There is an intense debate among investors about whether inflation or deflation is the greater evil lurking around the corner. There’s no question that deflation has been the stronger force since the credit crisis picked up steam starting last summer, causing the global financial system to nearly implode during the second half of last year. Economic activity largely shut down, causing steep declines in nearly all asset prices. For example, the Dow Jones/AIG Commodity Index collapsed by -57% from its high last July to its low in February. More recently, the Consumer Price Index was reported to have fallen by -0.7% in April from a year ago, the lowest reading since the 1950s (see chart below).
Lately, there’s been a lot of talk of “green shoots” – tentative signs of economic recovery. Stock markets have rallied, commodities prices have perked up, and bonds yields have risen, as economic data has begun to level off from a freefall. A growing number of investors are interpreting these developments as signs that the market has begun to adjust to an inevitable wave of inflation, thanks to the massive government efforts to rescue the financial system.
We believe that the threat of deflation still exists, although perhaps to a lesser extent than a couple of months ago. Despite the endless talk of green shoots, the slightest misstep by policymakers or some unforeseen shock at this juncture could cause a major setback to the fragile recovery and would likely tip the scales definitively back towards deflation. We fully recognize that inflation may in fact lie in wait, but due to the severity of the ongoing economic problems, we think that threat lies further down the road than the inflationists believe.
