on Deflation versus Inflation
September 25, 2012
Will deflation or inflation prevail? The answer to that one question determines portfolio construction, according to Bill Gross, founder, managing director, and co-CIO of PIMCO.
With a “titanic battle” underway between inflationary and deflationary forces, Gross’ own expectation is that inflation is about three times more likely, but he does not foresee a return to the extreme inflation of the 1970s. His advice is for investors to tilt their portfolios toward assets that will perform well in a mildly inflationary regime and avoid Treasury bonds, where he sees a bubble forming.
Gross delivered the keynote address last Thursday at IndexUniverse.com’s 2012 Inside Fixed Income Conference, held in Newport Beach, CA, across the street from PIMCO’s offices.
He spoke to a room filled with “children of the bull market” – investors who, like him, grew accustomed to small cyclical downturns eventually giving way to bigger upturns. Investors like him, he said, had been conditioned to believe that, given a long-enough timetable, assets will ultimately grow. He explained that this ethos is what “lead to the problems in 2008” and continues to plague the global economy today.
Looking forward, Gross questioned whether the next 10 years can realize the same pattern of mild lows and soaring highs that has existed since he founded his company in 1971. He believes this to be “a legitimate question” that “we all have in front of us when we advise clients.”
And underlying this fundamental question, Gross stressed, is the battle between deflation and inflation.
Let’s take stock of the contenders.
In one corner, deflation
Debt and deleveraging drive deflation. The last 40 years have seen debt balloon at every level of the economy – from individuals’ debt all the way up to the country’s as a whole.
In his talk, Gross likened countries with debt in excess of their GDP, like Greece, Italy, and Spain, to individuals with sub-prime mortgages on overvalued homes. In both cases, it became “quickly obvious” that they “couldn’t support that type of debt” and were heading toward bankruptcy.
Gross blamed the current state of the worldwide economy on the “natural tendency of the global financial markets to deflate very risky, highly indebted” entities – whether they happen to be “individuals, institutions, or countries” notwithstanding. With no intervention, the world would continue its “downward spiral,” with decreasing asset prices and increasing defaults, “just like the 1930s.”
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