The Index Investor
December 2019

Note: The language we use to describe our estimated likelihood of asset class over or undervaluation is based on US Intelligence Community Directive 203 on Analytic Standards, which includes the following table:

Market Stress Indicators (@29Nov19)

At the end of November, all five quantitative indicators showed a decreased level of market stress. This aligns with the market regime forecast probabilities implied by asset class returns (see next section). Both, however, are very much at odds with our qualitative analysis and regime forecast.

Macro Regime Forecast Probabilities (@29Nov19)

The Current State of Quantitative Regime Predictors

Our quantitative forecast methodology focuses on the level and change in three-month returns, over the most recent and previous three-month periods, for those asset classes, which should perform best under different regimes (in this sense, our regimes can be regarded as macro factors). We assume that relatively higher returns are associated with more widely held investor beliefs in the probability that a given macro regimes will develop in the future.

Over the last three months, there has been a relative strengthening in investors’ beliefs that either the normal times regime lies ahead.


Qualitative Considerations

Based on our qualitative analysis of accumulated and new evidence, we are considerably more pessimistic about the future than those investors whose trades have driven the returns on different asset classes. We continue to believe that three years from now the most likely outcome is that the global macro system will be in the persistent deflation regime.

In our forecasting approach, technology and environmental developments tend to precede economic and national security changes, which in turn precede social and political trends and events, whose effects then become visible in financial markets. As covered in more detail in this month’s Evidence File (see below), here are the most important new indicators and surprises that influenced this month’s changes to our regime probability forecasts:

Technology: The latest OECD PISA assessments of 15 year olds’ ability to apply reading, math, and science learning showed that, despite higher government spending on education, results have not improved in many countries, which does not bode well for future labor productivity gains. A new analysis by McKinsey found accelerating AI deployment, with a number of “power adopters” pulling further ahead in terms of business results. Also, 33% of companies expect AI adoption to lead to workforce cuts. Finally, a new paper reported progress towards using AI to detect and quantify causal relationships in large data sets, which has been a major obstacle to a step change in AI performance.

Environment: The UN Environmental Programme reported that forecast production of fossil fuels is 50% above the level that would be consistent with limiting the rise in global average temperature to 2 degrees Celsius. Another report found 148GW of coal fired electric generation capacity is either being build or about to begin construction. To put that in perspective, the coal generation capacity in the EU is 149GW. These developments are consistent with continued increases in the average global temperature and the adverse effects that could create.

Economy: A new analysis found that increased use of financial repression will likely to depress GDP growth rates, while other reports highlighted the growing pressure on government budgets from social care and pension spending. Another paper found heavy exposure of non-bank lenders (which don’t have access to the Fed’s discount window for liquidity) to lower quality credits. Finally, a new analysis found minimal benefits from financial globalization, which raises the probability that the next global downturn could see the imposition of capital controls.

National Security: In Iran, protests intensified while the US imposed tighter sanctions. If history is a guide, this raises the probability of Iran taking more aggressive external action to focus a restive population on an external threat to the nation. The very detailed 2019 report of the US-China Economic and Security Review Commission concluded that, “the Chinese Communist Party faces a number of significant internal and external challenges as it seeks to ensure its hold on power while sustaining economic growth, maintaining control at home, and advancing its regional and increasingly global ambitions.”

Society: New data show that healthcare costs in the US continue to grow faster than median incomes, and now consume an average of 11.5% of household spending. A new paper detailed the widening regional divisions in the United States that are driving increasing social and political conflicts, as well as rising “deaths of despair.” Both US fertility and geographic mobility rates were reported to be at all-time lows, which will depress future economic growth (and also says something about the state of popular uncertainty about the future). Finally, Gallup reported a very wide gap between the way most Americans define success, and the way they believe society defines it – another indicator of the deep divisions that impede collective action to address the problems facing the United States.

Politics: There were many reports in November about protests around the world that fundamentally reflect “the extreme disconnect between the public and the political system.” The US House looks ready to impeach Donald Trump and force a trial in the Senate in a presidential election year, which is guaranteed to further inflame partisan divisions. In the UK, Boris Johnson and the Conservative Party won “a thumping victory” over a Labor Party that lost the allegiance of long term loyalists after having moved far to the left on economic and defense issues under Jeremy Corbyn. Johnson helped his cause by moving the Tories to the left on economic issues relevant to working class voters. The Liberal Democrats had a surprisingly weak showing, having promised to reverse the vote to leave the EU and strongly supported progressive identity politics issues.

