No sustained deflation or inflation in medium term

INVESTORS nowadays are extremely confused over everything. They do not seem to know what they are wishing for. Take inflation for example. On the one hand, some investors are fearful that inflation will quickly give way to deflation.

They point to all the weak economic numbers, the falling asset prices, and the fragile banking conditions in the United States as evidence that deflation is about to engulf the US economy anytime soon.

A sustained bout of deflation given the current economic conditions can be devastating. In the current environment, sustained deflation can worsen and prolong the current recession and even possibly lead to another Great Depression.

On the other hand, there are investors who are convinced that inflation will soon be making a fierce comeback and the US economy will soon be engulfed in hyperinflation.

They are worried about the massive fiscal spending, the high budget deficit, and surging money supply.

With the price of crude oil and other commodities rising strongly and signs of economic stabilisation, yields on the long-term bonds have risen substantially as inflation expectations rise.

Both views cannot be right. While one view may be right, there is the possibility that both views can be wrong. In fact, it has been the view of iCapital since 2002 that the pricing environment will be one where volatility is the name of the game.

There will be neither sustained deflation nor sustained inflation

The inflation rate will move up in a cyclical manner for a couple of years and there will then be a few years when the inflation rate will fall precipitously. This cyclical behaviour is what has been happening in the last decade or so and this trend is expected to persist in the longer term.

The present US pricing environment is in a stage where the downward pressure on prices is still strong but to extrapolate from this that there will be sustained deflation is a different matter altogether.

The chart shows the present day rate of inflation compared with the very severe deflation during the 1929 Great Depression.

A drop from the current rate to the levels experienced in the Great Depression is very severe and will need an economy that is contracting at a rapid and sustained pace. iCapital does not see such a contraction. The US economy still has a few growth boosters.

The stimulus package is one. Another major boost will come from the recovery in the US housing industry. A third boost will come from a recovering global economy, led by China’s growth momentum.

At the same time, hyperinflation is out of the radar screen as underutilised capacities abound in the product and labour markets. What iCapital foresees in the medium term is a US pricing environment that will be surprisingly benign – not too much deflation, not too much inflation.

Such an outcome can be ideal for the equity market.

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