One of the distinguishing features of the Great Depression was marked deflation from 1930 – 1932, with prices falling precipitously (-30%) over that time.1 Deflation spiraled, and the stock market and investor portfolios tumbled with it.
With recent headlines citing deflation as a concern, we’re taking a moment to remind investors about the negative effects of deflation, its present-day risk in the global economy, and what steps investors concerned about deflation can take in their portfolios.
What is Deflation and How Does it Affect the Economy?
Deflation occurs when prices of goods fall on a broad scale, usually due to sharp declines of money in circulation or because of a big spike in the supply of goods with little supporting demand.2
The key phrase here is “broad scale.” The prices of flat screen TVs might fall year-over-year, for instance, but that’s more likely because of productivity gains and innovation within that sliver of consumer goods than it is a broad-scale economic issue.
When deflation does become a broad scale issue and prices fall due to economic forces, the impact is three-fold.
1) Consumers Hold onto Cash
As consumers start to notice falling prices, they instinctively hoard cash, waiting for the goods to get even cheaper before buying them. This chokes off consumer spending, which can in turn cripple a consumer-based economy.
2) Debt Becomes More Costly to Finance
The second effect is what’s known as the “debt-deflation dynamic.” As money becomes scarcer, the fact that the government and investors have debt doesn’t change – you still have to pay the bills, only now you have less cash available. This inherently makes debt more expensive, which forces the government and investors to spend a larger percentage of their income/revenues paying it down.3
3) Corporate Profits Can Fall
Third is the effect of falling corporate profits, which forces companies to cut output and wages, to hold off on capital investments, and to lay off workers. Falling income and rising unemployment pushes demand lower, setting off a self-reinforcing downward economic spiral.4
Thinking about all of these negative effects taken together, it’s not difficult to imagine the perils investment portfolios could face should deflation rear its head.
Is Deflation a Concern in the US Today?
We see it as unlikely for now. In 2009 there was a period when the Consumer Price Index (CPI) turned negative (chart), but this was fought off by the Federal Reserve’s wall of liquidity and implementation of quantitative easing (QE) programs. These actions pushed additional cash into the system to counterbalance the deflationary effect of banks hoarding cash and shrinking their balance sheets, and for the most part it worked.5 Prices have been in recovery ever since, and we think the outlook is reasonably good for modest inflation to continue from here:
Consumer Price Index for All Urban Consumers: All Items
(Click chart for larger version)
Source: St. Louis Federal Reserve, U.S. Department of Labor: Bureau of Labor Statistics
Is Deflation a Concern in Europe?
The deflation buzz has shifted to Europe now that the US appears to be in a steady recovery. On a TV interview with Bloomberg, the Global Head of Asset Allocation for Barclays Bank, Jim McCormick, called it Europe’s biggest risk.6
But at last count, prices are falling only in Latvia, Greece and Cyprus. And most forecasters, including those at HSBC, see low inflation as more likely than deflation on average in the euro zone.
Nevertheless, inflation remains stubbornly low - under 1% on average across the 18-nation bloc - despite the supportive measures taken by the European Central Bank to make money readily accessible and cheap for banks – actions that usually spur inflation.4
This chart demonstrates the issue, as the choppiness you see below signals mini-setbacks to the overarching trend of rising prices. Compared to the chart for the US, the Euro Area is notably bumpier and rising at a less compelling rate.
Consumer Price Index: Harmonized Prices: Total All Items for Euro Area
(Click chart for larger version)
Source: St. Louis Federal Reserve, Organisation for Economic Co-Operation and Development
We think Europe could escape a deflationary cycle via economic growth, which the IMF predicts will happen in 2014 with growth of around 1%.7 It’s also true that the European Central Bank hasn’t instituted a quantitative easing-like program in the euro zone like the Fed has done here in the US, so that’s a tool that still remains in the tool belt should things really sour.5
Overall deflation seems like a risk that Europe can escape, but it’s certainly not a forgone conclusion.
Should You Adjust Your Portfolio Due to Deflation Concerns?
We don’t think the risk of deflation in the developed world (Europe, US, Japan, etc…) is great enough to warrant any major adjustments to investor portfolios.
That said, there are still fundamental tenets to smart investing – such as diversifying across a broad range of sectors and countries - that can help fight the effects of deflation should they take hold. If Europe has a higher risk of deflation, for instance, it’d make sense for an investment portfolio not to be overly concentrated on European stocks and debt. The same would have applied to investing in Japan in the 1990’s, during their height of their deflationary cycle.
For investors concerned about the effects of deflation in certain markets or areas of the world, you can speak with your financial advisor about your portfolio’s exposure to those places and make adjustments accordingly.
WrapManager Can Help You Diversify Your Portfolio
WrapManager researches and recommends various money managers that invest across a broad range of styles, sectors, and countries, and we can help you check to ensure your portfolio is properly diversified relative to the market outlook and your needs.
If you’d like discuss the deflation concern more or want one of our Wealth Managers to run an analysis of your portfolio, give us a call at 1-800-541-7774 to speak with us.
Sources:
1 National Bureau of Economic Research
7 International Montetary Fund