Financial Markets: A new report found that many bond mutual funds have been misclassified, and are riskier than reported. Other reports highlighted the risks in the next downturn (in financial markets whose liquidity is increasingly questionable) posed by investment products like ETFs and mutual funds that offer investors daily liquidity while holding increasingly illiquid assets.

Tactical Asset Allocation Implications of Our Forecasts

Based on subscriber requests, this month we are re-introducing a feature from the previous version of The Index Investor: Tactical Asset Allocation Implications from our analyses.

These take two forms. The first takes a systematic approach, and is based on relative asset class valuations. Our starting point is our “neutral” model portfolio, which is equally weighted across nine broad asset classes, and also includes a 10% allocation to alpha strategies (equity market neutral and global macro) that are designed to have a low correlation to returns on broad asset classes. Based on asset class valuations, we systematically vary the asset class weights (but not the active strategy weight), increasing from 10% to 15% when an asset class is likely undervalued, and 15% when it is very likely undervalued. In the case of overvaluations, we go to 5% and then into cash, if there are no undervalued asset classes with room for an increase. In effect, this replicates the systematic rebalancing strategy we used for 15 years in our previous model portfolios.

The second tactical approach is based on our subjective view not only of current asset class valuations, but also of the implications of the broader macro trends and uncertainties that we analyze each month. Importantly, this subjective view reflects our primary goal of avoiding large downside losses, rather than seeking large upside gains.

Two final notes. First, with respect to US fixed income, we include credit products (investment grade and high yield) in the same asset class as government debt, and will shift into the former when their valuations become attractive. Second, we regard gold not as a separate asset class to be held long-term, but rather as a complement to cash, into which we shift in periods of substantial overvaluation across multiple asset classes.

Here are our tactical asset allocation views for December:

Pre-Mortem Analysis

One of the most important forecasting disciplines is to ask yourself why your forecast could be wrong. Dr. Gary Klein’s research has shown that a very powerful and insightful way to do this is via a “pre-mortem analysis.” This method asks you to assume that it is a point in the future, and your forecast has been proven wrong (or your strategy or company has failed). You are then asked to look backward from this imagined point in the future, to explain why you failed, what you missed, and what you could have done differently to avoid your fate.

The pre-mortem method takes advantage of the fact that humans reason much more concretely and in more detail when explaining the past than they do when trying to forecast the future.

So let us assume that it is one year from now, and our current forecast has turned out to be wrong.

How did this happen? What developments did we fail to anticipate? Here are three possibilities:

• The leaders of the world’s three major powers – Xi Jinping, Donald Trump, and Vladimir Putin are all facing weakening economies and declining political popularity. History teaches us that this can lead to increased “foreign adventurism” to distract the public from worsening domestic conditions, as a nation rallies around its leader in a period of heightened external conflict. Should a “kinetic” conflict develop between China and the United States, or between Russia and one or more European countries (e.g., due to a Russian incursion into the Baltics), it would generate a very sharp increase in uncertainty that would likely cause an equally sharp economic slowdown which, given high debt levels, would speed the arrival of the Persistent Deflation Regime.

• While the probability is remote, a supply side shock of some type could produce a sudden increase in inflation – the most likely scenario being a reduction in oil supplies due to a prolonged kinetic conflict between Iran and the US that produced a extended disruption in global oil supplies, or, less likely, an infectious disease pandemic or major crop failures (e.g., due to climate change and/or agricultural disease).

• Another route to the high inflation regime (repeatedly noted by Bridgewater’s Ray Dalio) would be a sudden loss of confidence in the US dollar relative to other currencies (driving up import prices), perhaps because of deficit monetization and policy paralysis as a severe downturn continues. However, this would also require that there was relatively more confidence in another currency, with the Euro being the most likely candidate. This currently seems unlikely, given both the Eurozone’s economic and political situation, and the prospect of an intensifying conflict between the West and China. However, if confidence collapsed in all major currencies, a sharp increase in inflation would lead to a dramatic rise in the price of gold.

