The real risk is deflation, not inflation

Q&A with Peter Gibson Peter Gibson is the managing director, portfolio strategy and quantitative research at CIBC. He is considered one of the best quantitative research strategists in the country, having made good calls in the past while employed at Desjardin Securities Inc. and Scotia Capital Inc.

Mr. Gibson made the right call in 2001, that the greenback would be massively devalued over the next few years, at the same time as interest rates fell. It was a prediction that bucked economic theory, but was accurate.

In early 2007, Mr. Gibson predicted that the easy money in the equities market had already been made and forecast major corrections due to shock to the financial system. Three months ago, he created a bond volatility index and began measuring the spread between it and the stock market index.

And what does a quant man do in his spare time? While growing up in Port Credit, Ont., Mr. Gibson dreamed of travelling in space. While he applied his science training to the business world, he is still pursuing his first love: In 1997, he paid $175,000 to book one of the first rides on Richard Branson's SpaceShipTwo suborbital ship to fly to the stars. He travelled to Philadelphia's National AeroSpace Training and Research Center to train. The trip is still pending.

Q. Let's look into your crystal ball. Six months down the road, what do you see happening in the economy?

A. My view is that the economy will show further signs of improvement, very much like the years 1979, 1989, 1999, when there was economic recovery after the crisis. As the outlook improves again, people feel better about the economy, but then they will start worrying about inflation again. That's problematic because nowadays it only takes a little worrying to push bond yields up.

Q. What is the tipping point when higher bond rates will trigger another change in the economy?

A. Somewhere between 4.3% to 4.6%.

Q. When do you predict that will happen?

A. I don't like to put a calendar date on it, but probably close to the third quarter or year end of 2010, the bond yield will have pushed up to its ceiling and the Federal Reserve will respond by tightening its bias. At that point, the change in tone from the Fed might cause the dollar to strengthen and gold to sell off temporarily. This will be an important development, because the Chinese will have to look at the implications for their market.

Q. So what's driving all this is an emotional response from consumers?

A. Yes. Whenever the economy is growing, the bond market very quickly gets back to fretting about inflation, and that's where the psychological aspect comes into play. It's a misplaced fear. I'd argue that the real risk is deflation not inflation. There is no evidence companies are able to pass on price increases, in any sector, anywhere in the world.

Q. Who is worrying?

A. It's not the guy on the street worrying about inflation, unless his wages don't keep up. Rather, it's the bond market, which is so large. You are talking trillions and trillions of dollars of government debt. If even 20% of the bond market started to panic about inflation, they won't sit around and wait for evidence of deflation. They will start to sell their treasuries quickly, because any time real inflation rises it cuts into the real returns for bonds. Imagine what would happen if $2-trillion of debt was being sold -- bond yields would rise rapidly because of fear the selloff would destabilize the economy.

Q. So the volatility in the stock market is directly linked to the debt?

A. Absolutely. A small amount of inflation can cause the bond yield to rise sharply, and since bond yields and stock prices are positively correlated, that's why volatility is suddenly coming into the stock market.

Q. So what do you tell investors?

A. We favour equities until the bond yields push higher. In Canada, the improvement in financial [stocks] will be muted. I'd be more focused on commodities until the bond yield rises.But investors today have to have a good grasp of the macro-fundamentals. I predict that 70% to 80% of future price moves in the stock market will not be due to stock fundamentals but to changes in the bond yield. Recently, stocks with poor fundamentals have done better than stocks with good fundamentals. That's what makes an environment like this so difficult for investors.

Q. What sectors will see the biggest impact?

A. The same forces that will drive the bond yield up later next year will cause gold prices to reverse and perhaps even oil prices to reverse as the Chinese economy slows down dramatically.

Q. You predict a crisis in China. Can you explain?

A. The global crisis caused a collapse in exports and forced China to prop up its domestic growth through massive stimulus. In the first several months, China put in about $1-trillion worth of lending, and that lending quickly found its way into another round of asset inflation. A real estate bubble if you like. The day when the bond yield starts to move again, it will probably cause the real estate crisis in China to start unwinding and probably affect the banking sector as well. If China is experiencing a banking crisis through the earlier part of the next decade, that will probably help keep capital in the U.S. treasury market and help protect the U.S. economy from a significant slow down. We'll probably see a stock market selloff in 2011-2012, but it might not be as bad as it would have been otherwise.

 

by

Karen Mazurkewich, Financial Post