So where's Goldilocks gone? And I'm referring not to the story of a little girl and the three bears and their porridge, but to those wonderfully benign economic conditions, where things were not too hot and not too cold, but just right.
For if you take the view of strategists at Morgan Stanley (MS), the Goldilocks era is behind us now.
In one of the most chilling research assessments I have read in (well) weeks, the full span of Morgan Stanley's Asset Allocation Committee – made up of globally respected names like Stephen Jen, Teun Draaisma, and Hussein Allidina – have come out with a new report entitled The New Inflation Regime.
The intention is to provide the investment bank's clients with a portfolio framework that profits from, and protects against, rising inflation risks. But in doing so, the MS team paint a frightening picture of how the world has changed.
Consider the following, where the experience of the past 15 years is being replaced by a new future world order:
- Disinflationary monetary policy is being replaced by lax monetary policy.
- Where domestic forces were dominant, global forces have taken or are taking their place.
- While China and other emerging markets have hitherto been exporters of lower inflation to the West, those same countries are now exporters of inflation.
- Where we had stable food and energy costs we now have escalating food and energy costs.
- While the past era has been characterised by intense global competition, the threat now is of protectionism.
- Where there was deregulation, spurring innovation and risk taking, we now have the spectre of re-regulation as the authorities seek to stabilise the system.
- The net result of which is that the long established trend of improving productivity growth is replaced by stagnant productivity growth.
Now, to be clear, economic stagnation is not Morgan Stanley's central economic forecast. But the bank's strategists do talk of a "whiff" of stagnation plaguing markets for a good while to come. They see inflation becoming more global, more elevated and more persistent – and, crucially, they believe that the world's central banks are either unable or unwilling to pay the required price to stave off inflationary pressures.
The core message: don't rely on economic slowdown to stave off inflation. Hence that whiff of stagnation.
The boom/slump inflation/deflation matrix here sums up the MS position rather well – albeit in a largely Westernised economic context. We are fast headed into a 1970s-type environment, but not necessarily into he depression scenario seen in the 1930s in the US and Europe, and, to a lesser extent, in Japan in the 1990s
It's chilling, all the same.
So where, you might ask, do you put your money so as to protect its value in this new era of relatively high inflation? The answers, according to Morgan Stanley, might come as a surprise.
First up, the bank's strategists are not convinced by the argument that gold is the ultimate inflationary hedge. The house states, bluntly, that over the longer term there is not that much correlation between consumer price rises and the price of the yellow metal.
Evaluating European sector performance during stagflation environments since 1970, Morgan Stanley makes the following observations:
- The most consistent winners: commodity-related areas – energy, materials and utilities – all of which have done well in the current stagflationary period too.
- Two groups with a strong track record but weak outperformers this time include real estate (traditionally considered an inflation hedge) and food retail.
- Worst relative performers historically include TMT and consumer cyclicals (consumer durables, autos, retail).
Overall, real equity returns and valuation multiples tend to be lower when inflation rates are higher. According to MS, based on UK equity data, investors had a 66 per cent probability of making a positive real return in any 12-month period since 1925 and the average real return was 6.3 per cent. When inflation was between four per cent and eight per cent, average returns and probability were worse – but still positive. The sweet spot was inflation of two to four per cent. Bonds do much worse however –in any one-year period you have a better than even chance of losing money, in particular from high levels of inflation. Price earnings multiples tend to fall with higher inflation, especially when it rises above three to four per cent. Consider yourself well and truly warned!
Paul Murphy is an Associate Editor with the Financial Times.