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Is 2018 the year that we finally shake off the hangover from 2008?

Since the 2008 financial crisis, investors have been gripped by a stubbornly deflationary mindset. But 2018 could mark turning point. John Stepek explains what that means for you.

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Will we see fireworks in the markets this year?

Happy New Year!

Hope you had a good Christmas and enjoyed whatever time off you had over the festive season.

As befits the first official Money Morning of 2018, I want to take a look at what might happen this year.

There are lots of little sub themes, ideas and "tips of the year" we could talk about and we'll have plenty on those in the next couple of issues of MoneyWeek magazine (subscribe now if you haven't already you get your first four issues free).

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But today I want to talk about the one big thing that could have a massive impact on every aspect of your portfolio: a shift in the stubbornly deflationary mindset that has gripped investors since 2008...

Four factors driving our deflationary mindset

I'm not one for attributing things to "animal spirits". Markets' fears and hopes are often grossly exaggerated they can be terribly melodramatic but they are fundamentally grounded in reality. If investors are still jittery about deflation then that's because there are a number of good reasons for that.

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Firstly, there's bitter experience. The 2007/08 crash is still almost a decade on the biggest market bogeyman in everyone's heads. This is partly a form of recency bias: the crash was traumatic and everyone remembers it vividly. So it's the scariest threat and the first one that springs to mind.

But it's not just the result of a psychological tic at work. The most obvious historic parallel with 2007/08 was the Great Depression. And the most obvious geographic parallel was Japan's experience in the 1990s.

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Neither of those cleared up quickly. In both cases, major relapses into deflation occurred either when central banks took their eyes off the ball or the business cycle turned again. So investors can be forgiven for feeling paranoid about a recurrence.

Secondly, there's the ongoing question of quantitative easing (QE) and its efficacy. I'd say that no one fully understands what effect central bank money printing has had on the financial system or the economy that includes the central bankers themselves.

What is clear is that it took several bouts of QE and a few market tantrums before the US Federal Reserve the leading central bank was finally able to wean the US off extra stimulus. The Fed has also had to be far more cautious than anticipated in raising interest rates over the past couple of years.

Thirdly, the world is still carrying a lot of debt and too much debt is deflationary. Otherwise valuable resources are diverted into paying off interest and debt rather than investing to increase productivity and boost growth. That can turn into a self-fulfilling spiral if it goes unchecked.

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Finally, recent experience has also taught that it's been either profitable or certainly not harmful to bet on deflation or disinflation. The worst-performing asset class has been the one most correlated with inflationary times commodities. Meanwhile, the bond bull market has been declared dead on many occasions, and so far has lived to tell the tale.

So investors have been taught over a fairly long period of time that betting against inflation has been a decent default position. Once you get comfortable with that sort of worldview, it takes a lot to change it.

In short, investors have a lot of good reasons to have stuck with a disinflationary mindset. And that in itself has encouraged and enabled a lot of disinflationary "this time it's different" arguments from demographics to technological change to secular stagnation, everyone with a pet theory can put it out there and it'll get a fair hearing.

Could 2018 represent a turning point?

But 2018 could mark a turning point. As we enter a new year, the consensus view is almost always for "more of the same". And it's no different this year. At the start of 2017, everyone expected more political turmoil, as we'd had in 2016. Now, everyone expects more bull market, which is what we actually got in 2017.

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I'd say that there's a sense of optimism that hasn't been there since the financial crisis. That's hard to pick up on in the raw stats you'll rarely find a consensus of forecasters arguing for the S&P 500 to fall in any given year, regardless of how gloomy things are. But the tone of most commentaries is very much accentuating the positive, rather than the negative, this year.

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That's an intriguing shift in mindset. It's happening at a time when economic growth is strong in most countries and unemployment is low. Indeed, it's fascinating to me that one of the biggest ongoing "fear" themes is the threat of robots taking all our jobs, at a time when employment levels are at record highs in most developed economies.

I suspect that most of this is a side effect of the ingrained disinflationary mindset. We see things we can't quite marry up low unemployment, but weak wage growth and make up stories to explain it. "Oh, wage growth must be low because workers are scared of being replaced by robots."

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But maybe it's not that. Maybe it's just time. And maybe this year is when all of the things that "should" be happening, start actually happening.

As Paul Ashworth of Capital Economics notes, strong economic growth does not "mean that equity markets will also do well". Stocks are expensive already. "And at this late stage of the economic cycle we would expect gains in nominal GDP to accumulate to workers in the form of higher incomes rather than to firms as higher profits."

That makes sense. Competition for workers has to be getting tight which logic dictates should mean higher wages. And given the political upheaval we've seen in the last few years, companies would probably be well advised to start sharing the spoils very visibly before governments start to grow more heavy-handed in their labour market interventions.

Of course, visible wage inflation would also start to convince the market that inflation is real. And if investors start to believe that inflation is a bigger threat than deflation, that implies a big shift in markets.

If you are fretful about deflation, then buying a government bond with a negative real (after-inflation) yield today doesn't look like a bad idea. Because you are terrified that the real yield could turn positive any minute now.

But if you start to worry about inflation, then a negative real yield looks a terrible deal. Because while it's bad today, it'll only get worse tomorrow.

That doesn't necessarily mean there'll be a mass panic move out of government bonds (there are so many "forced" owners these days that any retreat may be slow). But it does mean that interest rates could perk up faster than expected.

In short, the "Goldilocks" days may be coming to an end. We'll look at the implications in more detail in a future Money Morning.

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