• Though we believe it is still unlikely, it is becoming easier envision a scenario in which both Xi Jinping and Donald Trump leave their current roles, and are replaced by leaders who are more committed to lessening the intensifying conflict between China and other nations. This would likely provide a strong boost to confidence (and thus lead to an equally strong reduction in uncertainty). However, a reduction in perceived external threats might also intensify already substantial internal divisions and conflicts in China and the United States, which could, ironically, also lead to the deflation regime.

System Tipping Points/Critical Threshold Analysis

Like Professors Andrew Lo, Doyne Farmer and others, we regard financial markets as a complex adaptive system (CAS), that exist as part of a larger macro system comprised of other CAS between which there are multiple feedback loops. These other systems include those that produce technology innovations, and economic, environmental, national security (including cyber), social, demographic, and political outcomes.

We also find that these systems tend to operate and generate effects in a rough chronological sequence, albeit with many feedback loops between them. The following chart highlights that the changes we observe in different areas at any point in time are actually part of a much more complex evolutionary process.

While most media coverage of these systems focused on flows (e.g., the size of the government deficit), rapid non-linear change in complex adaptive systems is often caused by a key stock (e.g., the amount of outstanding government debt) exceeding a critical threshold.

The next table highlights the key macro system stocks that we monitor.

In the next section, we will discuss information received over the past month that is related to these stocks, and which we believe is significant to our assessment of the probabilities that a critical threshold will be reached and a regime change will occur. We will conclude with our estimate, at the end of this month, of how close the macro system is to these critical thresholds, and the implications for financial market regime change probabilities.

How Close is the Macro System to One or More Critical Thresholds?

As we have noted, the macro drivers of financial market regime changes typically follow a rough chronological sequence, from technology to economic, security, social, and political causes and effects. Yet there are many feedbacks loops between them, creating complex root causes for many of the critical thresholds we have identified.

Understanding the time dynamics in this complex system is critical to avoiding substantial downside investment risk.

We use the UK Met Office Warning Model to communicate our assessment of these time dynamics. We estimate the time remaining before a critical macro system threshold is reached that could trigger a regime change, which is usually accompanied by substantial changes in asset class valuations.

The model uses three increasingly serious levels of warning, from “Be Aware” (condition yellow), to “Be Prepared” (condition orange), to “Take Action” (condition red).

For our purposes, we denote as “Be Aware” (yellow) critical thresholds that we assess to be three or more years away. We estimate that “Be Prepared” (orange) thresholds could be reached within 1 to 3 years. “Take Action” thresholds are very likely to be reached within one year.

Given their nature, we also note that in our three “wildcard” areas (Environment and Energy related; Disease and Human Caused Bioevents; and Cyber and Electromagnetic Events), our forecasts have higher levels of uncertainty.

The following charts summarize our current estimate of the time remaining before different critical thresholds will be reached.

Conclusion

At the highest level, we believe the complex adaptive global macro system can be in one of four states, based on its degree of order versus disorder, and degree of social cooperation versus conflict. A very coarse-grained reading of history suggests that these states evolve in a predictable cycle, from ordered/cooperative, to disordered/cooperative, to disordered/conflicted, to ordered/conflicted.

We believe that the system is currently in its most uncertain state, characterized by high degrees of underlying disorder and social conflict, both domestically and internationally. Beyond some point, intensifying conflict eventually increases the degree of order in the system. That appears to be happening now, via the increasing conflict between China, Russia, and Iran and the United States and other Western nations.

Note: Combining Our Forecasts with Others From Other Sources and Extremizing the Result Should Increase Your Predictive Accuracy

Research has found that three steps can improve forecast accuracy. The first is seeking forecasts based on different forecasting methodologies, or prepared by forecasters with significantly different backgrounds (as a proxy for different mental models and information). The second is combining those forecasts (using a simple average if few are included, or the median if many are). The final step, which significantly improved the performance of the Good Judgment Project team in the IARPA forecasting tournament, is to “extremize” the average (mean) or median forecast by moving it closer to 0% or 100%.

