Falling prices? It’s not as good as it sounds!
Written by Paul Dodd on October 02, 2014.
We constantly hear about the evils of inflation which brings with it rising prices and falling purchasing power, but inflation’s antithesis, deflation, raises its ugly head far less often.
Deflation means that the general level of prices falls consistently over a period of time. The word general is important – a dip in the price of one or two items does not herald deflation but a more widespread and sustained fall in prices does. Japan suffered a severely debilitating and lengthy period of deflation, which started in the 1990s and lasted well into the noughties, but most economies have avoided deflation in recent times.
As consumers living in inflationary times, we are accustomed to bemoaning the decline in the value of our money in the face of constantly rising prices. Conversely falling prices sound pretty appealing! Deflation actually increases the value of money and therefore it costs less to fill your car with petrol and your supermarket trolley with shopping. What’s not to like?!
Unfortunately, those falling prices bring with them some very unwelcome side effects for our economies. Your fancy plasma TV may have dropped in price but that means that the manufacturer’s profits are falling, he has less money to pay workers and may have to let some go. Without jobs, their buying power is diminished. To exacerbate the situation, as prices fall, consumers tend to wait for further drops in price, a phenomenon known as buyers’ strike. As demand decreases, a deflationary cycle develops leading to a stagnating economy, further job losses and businesses going bust. With the fear of unemployoment ever present, people keep hold of their money and the economy goes spiralling downwards fast.
And here’s the rub. Economists have very few tools at their disposal to deal with deflation. Cutting interest rates is really the only defence and whereas with inflation, interest rates can be raised without limit, they obviously cannot be cut below zero. This means it is very difficult to halt the deflationary spiral and is one reason why economists and governments fear this particular economic problem so much.
Deflationary times call for appropriate measures with regard to the management of your money and investments. Debt is disastrous because while prices drop your debt will not. Avoid large loans on assets which will effectively be depreciating in value.
Careful management of your asset allocation is also essential to soften the blow of deflation. Cash becomes a much more desirable asset and investors will favour bonds over stocks which generally suffer in deflationary times. These don’t need to be abandoned altogether however, as always balance is key, and it is possible to select equities which will tend to fare better. Companies with cash reserves could actually benefit from deflation whereas those with heavy debt will be vulnerable. The risk of buyers’ strike means that those producing luxury goods could also suffer whereas companies producing necessities will weather the deflationary storm better. If deflation is a threat, it may also be an appropriate time to choose dividend paying equities. Of course, as ever, your strategy will depend on other factors such as your time horizon. The closer you are to retirement, the less time you have to sit out the deflationary cycle and the safer you will need to play it with your investments.
With so many ifs and buts, professional investment management of your savings becomes even more important in times of economic crisis, and that is true whether the dangers come from inflation or deflation.