Few people in the UK have any experience of deflation, when there is a general fall in prices for a prolonged period.
Instead, they focus on what has, historically, been the experience in the UK – the threat to savings and living standards caused by inflation.
Biography
Leigh has overall responsibility for managing Threadneedle’s equity products, and co-manages a couple of its equity funds.
He joined from Credit Suisse Asset Management, where he was director and senior portfolio manager for UK equities, and was previously associate director at Rowan Dartington and director at investment manager Hill Samuel.
Leigh holds a BA from Nottingham University and an MSc from University College, London, and is a member of the Securities Institute.
Yet in recent years it is the danger of deflation, not inflation, that global policymakers have been most concerned about.
Indeed, the programmes of quantitative easing pursued by various central banks around the world have been focused on alleviating the deflationary pressures which continue to affect some economies, including the eurozone.
Given its close economic ties with Europe, the UK would undoubtedly also be affected if deflation took hold on the continent.
However, we believe that the strengthening recovery in the UK, and the US, will be enough to offset the consequences of a mildly deflationary eurozone.
The effect of deflation on schemes
Falling prices encourage individuals and corporations to hoard money: after all, why spend now if prices will be lower in the future?
This causes consumer demand to fall, translating into a reduction in corporate profits, a contraction in the labour force and lower wages, fuelling further falls in demand and prices.
Once established, this deflationary spiral can be very difficult to escape, and can end in economic depression.
This process can be very damaging to schemes because of the impact on investment returns. A reduction in corporate profits poses a threat to equities, because valuations in this scenario would fall along with earnings.
Deflation also increases a company’s debt burden as the original amount borrowed remains fixed even as company income falls, increasing the likelihood of corporate and sovereign bond defaults, with the associated risk to schemes invested in these assets.
Moreover, pension schemes’ income from inflation-linked assets falls as a result of deflation. Indeed, according to some studies, deflation is more deadly for pension schemes than hyperinflation or stagflation.
Pressures from abroad
The current economic recovery in the UK is accompanied by modest inflation. Deflationary pressures, however, do exist in other parts of the world.
Large parts of southern Europe are already in, or close to, deflation. Greece, for example, has the highest rate in the eurozone and it is accelerating.
Widespread deflation in the eurozone would clearly be dangerous for the UK given the close economic ties. However, we expect the European Central Bank to embark on its own form of QE if the data remain weak.
Fortunately, deflation is easier to fight than inflation for which the cure – higher interest rates – is very damaging to economic activity and asset prices.
There is also the potential deflationary impact of Abenomics on the world. Japan is implementing a huge programme of QE with the aim of lifting its inflation rate to 2 per cent.
As a proportion of GDP, Tokyo’s programme is larger than the US Federal Reserve’s. Yet by sending the value of the yen sharply lower against regional and global competitors and effectively lifting their exchange rates, Abenomics threatens to export deflation abroad.
There is, however, a strong counterargument to these concerns in that the Fed will be winding down its asset purchase programme earlier than expected, because it believes its economic recovery is sustainable.
Inflationary pressures in the US have been subdued recently, partly due to falling energy prices caused by the shale gas revolution. Inflation in other parts of its economy remains modestly positive.
This contrasts sharply with the situation in Europe where weak inflation data reflect the troubled economic background and continuing debt repayment of overleveraged companies. The debt deflation cycle is a very real threat, and the policy response in the eurozone is crucial to keeping this threat at bay.
Because we expect the recovery in both the UK and the US to strengthen in 2014, this should offset the deflationary pressures from other parts of the world, and so we believe there is little reason for UK pension schemes to be concerned about deflation in 2014.
Leigh Harrison is head of equities at Threadneedle Investments