Forecasts for binary events (e.g., the probability an event will or will not happen within a given time frame) are most useful to decision makers when they are closer to 0% or 100% than the uninformative “coin toss” 50%. As described by Baron et al in “Two Reasons to Make Aggregated Probability Forecasts More Extreme”, forecasters will often shrink their probability estimates towards 50% to take into account their subjective belief about the extent of potentially useful information that they are missing.

When you average multiple forecasters’ estimates, you are including more information, which should increase forecast confidence and push the mean estimate closer to 0% or 100%. However, this doesn’t happen when you use simple averaging. For this reason, forecast accuracy is increased when you employ a structured “extremizing” technique to move the mean estimate closer to 0% or 100%.

You can download an extremizing model from our website to use when combining the forecasts you use in your decision process.

The extremizing factors in our model are those that the Good Judgment Project found maximized the accuracy of combined forecasts. Note that the extremizing factor is lower when average forecaster expertise is higher. This is based on the assumption that a group of expert forecasters will incorporate more of the full amount of potentially useful information than will novice forecasters.

High Value Information Observed In November 2019

In our model of the complex macro change drivers are arrayed in a roughly chronological process (albeit one with many feedback loops), in which technological and environmental changes precedes changes in the economy and national security, which in turn lead to changes in society and politics, all of which produce the effects we observe in investor behavior and financial market valuations and returns.


In our methodology, we classify new information as significant and highly valuable if either it (1) is an “indicator”, which reduces our uncertainty about the value of a parameter in our mental model for making sense of the dynamic macro system, or (2) it is a “surprise” which increases our uncertainty about either the range of potential values for a parameter or the structure of our model.

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Feature Article: What Do We Know About Escaping From the Persistent Deflation Regime?


Introduction

One of The Index Investor’s core deliverables is a monthly forecast of the probabilities that the global macro system will be operating in each of four regimes over the next 12 and 36 months.

One of the inputs into our forecasting process is our estimate of the base case probability of the system staying in the same regime or moving to another one, as depicted in the following table (based on our qualitative and quantitative assessments of the past).

As you can see, the high uncertainty regime is typically transitory, and is usually a sign of the system transitioning from one more stable regime to another (e.g., from the normal regime through a business cycle recession and back go the normal regime). High inflation is somewhat more persistent, but also has natural limits (e.g., self-reinforcing hyperinflation that is followed by collapse). In contrast, both the normal and deflation regimes are highly persistent, though at least in the 20th and 21st centuries, systems entering the latter have been relatively rare compared, for example, with the 19th century.

Yet today, we forecast that the probability of entering the deflation regime over the next 36 months is substantial. Given the historical tendency of deflation regimes to persist, it is critically important that investors understand what we know about what causes transitions into this regime, and how to escape its grasp.

This is an issue that has preoccupied us for nearly twenty years. We previously wrote about it in November 2002 (“Are We Headed Towards Global Deflation?”) and August 2010 (“The Risk of Deflation and Its Impact on Asset Class Returns”).

The Causes of Deflation

A frequently heard saying (at least if you spend time around macroeconomists) is that there are three kinds of deflation (defined as a decline in a broad index measuring the price of goods and services): good deflation, bad deflation, and ugly deflation (e.g., see “Deflation in a Historical Perspective”, by Bordo and Filardo). Let’s look at simplified examples of each of these.

Good deflation is caused by a sharp increase in the productive capacity of the economy — also known as a supply side shock (i.e., to simplify, the supply curve shifts to the right while the demand curve stays constant). Let’s look at two examples: One narrow, and the other broad.

In the USA, average natural gas price at Henry Hub (a major delivery point) was $8.86 per million cubic feet. Ten years later, it had declined to $3.17/mmcf. This happened because even though demand for natural gas grew over this period, total production grew even faster, from 25.6 trillion cubic feet per year, to 37.1 tcf.

To be sure, this fall in prices forced out of business those producers with the highest marginal cost of production. But this didn’t increase unemployment, because more efficient companies were growing, and laid off employees could switch to them. Moreover, this good deflation also generated significant social benefits — for example, the lower cost of natural gas enabled a reduction in CO2 emissions as electric power generation from gas replaced generation from coal.

