The “third wave of deflation” is now over despite further falls in commodity prices and weak exchange rates in emerging markets in the second half of last year, according to Dominic Rossi.
The global chief investment officer of equities for Fidelity International says that the market headwinds experienced last year led to levels of deflation similar to those experienced during the financial crisis of 2008 and the European sovereign crisis of 2011. Now though, he believes this is set to subside and make way for stronger economic prospects and in turn, improving market growth.
Investors have experienced particularly torrid market conditions over the last 12 months as a result of China’s slowdown, plummeting oil prices and a lack of faith in central banks’ abilities to cushion blows caused by the economic cycle.
Performance of indices over 1yr
Source: FE Analytics
Now though, he says that investors can look forward to brighter conditions in the second half of 2016 and throughout 2017. 
“Towards the back end of last year when much of this was unfolding we became particularly nervous about the response of a number of central banks to this third wave of deflation. We felt that they hadn’t really captured the impact that this would have on their inflation forecasts and expectations,” Rossi (pictured) explained.
“We were particularly concerned at the time about the threat to the US dollar and its impact on the deflationary wave in terms of exaggerating it and leading to unnecessary damage to global growth in capital markets.”
“That was the story we had painted. The good news is, the third wave of deflation is over and that is why we think volatility in capital markets is now subsiding.”
Despite a turbulent start to the year, investor sentiment bounced back during the second half of February as the low price of brent crude oil began to recover after it hit a 12-year low of less than $27 per barrel. Now, year-to-date, the FTSE 100 has provided a positive return of 27 basis points and the MSCI AC World index has returned 3.48 per cent.
Performance of indices in 2016
Source: FE Analytics
“This makes sense in terms of describing this whole idea as a wave. The idea was that it was going to hit the global economy but then it was going to wash over and we would move on,” Rossi said.
“Of course there is the question of whether there would be a fourth wave of deflation but my sense is that this third wave of deflation has hit and now we’re moving on from it.”
The chief investment officer says there are two main reasons why he thinks economic, and therefore market, conditions are likely to improve.
The first reason is that he believes the real volume shock of deflation hasn’t spilled across into domestic consumer sentiment despite the impact it has had on global export data.
In fact, he says that domestic, US and European economies have remained resilient amid the blows that trading sectors endured when it came to industrial production and points out that, from a volume perspective, some developed economies weren’t as badly impacted as market behaviour suggested.
“The fears of recession, particularly in the US, have been greatly exaggerated. I would argue that the risk of recession in the US this year is zero,” Rossi continued.
“The consumer is strong thanks to continued employment growth, there’s been no hiccup in employment growth in the US at all despite the impact of manufacturing industrial production, and income growth remains solid.”
“Because of the low inflation numbers and inflation expectations falling, real incomes have actually grown and the capacity of the consumer has continued to increase for spending, albeit modestly. The fact that the savings rate has picked up a little bit suggests to me that actually the US economy is riding out this deflationary wave really quite well.”
He says that Europe started the year in a more fragile position but has still shown continued signs of recovery. Meanwhile, he says that the UK employment market has gone from strength to strength recently. As such, he believes that the second half of 2016 looks to offer a positive macroeconomic backdrop for investors, especially seeing as he believes the impact of low inflation has already been endured.
“Headline CPI numbers in the UK have been close to zero thanks to the falls in recent months in oil prices and intense price warfare among the retailers with the ongoing deflationary pressures coming from online shopping,” Rossi explained.
“With the stabilisation of oil prices and commodities generally it seems to me that the worst of the low inflation numbers or the deflation numbers are behind us as well.”
“As we progress through the year, nominal growth - having been lowered as well as real growth over the last six months – has troughed and I think both nominal and real growth as we proceed through 2016 will now start to point upwards. The negative impact in both price and volume terms of the emerging markets crisis in 2015 really is largely behind us.”
Another significant factor which could breathe life back into global economies, according to the chief investment officer, is that policy communication errors of various central banks have now been reversed.
Markets experienced extreme divergence in 2015 as a result of vastly differing monetary policies across regions - while economies such as Europe and Japan were easing policy, the Fed was planning to deliver a rate hike before the end of 2015.
“If we start with the Bank of England, it was still talking about interest rate hikes in the second half of last year. Its inflation forecasts were wrong and it’s now recognised that and has put off interest rate hikes for the foreseeable future,” Rossi pointed out.
“The ECB had its misstep in the fourth quarter as well when Draghi underwhelmed with his policy response to delay inflationary numbers, but he’s since delivered. The PBOC [People’s Bank of China] messed up its communications over its adjustments to foreign exchange policy in December, but has since clarified its shift to a currency basket and it’s not considering a material devaluation of the renminbi so that’s really helped.”
Most importantly though, he says that the Fed has backed away from initiating four rate hikes in 2016. While the chief investment officer wasn’t initially critical of the Fed’s decision to raise rates by 25 basis points last December, he was apprehensive about its communication policy thereafter when it came to pushing further rate hikes for the New Year despite low inflationary numbers.
“What the Fed succeeded in doing is pushing its case against market expectations and allowing the dollar to surge,” he said.
“I think now that the Fed is focused on the right thing which is inflation rather than the labour market, it’s backed away from those for interest rate rises and that has allowed the exchange rate to at least stop appreciating.”
“When we put all of these factors together we do see an environment where equity markets will improve from here, nominal returns will be in line with earnings growth, so low double digits between now and the end of 2017, at an annualised rate of high single digits.”
“So we’re not talking about roaring bull markets but certainly decent nominal returns based on a backdrop of a much lower volatility than has been the case for the last 12 months.”
