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Inflation is back

The average price of a litre of diesel in Germany is near €1.15, the highest for a long time and well above August’s lows of around €1.08. While this is partly due to efforts by OPEC and others to cut production, it is also a symptom of a wider phenomenon.

The Euro has recently traded below 1.10 to the dollar as rising inflation in the US brings the Fed closer to its first interest rate increase this year. And China’s wholesale prices have turned positive, ending a long period of deflation.

So, in the debate between those who feel the world economy is slowing and risks a new deflationary debt crisis, versus those who feel that economic growth has reasonable forward momentum, Werthstein is firmly in the second camp.

That’s not just because inflation is rising. It is also because short term indicators like the German IFO business survey and the U.S. consumer survey are sending a clearly positive signal, while other indicators are neutral, like US job creation and much of the Chinese data, with very little that is outright bad. And looking ahead to the longer term, there is dynamism in new technologies like robotics and biotech (both are Werthstein Zeitgeists), stimulating substantial investment.

In principle, high debt can throw this economic expansion off course. But it is important to keep such risks in perspective. Banks in Germany and elsewhere in Europe are under pressure, of course, due to massive fines and tough regulations. Both are bad news for those banks’ shareholders, but that’s not the same as being bad for the economy. Tough regulations were meant to make the banks much less vulnerable to collapse, much less reliant on government bail-out, and that is what they have done. In China, although debt levels are high, nominal GDP is still growing far faster than other major economies, which makes it much easier to cope with that debt. China’s challenge is not directly about debt, it is about keeping rapid growth. In recent years that has been achieved at the cost of exporting deflation to the rest of the world, but the recent signs of rising prices suggest that is changing for the better.

What does this mean for investors?

On a medium term view into next year, this picture is good news for equities. But there is a sting in the tail that risks short term pain in the next few months. Central banks around the world have been focused on debt and deflation risk, and still do not expect that inflation is coming back. Negative or ultra-low interest rates reflect their pessimism. But just recently, it seems that investors are starting to lose faith in the central banks. Across the summer months, if you lent money to the German government for ten years, you were guaranteed to be repaid less than you invested, because the bond yield was negative. Over the last couple of weeks, that has started to change, with the yield edging back to a small positive figure, as investors begin to doubt the central bankers’ view of the world. And that is despite the billions of Euros-worth of bonds being purchased by the European Central Bank every month.

If the economy keeps growing, as we expect, and the debt dangers fade, then inflation rates and bond yields will likely all be rising in coming months. That can mean some short term pain for equities before the good news about growth is able to dominate again later on. And if by any chance there is an unexpected result at the US election on November 8th and Donald Trump wins, that would add to uncertainty about policy and likely cause more short-term weakness. All this suggests that it is now time to actively consider a significant reduction in equity exposure in portfolios.

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