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11 December 2023

A deflationary environment will work its own magic

By Martin Baker

I received plenty of feedback about last week's rather gloomy – indeed apocalyptic – prognosis for the world economy. So let me focus on some of the more positive aspects of the present crisis.

There's money to be made in the business of saving things. By this, I don't just mean saving the planet. I'm bored of being told I have to save the planet, which is more than capable of saving itself. No, I mean green technologies, and fuel-saving conventional technologies. The business of efficiency will itself become more efficient, and clever technology and fuel companies will be more attractively priced.

And then there's deflation. Fearsome, brutal monster that deflation is, it's undoubtedly good news for those who know how to deploy the right tactics.

There has actually been a bull market in sovereign debt issued by the United States and the major European governments. Some say that the investors' flight to quality has created a falsely inflated market. I disagree. I believe that deflation is going to stay with us for a long time. The US Government, as the president-elect has already indicated, is close to having an exhausted armoury. Rates just cannot get much lower than they are, and lending is still stagnant. Retail and commodity prices tumble and tumble.

The fluctuations of the oil price and the sharp spikes in soft commodities such as wheat and sugar have distorted the picture, but the general trend is assuredly downwards, I believe. The apparent exception to this rule is cocoa, where futures contracts for May delivery recently hit a 23-year high here in London. But part of the nominal increase is due to the anomalous fact that cocoa is one of the very few commodities to be priced in sterling as opposed to the dollar. Even though the dollar has also risen gently, the spot price is lower, so I think the anomalous futures price is just that – an anomaly.

So I anticipate a deflationary environment, which will work its own special magic for the issuers of bonds. Providing, that is, that the purchasers of those securities are confident that the issuers will be able to pay the money. With issuers like the US Government, if we seriously doubt the ability to pay, we may as well all retire to the country and start growing vegetables and tobacco for barter (paper money of any sort won't be good any more – after all, what's a dollar put a bearer bond?).

Naturally, the strong price reduces yield, but any sort of income in a deflationary environment is a huge result in real terms.