The threat of deflation has been in the news recently. Many analysts fear that deflation could take the global economy off the road of recovery and plunge it back into the depth of a depression. And rightly so. Deflation has the effect of making consumers hold on to their money rather than spend it and this could lead to a reduction in aggregate demand in the economy. Putting it simply, whilst deflation may be good for individuals, it is bad for the overall economy.
Whilst many articles online have gone on to say why deflation may lead to a doom situation, not many have tackled the question as to why deflation is actually occurring. Here, I will give two of the reasons as to why we have deflation and what you can do about it.
In economics theory, there are two types of inflation, cost push inflation and demand pull inflation.
- Cost push inflation is where prices of raw materials rise and thus the price of the finished product rises as well.
- Demand pull inflation is where demand for products increase and thus the price increases as well.
Deflation can also very much be categorized in this way. So deflation can be caused by:
- A Decrease in Costs
- or A Decrease in Demand / Increase in Supply.
And this is exactly what is happening.
Falling oil prices has led to a decrease in costs and low interest rates has led to both an increase in supply and a decrease in demand. This is explained below.
Fall in oil price
This is the obvious cause of deflation. Oil is the life blood of any modern economy. Oil is used in a vast array of sectors from manufacturing to transportation to energy. As the oil price drops, the cost associated with making products has decreased so the prices business charge decreases as well. As you can see, this leads to cost push deflation – deflation brought about through lower raw material prices.
*It is also important to note that other raw materials like copper have reduced in price recently thus leading to deflation the same way oil has done.
Low interest rates
This might come as a surprise as many people would see low interest rates as factor that leads to inflation. Normally, cheap credit would lead people to spend more more and lead to demand pull inflation. But this is not the case in this instance. Low interest rates has actually led to deflation in two ways:
- Increase in Supply – Interest rates have essentially been at 0% over the past 6 years and this sends false signals to companies. Companies have a cost of capital which they use when they are judging projects. And once they start to think that capital is available for close to nothing, they take on some pretty marginal projects. Thus companies having got this ‘false signal’ have gone out there and built excess capacity (more factories) as capital is almost free, for demand that is not sustainable or does not exist. The ‘flaw’ here is that businesses built factories due to cheap credit as opposed to projections of increase in demand
Once you’ve built the factories, theirs now no point of leaving them dormant so by operating these new factories, the market is flooded with excess products. Supply is greater than demand and thus price levels are naturally falling.
- Reduction in Demand – Most of the developed world has an ageing population – the majority of the spending power is gravitating to an older population. It is a characteristic of older people that they don’t like to spend more than their income. So when interest rates are down, income received is down and thus these people just spend less. And this leads to deflation as aggregate demand has been reduced.
What are the best assets to hold for a deflation?
At the moment we have disinflation as opposed to deflation. Disinflation is where there is a slow-down in the inflation rate (i.e., when inflation declines to lower levels).
Deflation on the other hand occurs when the inflation rate falls below 0% – prices are cheaper from one month to the next.
So if you are expecting deflation, what are the best classes of assets to buy?
1) Fixed Income Assets – Holding corporate bonds or treasuries will give you a good ‘real’ return in periods of deflation. Even though general prices are going down through deflation, you are still getting the same fixed income stream every months and thus the income you receive will be worth more and more with every passing month.
2) Cash – The phrase “cash is king” is often cliche. It’s not cliche during deflation, it’s rule number one. Cash is one of the few ‘safe’ investments you can make in this scenario. Having cash in deflationary times means that your cash will be more valuable, or worth more and more as the months pass by.
During normal inflationary periods, investors focus on their return ‘on’ capital. When deflation kicks in, the focus switches to the return ‘of’ capital.
3) Gold – This is still up for debate. Conventional widow states that you should avoid commodities during deflation. During the Great Depression from 1929-1932, commodities in general crashed. However, in very extreme circumstances (emphasis on extreme), some have argued that gold can make sense when acting as currency. The majority of proponents for owning gold during deflation would cite its store of value or hedge against uncertainty. While gold can be played via the SPDR Gold Fund (GLD), many hedge funds advocate physical gold. That said, those doing so are mainly seeking inflationary protection.
4) Technology Stocks – Regardless of economic fundamentals, technology will advance and still be in demand. Companies that dominate their industry should have an advantage. A basket of technology stocks could be purchased via the technology exchange traded fund (XLK). However, that gives you exposure to a lot of companies and some technology companies are definitely overvalued at this point in time. You need to invest in specific technology companies with pristine balance sheets such as Microsoft (MSFT), Oracle corporation (ORCL), Cisco Systems (CSCO), Altera corporation (ALTR) and Symantec corporation (SYMC).