Haruhiko Kuroda, like his western colleagues, has a printing press and is not afraid to use it.

Nor are all emerging markets created equal. While investors fret about China, they may overlook Vietnam, its little neighbour that is winning business hand over fist because of its competitive wage levels — around half those in China. Vietnam is also in the process of opening up its economy to foreign capital; its stock market is the cheapest in Asia, and analysts expect major index providers such as MSCI to re-categorise the country from its current ‘frontier market’ status toward the weightier ‘emerging market’ designation, which is also likely to trigger significant inflows of foreign capital.

But the relative exoticism of these markets highlights the paucity of opportunity here in the slow growth, debt-impaired West. Yes, we have robotics and alternative energy and biotechnology and crowdfunding, but there’s also a war being waged by central banks on our own money. Our plucky little portfolios could benefit from some tailwinds on their journey. Squalls and storms seem, sadly, more likely.

Tim Price is director of investmentat PFP Wealth Management.


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