Will 2021 hold one last deflation scare?
With many looking ahead to a world of high inflation, John Stepek looks at a couple of potential scenarios that could give the world one last deflationary fright.
At this time of year my inbox is flooded with predictions for the year ahead. Today, I thought I'd pull out some of the more interesting ones to share with you.
We all know that predicting the future is impossible. Or if you didn't, then I'm pretty sure 2020 might have taught you a thing or two. But it's certainly worth thinking about whether there are any outcomes that could spring nasty surprises or present intriguing opportunities – just in case.
A deflationary fright that leads to an inflationary new world
According to Vincent Deluard of financial services group StoneX, 2021 will be the year of the V: “Vaccine, Value, Velocity”. I happen to agree with these, so I'm a bit biased here.
But one thing I find interesting is Deluard's point that this winter is likely to look grim from an economic point of view, due to the fresh wave of lockdowns. He notes that “investors have their eyes on the ‘spring of hope’ rather than the ‘winter of despair’”. Stockmarkets are forward-looking, so the bad economic and earnings data probably won't faze them. However, it will panic politicians and central bankers. As a result, there's a good chance that they'll pour on even more “stimulus”.
But this deflation scare will prove to “be the mirror opposite of the inflation scare of 1980-1981”. Back then, as Deluard points out, Paul Volcker's interest rate hikes had already killed off the inflation of the 1970s. But bond investors had been “traumatised by a decade of catastrophic losses... over-reacted to a couple of bad inflation data points”. As a result, bond yields went even higher and the Fed tightened even further (unnecessarily so, reckons Deluard).
In short, after 40 years of disinflation and ten years of encroaching deflation, the authorities are primed to go overboard in response to any sign that the economy is heading back into a slump. So what does that mean? Well, you potentially get a sell-off in the cyclical recovery plays that have done well in recent months. But what happens after that?
Well, we get the reflationary boom. Demand suddenly returns as people are let out. But there's nothing for them to buy because companies have been running down their stock, because many of them have been on near-life support for almost a year. “I expect prices to spike across the still-disrupted supply chain in 2021”, says Deluard.
I must say this makes a lot of sense to me. As do Deluard's portfolio suggestions, which are similar to the ones we've been arguing for all year – emerging markets, value stocks, and miners. He also suggests hedging the portfolio by owning – among other things – gold and the Japanese yen.
We've looked at ways to get exposure to all of these in recent issues of MoneyWeek. If you're not already a subscriber, get your first six issues free here.
Could France need a bailout?
Another end-of-year report that's always an entertaining read is SaxoBank's Outrageous Predictions. This is where the group's analysts try to put their contrarian caps on and take a guess at what wildly unusual things might happen in the year ahead.
One that caught my eye came from Christopher Dembik, the head of macro analysis – the idea that Germany might end up bailing our France.
What's the rationale here? Well among all developed nations, France had a strikingly high debt-to-GDP ratio even before Covid-19, and if you include private debt then it's in a much worse conditions than Italy or Spain. Throw in the impact of coronavirus and the picture is downright ugly.
Dembik paints a scenario in which French banks are hit by a wave of corporate bankruptcies. That sparks a sell-off of the French banking sector, and in the end, "France has no other choice but to come begging cap in hand to Germany, in order to allow the European Central Bank to print enough euros to enable a massive bailout of its banking system, to prevent a systemic collapse."
Why did this one catch my eye? Well, it reflects a point made by financial historian Russell Napier in his podcast interview with Merryn earlier this month. (Listen to that here.) Russell's argument is that a heavily-indebted France (the gap between the state of the French balance sheet and that of Germany's is far, far wider than it was when they first shared a currency) would have to lead to the dissolution of the euro, in order to keep the European Union together.
Would Germany agree to mass money printing instead? It's an interesting idea. Either way, it highlights a significant tension point in the eurozone over the year to come. I wouldn't make it your top priority investment-wise, but as 2021 progresses and the French election of 2022 starts to loom into view, don't be surprised if this one creeps up the risk agenda.