A broader example of the same type of “good” deflation was the fall in the US price level at the end of the 19th century that was caused by the expansion of production of many goods as the industrial revolution entered its second phase. Note that in many “good deflations”, real per capita GDP continues to increase.

Bad deflation is caused not by an increase in supply, but rather by a reduction in demand (i.e., the demand curve shifts to the left while the supply curve stays constant). This is the type of deflation that Japan has faced (e.g., see, “Understanding the Costs of Deflation in the Japanese Context”, by Taimur Baig of the IMF). The extended fall in global demand between 1890 and 1896 (which, before the 1930s, was referred to as the “Great Depression”) is another example.

In bad deflations, in order to stay in business, producers are forced to cut prices down to the marginal cost of production. However, because of employees’ resistance to wage reduction, companies facing deflation often find it hard to reduce costs. As a result, the least efficient companies are forced out of business. In this case, however, because of weak overall demand, laid off employees will be more likely to become unemployed, which will further reduce aggregate demand. The classic policy remedy for this situation includes expanded government spending and/or tax cuts (fiscal stimulus) as well as expansion of the money supply to reduce interest rates in the hope of incentivizing more investment and consumption spending.

Ugly deflation occurs when the negative impact of bad deflation is amplified by the presence of high levels of debt throughout an economy, as happened in the United States during the 1930s Great Depression. High leverage lowers the threshold at which a fall in revenues will force a company into financial distress (which can lead to cost cutting and layoffs) or bankruptcy (which can result in its liquidation). Deflation worsens this dynamic by raising the real value of outstanding debt, without raising the debtor’s real capacity to service it. This process can also result in the lenders on the other side of those debt contracts falling into financial distress if a sufficient number of loans go bad. Finally, for consumers, high debt levels can cause even a slight fall in income to trigger financial problems.

The situation facing the world economy

Today we face a triple whammy of all three kinds of deflation:

Increased Productive Capacity

Over the past 25 years, the global economy has experienced a series of supply shocks, including, for example, the introduction of the internet and innovations in other information and communication technologies (ICT) and the profusion of new business models they spawned; the entry of China into the World Trade Organization in 2001; and with the advent of fracking (as well as the falling cost of electricity generation from wind and solar) the reversal of what had been a steady increase in the cost of energy. Looking ahead, the exponential improvement of automation, artificial intelligence, biotechnology, and advanced materials technologies promises to deliver further expansions of global production capacity in a wide range of economic sectors.

Weak Demand

In our August and September 2019 issues, we described the complex mix of interacting trends that are contributing to weak global demand (secular stagnation), including, for example, population ageing, weak productivity growth, rising inequality, increasing corporate concentration and pricing power, burdensome debt service payments, and high levels of general uncertainty and fear (“The Next Downturn: How Different? How Deep? How Long?” and “Future Labor Productivity Growth: The Supply Side Secular Stagnation Story”).

Excessive Debt

Global debt levels today are at unprecedented levels as a percentage of GDP, especially when off-balance sheet items like unfunded social security and defined benefit public pension liabilities are included. Particularly worrisome are high levels of corporate debt, much of which is now held by credit hedge funds, exchange traded funds, and other non-bank lenders that despite lacking access to liquidity via central bank discount windows, have still promised their investors access to liquidity over periods of time that are considerably shorter than the tenor of the debt they hold. This is the Russian Roulette version of maturity transformation. On top of this are still very high levels of consumer and student debt, despite attempts to deleverage for a decade after the 2008 Global Financial Crisis (a cause which certainly hasn’t been helped by rising inequality, social pressures for aspirational spending driven by conspicuous elite consumption, and still lax lending standards, for autos and student debt).

What do we know about escaping from the deflation regime, once we’ve fallen into it?

The glib answer is that it’s bloody hard once deflation expectations become entrenched, as we have seen in Japan.

Not so glibly, the historical record teaches us that successful exits from the deflation regime critically depend on an accurate diagnosis of the type of deflation policymakers are dealing with.

Unfortunately, today we face a very complex, interacting, and dangerous mix of all three types of deflation. Should we enter it, successful exit from the deflation regime will therefore require deft use of the monetary, fiscal, and structural policy tools that are available to national decision makers.

