Most investment portfolios are geared to an inflationary, not a deflationary, economy. This is because deflation, meaning a general decline in prices in the economy, hasn’t been seen in North America since the 1930s depression.
Could deflation occur here again in the near future? Some economists have warned that it could, although inflation still holds sway at present.
Deflation eventually took hold in Japan after the bursting of that country’s stock market bubble in the early 1990s. Japan’s consumer price index has been falling by 1 to 2 percent annually since 2000.
Gary Shilling, president of A. Gary Shilling and Co., a prominent U.S. economist who has written books on the subject, believes there is a chance, especially with high amounts of unused capacity, cheap Chinese imports flooding the North American economy and rising unemployment, that a similar post-bubble deflation could develop on this side of the Pacific Ocean.
The probability of this occurring apparently has been high enough for U.S. Federal Reserve Governors, including Chairman Alan Greenspan, to mention deflation in their recent speeches going back to last November, although Mr. Greenspan more recently maintained that there is only a “remote” chance of a “corrosive deflationary spiral.” He has certainly made it clear that the Fed will do everything in its power to prevent deflation by keeping interest rates low and boosting money supply (although presumably Japan also didn’t want deflation).
In a speech last November, Fed Governor Ben Bernanke noted “the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending—namely, recession, rising unemployment, and financial stress.”
He also said borrowers, though enjoying the low interest rates that accompany deflation, would be among the most seriously hurt by deflation, as farmers who borrowed to buy land were during the period of sustained deflation following the American Civil War.
If deflation proceeds at a clip of 10 per cent a year as it did in the early 1930s, loans “must be repaid in dollars whose purchasing power is 10 per cent greater than that of the dollars borrowed originally. In a period of severe deflation, the real cost of borrowing becomes prohibitive. Capital investment, purchases of new homes, and other types of spending decline accordingly, worsening the economic downturn.
“The financial distress of debtors can, in turn, increase the fragility of the nation’s financial system—for example, by leading to a rapid increase in the share of bank loans that are delinquent or in default. Japan in recent years has certainly faced the problem of ‘debt-deflation’—the deflation-induced, ever-increasing real value of debts.
“Closer to home, massive financial problems, including defaults, bankruptcies, and bank failures, were endemic in America’s worst encounter with deflation, in the years 1930-1933—a period in which the U.S. price level fell about 10 per cent a year.”
Cash, then, is king during a period of deflation, and investors contemplating ways to deflation-proof their portfolio would be wise to have a good-sized amount on hand, even if it earns little or no interest. Also, some of the portfolio should be in low-risk government bonds that will continue to generate more cash and provide capital gains if interest rates fall further.
Other deflation-proofing tactics:
· Avoid investing in banks and companies with high debt;
· Invest in companies that have a strong influence over the prices they can charge for their products and services, such as those with patent protection or strong brands;
· Invest in companies that pay high dividends (that would be sustainable during deflation);
· Avoid complicated investments with fancy structures or those where derivatives are involved (as the financial stress could cause a lot of failures of counter parties in derivative arrangements);
· Stay away from inflation-indexed bonds, also known as real return bonds, as the returns on most of these bonds are geared to reflect declining prices as well as rising prices.
· Avoid land, low-quality real estate investments and other hard-to-sell assets that would suffer in a period of financial distress.
Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. He can be contacted at wcheveldayoff@yahoo.ca.
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©2003 Wayne Cheveldayoff