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From Goldilocks to Noah: ancient tales apply in tough economic times

Lothar Mentel - 07 September 2010

Before the recent financial crisis we were supposedly living in a ‘Goldilocks’ economy, with all the conditions for a perfect economic porridge. The economy was at a warm temperature with no danger of overheating. Prices grew slowly and this disinflation allowed interest rates to fall. With bonds delivering fixed coupon repayments, this lack of inflation was good news for bond investors. Nor was it too cold: earnings continued steadily upwards and so equity investors also benefited. Economists termed this period the ‘Great Moderation’. Yet its underlying stability fostered a rise in debt, and a declining awareness of risk, all of which has since come home to roost. Now the concern is that the economy is potentially too weak to recover.

The global economy does appear to be in a precarious position, particularly if bond markets are to be believed. The overriding concern is that, despite the best efforts of central banks and governments, there are just too many headwinds for a recovery to gain any meaningful ground over the short term. Without economic growth, the threat of deflation, a decrease in the general price level of goods and services, looms as it has done in Japan over the past decade. Such a scenario makes the fixed coupons from bonds look increasingly attractive. Yet inflation, particularly in the UK, remains stubbornly high. In fact, there’s a possible scenario more akin to stagflation – negative growth with rising inflation. Suddenly the recent bond market rally looks less convincing.

We believe the most likely scenario is little growth combined with a little too much inflation. This is not an outcome that is currently priced into either bond or equity markets. Bond markets are ignoring the possibility of mild inflation whilst equities are factoring in low or negative economic growth.

So, what do we feel might drive inflation in periods of economic contraction? The current interaction between employers and employees provides some insight. Productivity and hours worked are known to be increasing. This is because companies require more from their remaining workforce to meet existing demand. Yet more work leads to requests for more money.  Companies usually look to hire, primarily from the ranks of the unemployed who are likely to be content to work at current pay levels, rather than raise salaries. However, firms simply aren’t confident enough to do so just yet. Unemployment is therefore staying higher for longer whilst salaries for those in employment, with relevant skills, are likely to rise.

Further inflationary pressures are likely to come from rising commodity prices, driven by demand in the rapidly growing developing economies. Economic contraction in the western world will lead to a necessary transition from export-led to domestic-led growth in the developing world as the West produces less goods and developing countries work to meet their own growing demands. Capital investment into businesses in these countries would likely follow this growth, pushing their currencies higher. Meanwhile, over in the West, as our money would be worth relatively less, we would ultimately be importing inflation alongside goods.

So, the case for stagflation is perhaps more compelling than the markets have factored in. But economic growth in the developing world will translate into global economic growth. As a result, perhaps even stagflation would be short-lived, leading to a more palatable world of anaemic growth with inflation. This environment would also result in interest rates remaining lower for longer. Any debtor, governments included, would benefit from a certain degree of inflation.

And so we arrive at the ‘Noah economy’, a situation where governments continue to flood the economic system with cash, and economic statistics continue to come in two-by-two: inflation just above 2% and economic growth just below it. There’s no room for Goldilocks and the three bears here; it’s a plausible scenario which would mean current bond prices are too high and equity valuations too low.

In this environment, only certain companies would benefit. This greater differentiation will play to the strengths of those fund managers who have anticipated these events. In the investment space, active managers will increasingly be able to add true value.

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