AVOIDING THE WORST EFFECTS OF DEFLATION 12 Index Review The summer is drawing to a close and markets have continued to be reasonably friendly with the <strong>FTSE</strong> nestling comfortably around 4700 and the various economic data releases giving hope that the worst of the current downturn might now be over. The fact that the German and French economies grew in the second quarter came as something of a surprise to the markets, though this might have more to do with the very high levels of personal state aid available in both nations than with an actual turnaround in the economy. Simon Denham, managing director of spread betting firm Capital Spreads, calls the odds. IN THE UNITED Kingdom the vast sums added via banking support, quantitative easing and general state spending seem to be holding back the worst (for the time being) but it must be admitted that the general outlook once the purse strings start to be tightened is rather harder to estimate. Economists seem to fall into two camps, with the apocalyptic grabbing the headlines and the more generally neutral bringing up the rear; after all, middle of the road forecasts do not make for good copy. Inflation in the US and Europe, or rather deflation, is causing considerable concerns, especially as the massive increase in money supply would normally have been expected to have the opposite effect—especially across the Atlantic. One wonders what the CPI number in the States (currently -2.1%) would have been had the Fed not spent the trillion plus dollars on its various policy initiatives over the last year. Europe meanwhile (when compared to the UK and US) has, in the main, kept its powder dry. The economies are not so heavily weighted towards the service sector and levels of personal debt are way below those prevalent in the Anglo Saxon economies. Their capacity to maintain domestic demand levels without state aid has therefore been that much greater. If growth in the West flags once again eyes will be turned rather more aggressively on the Northern European Bloc to open the floodgates to aid expansion. Above everything is the fear of the “ghost at the feast”. Japan’s lost decade (actually nearer two decades now) is a spectre that nobody wants to contemplate, though for high inflation, high personal expenditure, nations such as the UK it has always seemed most unlikely. Even with the vast sums being expended, the sad fact is that the money supply data is still falling (M4 growth in the UK is now dipping sharply) as banks retrench into their domestic economies. Japan has shown that even extreme levels of state funding can have little impact once the effects of deflation become endemic. Japan’s public debt is now 200% of GDP but nobody seriously expects hyper-inflation to rear its head in the land of the rising sun. In fact the deflationary aspect of Japan’s economy means the real value of its debt keeps increasing year on year. In Europe we have become used to governments inflating their way out of a poor debt situation (if inflation is 5% then the absolute value of Simon Denham, managing director of spread betting firm, Capital Spreads, October 2008. TURNING JAPANESE? £1,000,000 debt is just £950,000 next year, £902,500 the next, etc). Imagine the effect of consumer confidence and expenditure if personal debts (mortgages, credit cards, etc) were greater in terms of salary and income next year even though they had not increased at all. Actually we do not need to imagine as we have the case study of the effect in Japan to show us. The weak pound means inflation has continued in positive territory in the UK but the recent strength of sterling means that this effect is being whittled away. By mid-October, if the pound remains where it is now, inflationary impulses will have largely worked its way through the system. Compounding this export growth has been in fact export contraction and the trade balance has fallen as import levels have reduced even further. If entrenched deflation takes a hand, investors will experience the Japanese effect of waning stock valuations. However, if inflation spirals out of control, rates will have to be hiked and money and bonds may well regain their attraction over equities. A continuation of the current equity rally will rely on reasonable, noninflationary growth, but this is a rather narrow path to tread. As ever ladies and gentlemen, place your bets. S E P T E M B E R 2 0 0 9 • F T S E G L O B A L M A R K E T S
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