Deflation??
When prices go down, it’s generally considered a good thing—at least when it comes to your favorite shopping. When prices go down across the entire economy however, it’s called deflation and its usually bad news for the economy and your money. Deflation is when consumer and asset prices decrease over time and purchasing power increases. Essentially, you can buy more goods or services tomorrow with the same amount of money you have today, which is the mirror image of inflation. While deflation may seem like a good thing, it can signal an impending recession and hard economic times. When people feel prices are headed down, they delay purchases in the hopes that they can buy things for less later. But lower spending leads to less income for producers and that will lead to higher unemployment, lower prices and even less spending. In short, deflation leads to more deflation. Throughout most of our history, periods of deflation usually go hand in hand with economic downturns. Deflation is not to be confused with disinflation. While they both sound like they would indicate decreases in prices, disinflation signifies that prices are still rising, just more slowly than they have been. There are two big causes of deflation, a decrease in demand or growth in supply. A decline in aggregate demand leads to a fall in the price of goods and services if supply does not change. Rising interest rates may lead people to save their cash instead of spending it and may discourage borrowing. Less spending means less demand for goods and services. Combine that with declining confidence from people worrying about the economy and unemployment, deflation is most likely around the corner.
Higher supply means that producers may have to lower their prices due to increased competition. This boost in aggregate supply may stem from a drop in production costs. If it costs less to produce goods, companies can make more of them for the same price. This can result in more supply than demand and lower prices. Technology can be a significant contributor to a decrease in production cost. Deflation is actually more harmful than inflation and is associated with economic contractions and recessions. During periods of deflation, the best place for people to hold money is generally in fixed income. Other types of investments, like stocks, corporate bonds, and real estate investments, are riskier when there’s deflation because businesses can face very difficult times or fail entirely. Central banks have few strategies to fight deflation. They can buy back treasury securities to increase the supply of money and they can also make borrowing easier. If central banks lower the reserve rate, which is the amount of cash commercial banks must have on hand, banks can loan out more money. This encourages spending and helps raise prices. Thankfully, deflation doesn’t happen often, and when it does occur, governments and central banks have some tools to minimize its impact.
Why talk about deflation when we are still being robbed at the grocery stores and still have a couple more scheduled interest rate hikes ahead of us? Many indicators are already in place to have deflation upon us sooner than many may expect. We are in a disinflationary period, which doesn’t always lead to deflation but there are signs. Commodity prices have already been deflated with the exception of corn and oil, and central banks hawkish tone has changed. Most importantly, the 2 main factors holding up inflation, low unemployment and supply issues are changing also. Recent banking issues in the US could tighten up credit and slow the US economy, which has already an increased chance of a recession later this year.
What does that mean for investors? While carefully selected fixed income should perform well this year, stock markets around the world will most likely be volatile and a complete recovery from last years downturn may not happen until later next year. If there is a recession, we may even briefly re-test the lows from October of last year. Things can of course change quickly, and markets could recover much sooner. But the chance that the fixed income part of your portfolios will outperform the equity part this year, seems likely. For some portfolios it may be appropriate to re-balance to a higher fixed income allocation. We are however at the end of this interest rate cycle and that will bring relief to the financial markets. These interest rate hikes from 0%-5% in 1 year have done some damage, more damage than in the late 70’s going from 10%-20% and we are starting to see the consequences now. But markets will work their way through all that, as they always have. Next year will also see an election in the US, and Canada will follow in 2025. Election years are generally good for markets, regardless of the outcome.
