Inflation is dead, long live inflation

German Chancellor Angela Merkel said at a news conference, “The German government believes we must not achieve growth at the expense of high deficits.”

The fiscal experiment and monetary accommodation done worldwide in the aftermath of the 2008 stock market crash is on the verge of failure. Bond vigilantes in countries like Greece, Spain and Portugal have suddenly created a fear in the minds of politicians and they are withdrawing from stimulus spending, which itself is deflationary to austerity measures, which is even more deflationary. So, one way or the other, they are in trouble.

The inflation-deflation debate is practically over for the time being with stocks and commodities under pressure and bond markets reacting positively. Market participants analyse past data to take investment decisions. This used to work well when economic cycles used to behave. The current market movements dictate that it will be difficult to extrapolate this data into the future.

Here are some key factors that suggest the concerns are far from over. First, in spite of the huge printing of currency in the US, money supply indicators are hinting negative growth and are dropping consistently. Second, the various austerity measures in major economies like Spain and Portugal and the UK. The stealth revaluation of the Chinese yuan against the euro by about 18 per cent since the start of 2010 will put pressure on China’s exports, 20 per cent of which go to Europe.

On the domestic front, the money supply (M3) year-on-year growth also gives us a reasonable peek into the immediate future, which is certainly not rosy. The M3 growth has declined to almost a five-year low. As M3 continues to rappel down, it will slow economic activity; going forward, inflation would, hence, not be a major concern. This would make a case for fixed income becoming more favourable.

We believe equity markets, on the back of the weakening commodity cycle, will struggle more in the coming months, which will make money flee to bonds. We are looking at curve flattening, basically long bonds yields falling, as markets adjust their view that the inflation experiment has failed for all practical purposes and we are looking at the immediate prospect of deflation in major world economies.

But, spending will still be the curative way out of this mess, a fact well known to politicians who are more worried about deflation. The day the realisation dawns upon them, possibly near the US Senate election slated this November, that deflation is gripping the system, the printing press will start with vengeance and the long awaited flight of capital will take place from bonds to anything which is not paper.

The author is head, fixed income, Canara Robeco Mutual Fund