Reversing national exposure to the global supply shocks that cause good deflation is the least important challenge to address. That said, this seems to be one of the Trump administration’s policy objectives in the current US/China trade war.

Addressing secular demand stagnation that causes bad deflation is not only far more important, but also much more difficult, given the complex tangle of underlying root causes we face today.

With government debt rates at or below the “zero lower bound”, the ability of monetary policy to further stimulate demand is now much weaker than it has been in the past. A possible exception to this would be deliberate attempts to reduce a nation’s exchange rate, in order to raise import prices (and thus the overall price level), while boosting demand for cheaper exports. However, this type of “beggar-thy-neighbor” approach would almost certainly trigger retaliation by other countries.

That makes government fiscal policy much more important. However, this faces many challenges, including not only deciding on the mix of initiatives to pursue in the face of high uncertainty (e.g., tax cuts versus increased spending on transfer payments, infrastructure, R&D, defense, and other investments, and whether to pay for these via higher taxes on the wealthy and/or via deficit spending), but also gaining approval for these initiatives in the face of what is likely to be opposition from highly polarized and antagonistic legislatures and electorates. Moreover, as we saw when the United States attempted to pursue fiscal stimulus to moderate the impact of the 2008 downturn, the implementation of approved initiatives (like infrastructure projects) is highly likely to face local opposition (e.g., environmental litigation) and further delays.

As we have seen in Japan, the challenges of using monetary and fiscal policy to escape deflation pale in comparison to the political obstacles to the use of structural policy, such as changes to education healthcare, and financial systems, or the markets for goods, services, and labor, where defenders of the status quo are usually very firmly entrenched. Unfortunately, these are the very areas where change is likely to be critical to sustainable resolution of the weak demand problem.

However, all these challenges pale in comparison to the real elephant in the room: the debt problem that can trigger ugly deflation. As a veteran of the Latin American debt crisis (as well as assorted other workouts in North America and Europe), I long ago learned that there are only four solutions to excessive debt:

Prolonged Austerity – Cut spending in other areas in order to make debt service payments to creditors. The longer this approach continues, the more likely it will become self-defeating. Economically it depresses demand, which can worsen deflation and increase the real size of the debt, while also increasing political opposition to austerity.

Higher Growth – Everybody’s favorite silver bullet. Increase revenue/income to enable you to repay your debts without cutting, and hopefully while increasing consumption and investment spending. Unfortunately, it usually doesn’t work both because of the complex mix of challenges that must be resolved to increase aggregate demand, and because heavy debt service payments are often a critical obstacle to growth (e.g., they limit investment from internal cash flow, and restrict access to external financing).

Higher Inflation – This only works under three conditions that rarely fully apply: (1) your debt is denominated in a high inflation currency; (2) if this isn’t the currency in which you generate your revenue, then you have sufficient access to foreign exchange at the depreciating exchange rate inflation should cause; (3) the debt is fixed rate; and (4) the debt had a tenor/duration that is long enough for the inflation rate to substantially reduce its real value.

Restructuring and Write Offs – This is where most situations of excessive leverage and financial distress usually end up. Sometimes this process works well, as in the case of US Chapter 11 bankruptcies that often effectively convert debt to equity, and enable the company to keep operating. But the debt workout process can also get very ugly. Seizure and liquidation of collateral, particularly if it becomes widespread, can easily make a bad situation much worse, as falls in collateral reduce lenders’ incentives to roll over maturing loans that borrowers can’t repay, triggering more collateral liquidation, business failures, increased unemployment, weaker demand, and what the economist Irving Fisher termed a vicious “debt deflation” spiral. And Fisher wrote long before the invention of Credit Default Swaps, which, as we’ve seen in cases like the Thomas Cook Group Plc bankruptcy, can easily make debt restructurings much more complicated and push them towards collateral seizure and corporate failure.

It is almost certain that some people will claim there is a fifth alternative, commonly called “extend and pretend”. This entails using monetary policy to lower interest rates to reduce debt servicing burdens, and political and regulatory pressure to induce lenders to rollover maturing loans, or even increase them to cover interest payments that companies can’t pay out of operating cash flow or the proceeds from asset sales. However, as Japan has shown, kicking the can down the road like this (usually in the hope that an eventual revival of demand will enable excess debt to be repaid) can actually worsen the situation. So-called “zombie” companies on life support are unable make the investments (e.g., in research, training, and capital assets) that are needed to increase productivity, wages, profits, and aggregate demand. Instead, they serve as a drag on the economy.

