Thomas Thygesen looks at how best to ease into an optimised and diversified exposure to an inflationary scenario

The past few years have been challenging for most investors, and not just because prices have declined. More seriously, they have declined in a way that raises profound question marks over some broadly-held assumptions, highlighting the need for a deeper historical allocation framework.

The big surprise of 2008 was that the stock market crashed before it had distanced itself from the lows set at the beginning of the decade, destroying hopes that the dotcom crash had been a temporary aberration. That crash was also bad, but it essentially took stock prices back to where they were only a few years earlier and it happened after an explosive, bubble-like ascent. It did not seriously hurt broadly-held views about how fast markets return to trend after a deviation. The credit crash of 2008 sent stock prices back to levels last seen in the mid-1990s, and it extended the stock market's losing streak versus bonds to more than 20 years.

It also revealed the limits of the benefits of diversification. In fact, as the crash unfolded, the correlation with equity returns soared for assets that had been thought to offer more substantial diversification.

Structural waves
The collapse of these widely-held beliefs about the behaviour of markets suggests that the crash was more than an isolated event - it was a symptom of a structural crisis that has been building for almost a decade. Structural bull and bear markets are not as unusual as they are perceived to be; there are a handful of episodes over the past 125 years where risk premiums and stock market returns were negative over more than a decade, and each one was greeted with disbelief.

The difficulty in anticipating these trends is compounded by the tendency for each new structural bear market to be the opposite of the one before: each one associated with a long-term peak for inflation and bond yields is followed by one with a trough. The last structural bear market in the 1970s marked the culmination of 40 years of rising inflation and yields. It was essentially a technological crisis, with faltering productivity growth leading to sustained capacity shortages, and it ended with a political regime change - the Reagan-Thatcher revolution unleashed the dynamic forces of the supply side and paved the way for a long, powerful bull market fuelled by faster productivity growth and falling inflation.

The current bear market comes at the end of 30 years of falling inflation and bond yields. Its roots go back to the Asian crisis when consumption began to fall behind production capacity and deflation risks started mounting. After 30 years of learning that rising inflation is a bad thing and falling inflation is a good thing, we now have to understand that when inflation is low, falling inflation is the worst thing. Deflation undermines the stability of the financial sector - waves of bank failures accompanied not only the current deflation crisis, but also those in the 1930s and the 1890s - and this forces markets into violent de-leveraging. This, in turn, leads to simultaneous and closely-correlated collapse across a wide range of ‘diversified' but debt-supported asset classes. The only thing that provides true diversification in a deflation crisis is government debt.  
From deflation to inflation
The solution to a deflation crisis is likely to be a regime change in economic policy, similar to the one in the 1970s, but with the opposite ‘sign' - massive stimulus in a modern variant of the active demand-management regime that followed the deflation crisis in the 1930s. This regime change was initiated with last autumn's financial sector bail-outs. Since then, interest rates have been cut to zero and fiscal stimulus packages launched. More recently, non-conventional weapons have been introduced in the form of monetisation policies.

Using the proverbial printing press is the policy equivalent of nuclear weapons on the battlefield - extremely potent, but hard to control. The main effect is that we can feel more confident about the longer-term outcome in the struggle against deflation: there is clearly no limit to how far policymakers will go to restore inflation. Nonetheless, it is still uncertain how long it will take. Deflation risks are likely to continue worsening for some time. Creating millions of jobs, recapitalising the banks, devaluing the currency will all help, but it will likely take two to three years before the full effect materialises.

However, once the turning point is reached, the change is likely to last. One thing we have learned from historical deflation episodes is to avoid a premature withdrawal of policy stimulus. Debt-saddled governments will not be able to sustain a fiscal expansion if real rates increase too soon. When interest rates reach zero, they stay there even well after inflation starts rising. At the same time, increased economic and financial regulation is likely to reduce investment and productivity growth, resulting in a more inflation-prone economic environment. Western economies are also likely to face upward pressure on import prices as Asian currencies rise. When inflation establishes a trough, it is likely to be the low point for several decades. 

The delayed effect of the policy regime change poses a major challenge to asset allocators: the deepening recession argues for tilting the portfolio composition heavily towards low-volatility, government-backed assets, but these are the assets that will suffer most from a change in the balance, at some point over the coming three to four years, between long-term inflation and deflation risks. In fact, the non-conventional easing could lead to an explosive situation for treasury investors. Printing money clearly raises long-term inflation risks, but the money will be used to keep bond yields artificially low right now, and this could well result in the creation and subsequent bursting of a bubble in government bond markets.   

The timing of this change is uncertain, so the portfolio composition should change gradually as the probability of the regime change increases. The planning of the portfolio transition should have two key elements: identifying the most efficient hedges against inflation risks while controlling for cyclical risks; and identifying allocation triggers that can guide the timing of changes.

When it comes to improving the portfolio's response to rising inflation, our analysis strongly suggests that equities are only a mediocre hedge - returns tend to suffer when inflation is high, even though returns increase with modest increases in inflation. Over the past 85 years, equity returns have had a negative correlation with inflation, although not to the same extent as fixed income assets. Equities also have a particularly high exposure to cyclical risks.

Instead, we would focus on assets that have either no or positive correlation with inflation. Commodities have the strongest link from rising inflation to higher real returns on all time horizons, but they also have high volatility and do not normally perform well in the current cyclical environment.

Less volatile opportunities are found within fixed income. Relative credit returns also have a strong positive correlation with inflation, and they actually tend to do very well in the last part of a recession. Index-linked bond returns are not affected by changes in inflation and share the other low-risk qualities of government bonds. As a result, we think it makes sense to emphasise a higher weight for credit and TIPS bonds in the fixed income portfolio and for commodities in the overall portfolio in the first steps of the transition, while equities are likely to play a more significant roles in the last part.

With respect to the timing of the transition, we identify three intermediate steps from deflation to inflation, beginning when the bailouts  stopped the credit meltdown in Q4, 2008. The first step is the actual implementation of non-conventional policy tools, which is unfolding as we approach the end of Q1. This is likely to herald a turning point for commodity prices and a peak for credit spreads. Step 2, which will have a more profound effect on inflation risks, will follow when Western currencies start weakening in response to the policy changes - probably in some three to six months. This is likely to herald a big decline in credit spreads and a faster increase in commodity prices. The third step comes when employment expectations stabilise in the West, probably some 12-18 months after step 2. At this point, recession risks will be diminishing, allowing equities to take over as the main tool in the inflation-ready portfolio.

Thomas Thygesen is chief strategist in the SEB X-asset strategies team at SEB Merchant Banking