There seems to be some market confusion as to whether the United States in particular is in more danger from deflation than from inflation, at least in the short term. What is your view?
Laurie Carroll: The United States is right to be particularly concerned about deflation. Japan is still trying to deal with deflation after 20 years. There is no doubt that we have seen a dramatic reduction in house sales in the United States as a direct result of the withdrawal of tax credits to home buyers there. This could be regarded as a fiscal tightening measure, and although it was probably inevitable, it has hammered the US housing market, which now remains a very significant drag on growth. You can see the danger signs too in consumer attitudes, with people being very keen on cutting their borrowing and increasing their savings. This deleveraging by the consumer takes money directly out of the economy. The US economy needs the consumer to spend to drive real GDP growth.
I do not think that anyone, prior to the crash, appreciated the extent to which the consumer would shift into deleveraging. Consumer spending has been a very reliable component, accounting for around two-thirds of GDP, and now people are talking about a generation that has shifted toward short-term retail funds and is not investing much in equity or longer fixed-interest assets. We don’t yet have the “depression baby,” but we have people who have become attuned to the shock of the recession, and it takes a long time to change.
When people switch from spending to saving they have to be strongly incentivized to spend again. The United States did this on housing and new house building, and government stimulus worked until it was withdrawn, but it seems to have had little carry-through after the withdrawal. Of course, in countries with no social safety net, such as China, it is very difficult to get strong consumer spending since people place a very high priority on saving sufficient to get themselves through any emergency that might come along. This generates a very persistent habit of saving, and you get very high savings rates precisely when you want to encourage much higher levels of domestic consumer spending. China is going to have to spend vast sums putting in place a much more trusted social safety net as part of its ambition to build up consumer spending, but that is going to take a number of years to come through.
However, these are longer-term plays, and my focus is on short-term strategies. Key for me is the behavior of central banks. With deflation seen as the bigger near-term threat, the US Federal Reserve will be keeping short-term rates low for a long while yet. We could see some movement from the Bank of England, given the higher rate of inflation in the United Kingdom and the fact that it has proved “stickier” than many anticipated. But we do not expect to see any raising of rates from the European Central Bank for a long while yet.
In October 2010 we saw some price action in the two-year bond space, but strong demand brought the price down again. Corporate bond spreads gapped out just a bit in September, but again, it is hard to see us moving too far from where we are right now, given the level of uncertainty in the markets. We now have the Dodd–Frank Act, but much of the detail work still has to be drafted, so we will be well into 2011 before we get any clarity on the regulatory front. This being so, I do not see people changing their strategies a lot much before the first quarter of 2011. If anything, I would expect market thinking to become more conservative.
Right now we are in a very neutral stance. It is very difficult to put a position on one way or another at this point as far as government bonds are concerned. There is still value in investment-grade corporate bonds, so we are overweight in corporate credit. We do not see any point in hedging against interest rate risk right now since it is still very unclear what is happening, and a hedge just becomes yet another risk that you are assuming. The simplest strategy right now is to continue investing in corporate credit. There is a great deal of new paper coming on to the market, particularly in the financial sector as the banks look to shore up their books.
As to sovereign debt, we are very selective in the countries we want to go into. Some of the bigger, better trading nations are giving cause for concern, and this saga has by no means run its course. Much of the future difficulty for European politicians lies in trying to reduce the scale of public benefits, such as pensions, in an effort to cut government deficits. It is very hard to get people to accept a decrease in lifestyle. Increases are easily absorbed, but decreases are fiercely resisted.
The US administration has just added another very difficult-to-pay-for social layer, in the shape of the healthcare acts of 2010, and that will doubtless cause the United States further difficulties going forward.
Another very significant factor in the equation is the potential fallout from the competitive deflation that various countries are now engaging in against the dollar. In some senses this is the same conflict as that between tight and loose monetary policy playing out in the realm of currencies. Developing countries are experiencing above-trend growth that threatens to boost their currencies against the dollar. This hurts their export markets, so they seek to devalue their currencies downward against the dollar, which itself is weakening through a combination of weak US growth and the impact of the first round of quantitative easing and market fears over the inflationary impact of the much anticipated second round of quantitative easing, which is now scheduled to run through 2011 and to be worth around US$600 billion. This “competitive devaluation” of currencies is creating something of a “race to the bottom.”
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