One of the economic policymakers I most admire has reached the same conclusion. William White chaired the Economic and Development Review Committee at the Organisation for Economic Co-operation and Development from 2009 to 2018. Before that he was the Economic Adviser and Head of the Monetary and Economic Department at the Bank for International Settlements. He was one of the few who accurately forecasted the 2008 Global Financial Crisis.

In an interview earlier this year with “The Market” (www.themarket.ch), White noted that, “The path that we have been on has led us to a dead end…Years of expansionary fiscal and monetary policies have left the world economy overburdened with debt. In the next downturn, much of that debt will become unserviceable… Our economies would benefit greatly from more voluntary debt restructuring by creditors, and the sooner the better; orderly solutions are better than disorderly solutions. Moreover, there is a political advantage in forcing those who have made imprudent loans to pay a price for it. This would take the sting out of the populist cry that the elite always get off, while ordinary citizens suffer…

“Recently, the OECD, the IMF, and the Group of Thirty have drawn attention to the serious inadequacies in the legal framework for restructuring private sector debt in many countries. Laws are poorly drafted and the judicial framework is inadequate. There are not enough out of court deals, nor specialized judges, nor adequate flows of information, nor adequate enforcement…Many banks also have an inadequate capacity to manage bad loans internally, and in most countries no external market exists for distressed loans…All of this could and should be dealt with.”

Conclusion

As it turns out, we actually know quite a bit about how to escape the persistent deflation regime, should we fall into it. But that is the easy part. We also know from recent experience just how difficult it will be to gain political approval for the policy changes that will be required. And even if that challenge is met, the actual implementation of those policies will face equally daunting obstacles, with large-scale debt restructuring the biggest of all.

Asset Allocation Implications

There is a reason so much government debt has negative yields today. Rather than a source of income, it has become a defacto source of insurance against capital loss for which investors are willing to pay a premium. In the deflation regime, fiscal deficits will sharply increase, and government debt issuance will grow. However, to keep interest rates low (to minimize debt servicing problems), much of this new issuance will almost certainly end up on central bank balance sheets. With respect to real return government bonds (like TIPS), it is important to recognize that the way they adjust for inflation substantially differs across issues. Some of them increase capital value to compensate for inflation, but do not decrease it in the case of deflation. As such, these will produce very attractive returns in the deflation regime.

The deflation scenario will sharply increase yields (and defaults) on non-government bonds and loans. Withdrawals from bond and loan funds that promise investors daily liquidity will very likely trigger sharp price falls and market liquidity problems, which will likely have a non-linear impact on public uncertainty and fear. On the other hand, it is almost certain that bonds issues by companies with strong business models and balance sheets (i.e., low leverage) will be unfairly penalized during the period of market panic, and become underpriced relative to the risk they represent.

As the capital structures of most commercial property projects have high levels of debt, the same cautions regarding corporate debt apply here too. That said, commercial property will likely benefit by the tendency of some investors to move into this asset class when political-economic uncertainty sharply increases. In contrast, housing is usually highly leveraged and owned by individuals who will be exposed to much higher employment and income uncertainty in the deflation regime. As such, returns will likely be negative.

Returns on gold will almost certainly be high in the deflation regime. Timber will likely also deliver attractive returns, particularly if and when fears increase that exploding government debt levels will eventually result in high inflation. Due to very weak demand, other commodities are very unlikely to deliver attractive returns.

Returns on equity asset classes – including private equity (which specializes in highly leveraged investments) – are almost certain to be low during the deflation regime. However, sectoral returns within them – such as the consumer staples sector – will very likely be positive.

In terms of uncorrelated alpha strategies (that aim to deliver positive returns with a low correlation to returns on broad asset classes), higher levels of uncertainty will likely produce positive returns for global macro. Distressed debt strategies are also likely to deliver attractive returns. However, as the number of these funds is very likely to grow during the deflation regime, declining average manager quality will likely reduce overall average returns for this strategy.