By Andrew Wiggins
With the UK government and ECB’s unprecedented monetary easing measures, one of the key questions facing institutional investors has been: will this cause an increase in inflation? Last week’s announcement from the Bank of England that it expects inflation to rise to at least 3% by the summer and to remain above target for two years, means that question has become a case of not if, but when, and by how much?
The answer lies in understanding how governments across Europe have been systematically applying Financial Repression to liquidate excessively high national debt levels. Financial Repression is when real interest rates are kept negative over extended periods of time through substantial and sustained quantitative monetary easing. This should create healthy GDP growth while at the same time anchoring nominal interest rates below GDP growth rate and inflation.
In the past such a policy proved quite successful. Through systematic Financial Repression over a 35-year period between 1945 and 1980 the US reduced the national debt-to-GDP ratio from 120% to 35%. Assuming a similar debt liquidation pace, it will take more than 10 years for EU debt/GDP ratio to be reduced from the current 90% to the Maastricht limit of 60%.
While the Bank of England expectations still point to a relatively subdued inflationary environment, history provides many warnings with respect to inflation: it tends to be sticky until it changes; when it changes, the change tends to come as a surprise or shock. Such shocks tend to alter inflation expectations. In the scenario of an inflation shock it could mark the beginning of Financial Repression taking hold with the onset of a secular rise in interest rates and sustained negative returns on government bonds.
This raises the question whether, on the way to debt monetisation, central banks will cause the death of an entire asset class in the next couple of years? With real benchmark bond yields already negative and nominal yields – for all intents and purposes – approaching zero, the risk of holding government bonds is massively asymmetric and skewed to the downside. How long will investors pay par for virtually a zero coupon bond with negative real returns, especially in the face of the pending onset of Financial Repression? In view of this, investors will have to accept higher investment risks to obtain positive real returns with a more balanced risk/return. Therefore, for 2013 we continue to favour selective corporate and high yield issuers, infrastructure debt and other spread products, notably selective emerging market debt. There is evidence of increasing demand from investors for these asset classes.
If history repeats itself and as long as inflation does not exceed 4-5%, equity markets will outperform bond markets in a Financial Repression scenario, with positive real returns. With inflation picking up this is particularly the case for high dividend and dividend growth stocks. For 2013, we conservatively forecast overall equity returns in the region of 8-10%. Within equities we prefer European and Asian stocks over US stocks, given valuations for the former are below their long-term averages, while US equities are slightly expensive compared to long-term history.
Andrew Wiggins is head of UK institutional at Allianz Global Investors
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