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How will markets bear up if world economies deflate?

How will markets bear up if world economies deflate?

As the UK economy faces up to a period of negative inflation – or deflation – Kathleen Gallagher asks John Bilton, head of the global multi-asset strategy team at JPMorgan Asset Management, how various assets would be affected by deflation.

Developed world equities

“With disinflation, equity prices will dip. However, given that this deflationary period will be contained, equities will right themselves as the economy heals. I expect markets will look through this period and take the view that growth is improving.

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“We are favouring equities. If the calculus changes and it looks like we are in for a prolonged period of disinflation, then history tells us we need to pare back some of the allocation to equities.”

Emerging market equities

“Emerging market equities are in for a trickier time, and a lot depends on sentiment at any given time. The disinflation we are seeing, along with other factors that hinder emerging market performance, will all be magnified because developed market central banks are trying to battle deflation.

“The dollar is being quite well supported – we could be in a full-on bull market for the dollar. Emerging market countries tend to struggle through this.”

Government bonds

Bonds generally perform quite well in a deflationary period. However, investors have been nervous that the continued bull run in bond markets has to come to an end, but Mr Bilton does not agree.

“We do not expect government bonds to sell off dramatically. People had been desperate to short the US 10-year treasuries for some time, but that’s been a poor trade. The trade has been fighting a global output gap and a slow healing of demand in Europe and Japan.”

High-yield bonds

“This is a contentious area of the market – you’ve got to look at where the deflation risk has come from. The precipitous drop in the price of oil is the eye of the storm. With the commodity’s price being the trigger, it makes it a challenging world to invest in high-yield bonds.

“Still, high-yield bonds have a really attractive yield, but from a multi-asset perspective you need to weigh up the liquidity risk and compare it with the equity markets. It’s not something I’d want to be overweight in.”

Commodities

“This disinflationary period is being driven largely by the drop in the price of oil. The main question is whether it is being driven by supply or demand. We believe it is the excess capacity that has driven these lower prices and that this will take some to normalise.

“We are going through a price-discovery period and this will lead to some volatility in the market, and this should persist for the next three to six months. But we expect this to stabilise in the second half of the year.”