Investing in a deflationary environment

- compiled from information supplied by UBS


Inflation is commonly defined as a persistent rise in the general level of prices, while deflation is defined as a sustained drop in the general level of prices (as measured by the consumer price index, for example). The emphasis here is on the words “sustained” and “general”. Prices which fall over a period of a few months do not usually present a problem. Also changes in demand and supply will mean that at any given time, prices of some goods and services will fall. While this may be painful for the sectors and industries affected, it is not what is meant by deflation.

According to the article, “...deflation has two faces ... “good” deflation ... results from more efficient and thus cheaper means of production, (think flatscreen TVs). This type of deflation prevailed for much of the 19th century, accompanying strong economic growth. But there is also “bad” deflation, which is associated with a deep, dark economic recession. In this form, overall economic conditions are such that declining prices reinforce expectations that prices will fall even further in the future. This prompts consumers and businesses to postpone purchases, only aggravating the drop in total demand that caused prices to weaken in the first place.”

Bad or pernicious deflation occurs where there is a collapse of aggregate demand - a drop in spending so severe that producers across all sectors must cut prices on a sustained basis in order to find buyers for their products. At present, aggregate demand has collapsed and most major developed economies are in recession, giving room for concerns that we may enter a prolonged period of deflation.

UBS contend that, in the longer term, inflationary pressure may be the bigger problem but that deflation risks cannot be dismissed out of hand and investors are well advised to contemplate its consequences.

One specific and profound economic consequence of deflation is that it actually increases the real value of debt. e.g. Consider a loan of $1,000: If prices drop 3% per year for 10 years, the nominal repayment sum at the end of that period would be worth more than $1,340. In contrast, 3% inflation would have lowered the value of the loan to only $737. Thus, deflation is bad for borrowers but good for savers.

Deflation discourages borrowing and encourages saving. This single effect of deflation has consequences for virtually all asset classes.

Managing assets and liabilities in deflationary times

The various forms of deflation will affect the balance sheet of a private household or a company in different ways. If deflation is protracted, not only will consumer prices fall, but typically so will wages. Thus, the “real” (inflation-adjusted) burden of a private household’s debt increases as its ability to pay for interest, fees and amortisation shrinks with its falling wage income.

Usually, in a deflationary environment it is not only consumer goods and services prices which fall, but also asset prices such as equities or real estate. Falling real estate prices diminish the home equity position of a private household and one can even end up in a situation where home equity is negative, i.e. outstanding mortgage debt is higher than the value of the home.

Thus in a deflationary environment it would be better to pay down debt, either by selling the asset that is likely to fall in value anyway or from savings. Debt that cannot be paid down should be financed wth short-dated loans since central banks usually cut interest rates all the way down to zero in a prolonged period of deflation, driving short-term loan rates below those for longer-term loans.   

Equities - Diversification is key

According to the report, the consequences of deflation for equity market returns are intimidating. There is some counterbalancing as the real purchasing power of money increases weak nominal returns. The net effect of deflation on discount rates for earnings is less clear. From a theoretical point of view, risk premiums tend to rise in a deflationary environment and bond yields tend to fall. Past deflationary periods have seen earnings fall as a result of lower sales or because purchases are delayed by consumers. Intuitively, equities generated weak returns and haven’t been a good hedge against deflation.

Some companies are able to operate even under these circumstances to show slightly positive earnings growth. The health care sector offers the advantage that their product demand can’t be delayed and that the price sensitivity of their dients is very low in general. Both arguments also apply for the tobacco industry and regulated utility companies although to a lesser extent. In addition companies that have strong balance sheets and good credit ratings suffer less from the rising risk premiums effect. They also enjoy better access to capital markets than weaker companies. Integrated oil companies generally meet these criteria, for example.
Companies with relatively high debt levels and fixed maturities and that are also exposed to discretionary consumption suffer in a deflationary environment, e.g. auto-makers. Both low-end and luxury goods companies would be hurt, as purchases can be delayed by a couple of years. Such companies are unlikely to deliver superior earnings growth. Capital goods companies like machinery producers have long lead times and find it difficult to operate profitably when orders are reduced or delayed.

In a deflationary scenario, international diversification plays an important role for investors. Regions with higher inflation and growth rates and a long-term positive outlook are most attractive, e.g  emerging markets especially in Asia.

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