Rather than inflation, if there’s one thing that investors should be worried about, it’s deflation. It’s when prices decline, asset prices fall, incomes shrink and no amount of Government stimulus can get the economic machine powering again.
Deflation is regarded by economists as a curse, and if the rot sets in it can last decades. Take Japan, for instance. Starting from the early 1990s interest rates were driven down to zero for years with little effect as the economy was mired in a vicious spiral of low growth.
The Economist magazine highlights deflation as the greatest concern for the world economy. Falling consumer and producer prices, and shrinking incomes are the hallmarks of deflation, as are tumbling property prices, and a rising number of loan defaults. The US has all the symptoms of deflation. Interest rates have been ground down to almost zero for years, and the economy is still faltering.
Could deflation hit Australia, and if so where should you hide?
The problem is that deflationary attitudes – for whatever reason – can set in and remain for generations. The children of the Great Depression were brought up to be frugal, to compare prices and chase the lowest price. In deflationary times, there’s always the expectation that prices will be lower in the future, so investments and purchases are pushed back to a later date.
Investing for high returns in deflationary times is exceedingly difficult (read more below).
It could be said that the Australian retail industry is suffering from the symptoms of a deflationary mindset that has entered the Australian psyche. People are spending less, saving more, and are waiting for ‘discounts’ or ‘sales’ to buy. Retailers have been forced to discount more frequently, and more heftily, to attract buyers. Many retailers began Christmas sales in early December to lure reluctant buyers.
The chief executive of Campbell Soup complained of a “recessionary mindset” that had beset the average Australian consumer. ‘We are adjusting our plans and programs as Australian consumers increasingly reflect a recessionary mindset, which is impacting a broad range of categories and brands in Australian supermarkets,” he said.
The risk of deflation is rarely spoken about because inflation is a more likely scenario. Inflation is exaccerbated when Central Banks print too much money, which is exactly what governments globally have been doing since the global financial crisis hit in 2007.
The hallmarks of inflation are rising prices for consumer goods, food and asset prices such as property. But in most economies around the world asset prices (including shares, property and bonds) have been plummeting, not rising, and food prices are in retreat. It’s an unsettling trend for economists as it points to a theory that rarely gets applied and it’s the liquidity trap. It’s what happened to Japan. It happens when printing money no longer has the power to kick start an economy.
Economist A. Gary Shilling argues that deflation is a far greater threat than inflation as the global economy undergoes a slow period of deleveraging. Consumers today are not spending but paying down debt; businesses are forgoing investments, hiring less staff and paring back rather than expanding. In response, credit is contracting, factories are closing and unemployment is rising.
The worry for Australia is that we take out the top spot globally for personal debt levels, even higher than the US – and much of this debt is for personal loans and credit cards. A rise in debt-repayment problems is symptomatic of a deflationary trend. Data intelligence company Veda noted that one in five Australians are worried about their ability to meet future debt repayments. At the same time the Australian property market is slackening with price falls nationally in line with those seen in 2008 at the time of the financial crisis.
Deflation occurs when prices for household items like washing machines, furniture, books and the like keep getting cheaper all the time. Today, you can pick up a brand new washing machine for $400. Shoppers can go to EBay, or other discount stores, and buy whatever they like for a fraction of the price – either new or second hand. Discount shopping sites are popping up every day. Some online shopping sites have foregone cash exchange altogether – instead, shoppers trade goods with each other – swapping a couch for a mobile, or a washing machine with a fridge.
These are all deflationary signs.
The fact that commodities prices are flat, or falling, is another worry. Commodities prices normally rise with inflation, with gold, particularly, being the historic hedge against inflation. But gold has been acting strangely lately – stumbling from its high of $1900 an ounce back in September last year to just over $1600 today. Some experts reckon gold’s recent price fall reflects the market switching away from a fear of inflation to a fear of deflation.
Economist Paul Krugman talks a lot about deflation in his column in The New York Times. He points to globalisation and rapid productivity increases as the cause of excess production capacity. In essence, we are producing too much and demand is no longer keeping up with supply. “Perhaps because income is too unequally distributed, perhaps because consumers are satiated. The result is global excess capacity, which exerts an inexorable downward pressure on prices.”
The problem is that when people expect falling prices, they become less willing to spend, he says. And in particular, less willing to borrow. “After all, when prices are falling, just sitting on cash becomes an investment with a positive real yield – Japanese bank deposits are a really good deal compared with those in America – and anyone considering borrowing, even for a productive investment, has to take account of the fact that the loan will have to repaid in dollars that are worth more than the dollars you borrowed. If the economy is doing well, all this can be offset by just keeping interest rates low; but if the economy isn’t doing well, even a zero rate may not be low enough to achieve full employment.”
In other words, when deflation hits, borrowing becomes rather pointless and cash in the bank is king. In deflationary times the number one priority for investors is to preserve capital for when prices hit rock bottom. Return of capital, rather than return on capital, is the aim.
The problem with deflation is that if everything is going down, diversification across asset classes from stocks, bonds, property is hardly optimal. In other words, diversifying across a range of badly performing investments is doomed. Instead, in deflationary conditions investors should be increasing their stake in cash accounts, term deposits and government bonds in anticipating of lower prices down the track. Cash becomes king.
While we’re taught to be on the lookout for inflation, sophisticated investors should also be concerned about the possibility of deflation on the horizon. While inflation makes us stack up on gold, and buy tangible assets like commodities and property, deflationary conditions make cash the standout investment option.
In summary, keep watch on the consumer and producer price indices, wages, property prices, commodities prices, gold, and the costs of household goods from dishwashers to microwaves. If they’re all going south, deflation may be the cause.