Investors should not ignore the deflation threat

Not a bit of it. Many consumers and some politicians are tempted to view deflation (or at least falling inflation) as an unexpected tax cut. Even Carney has described the tumbling oil price that has prompted the sharp drop in UK inflation rates as an “unambiguously net positive”.

 

It’s easy to see why deflation has its apologists. Surely things getting cheaper is a good thing, right?

 

Wrong. I lived and worked in Asia during Japan’s Lost Decade, and saw first hand the chaos deflation wrought. 

 

 

Let me be clear – deflation is bad for three principal reasons.

 

First, deflation pushes up real interest rates; the last thing you want to happen if prices are falling. Second, when you borrow money, the amount that you agree to pay back is often fixed. In a deflationary environment, the loan’s capital amount rises in real terms. Third, if you as a consumer know that prices are going to be lower next month, you’ll wait till next month to spend. This deferment of expenditure dampens growth by taking demand out of the economy.

 

For companies, deflation can be a disaster. If a firm’s debt is rising in real terms, the value of its shareholders’ equity can generally only do one thing: decline. And the deferment of expenditure hits companies’ sales directly. This, combined with higher real interest rates, causes the intrinsic value of companies to decline and thus their share prices to fall.

 

While deflation might be bad for equity investors, it’s great for bond investors. Coupons are worth more in real terms, and deflation normally results in declining yields and thus a rise in bond prices in nominal as well as real terms. Of course, this only applies to bonds where payment of coupons or repayment of principal is not brought into question – in other words, to bonds issued by governments that control their own money supply. It can be a different matter for corporate bonds, and the damage to them can be similar to that inflicted on equities.

 

Property tends to be a poor investment during deflationary periods. This is not so much because of the intrinsic qualities of property, but because property investment tends to be financed with debt. If the real value of that debt goes up as a result of deflation, the real value of the property investment will fall.

 

As for gold, it shouldn’t really be considered an investment but a form of cash, as indeed it has been for the last 3,000 years or so. And since it doesn’t yield anything, it will generally be the preferred choice only when real interest rates are negative – which they can’t be if inflation is negative.

 

One of the most dangerous aspects of deflation is that the threat it poses can seem benign – at first. But there are warning signs that should alert a central bank, and investors, to the problem before it gets too serious.

 

There is now a broad consensus among central bankers that deflation should be avoided and, more importantly, that it can be – through quantitative easing and other monetary policy measures.

 

In the Eurozone, the Germans’ fears that loose policy would lead to runaway inflation have proved unfounded; and while they may not become fervent supporters of money printing any time soon, they appear to be stepping out of the way.

 

With the European Central Bank widely expected to announce a wave of bond purchases tomorrow, the big question is whether it has left QE too late to tackle the deflationary threat in the Eurozone.

 

On the basis that central banks generally know how to avoid deflation, and are in a good position to see it coming, we must watch out for signs that, for whatever reason, they have decided to allow deflation to happen, or are unable to stop it.

 

So signs of disagreement within monetary policy committees, or between central banks and governments, would be truly ominous. If they fail to tackle the threat of deflation in time, central banks risk triggering a deflationary spiral like that endured by Japan. Seldom have the stakes been higher for Mario Draghi than they are this week.