Deflation is a rare occurrence. However, given the state of the global economy and a general prevailing sense that Europe may be slipping into deflation, many investors are concerned about the possibility and wondering about a deflation investment strategy.
Deflation refers to a situation where general levels of prices for goods and services in the economy are falling. This causes capital investments and purchases to be delayed, declining revenues and increasing layoffs and unemployment. Clearly, this is quite worrying, and great care needs to be taken when working out how to invest for deflation. Even if it may never be required, a well defined deflation investing strategy is critical to have to avoid devastation in asset values
Investing during Deflation
I would like to state that I am not very worried about the possibility of deflation, Europe notwithstanding. ECB has launched an aggressive round of Quantitative Easing, the results of which remain to be seen. However, QE policies have shown to work in the US and Britain, and should have some success in warding off the Eurozone deflation. The EU target is at 2% rate of inflation.
If you are worried about the possibility of deflation, here are a few tips to help you understand the effect of deflation on the stock market.
1. Cash is the safest asset class
When prices are falling, the value of money increases over time. So it stands to reason that keeping high levels of cash will increase your purchasing power. Also consider the fact that the value of tangible assets decline during a deflationary environment. This means buying assets such as real estate, or other hard assets tend to be bad investments with negative rate of return.
2. Debt should be avoided
If you have debt, the real value of the obligation rises over time during deflation. At the same time, your capacity to repay the debt is likely to decline as jobs become scarce, business revenues and therefore salaries decline and the value of collateral goes down. Paying down your existing debt should be of utmost priority and you should avoid taking out new debt.
This is true for consumers and it is also true for businesses. Highly leveraged businesses will have trouble servicing their debt, and should be avoided as investments.
3. Consider Bonds
The flipside of being a debtee is being a lender. Regular cash income becomes very attractive specially from companies or entities that are likely to be able to continue paying coupons on their bonds. The safest bonds are of course the US Treasuries. You should expect the interest rates to be low but these should stay above the interest rates you can get through bank deposits.
4. Emphasize Dividends from Strong Companies
Similar consideration as to buying bonds applies here. You should remember that equity is a riskier asset class, so when evaluation dividend paying companies, greater emphasis should be placed on balance sheet strength and earnings sustainability.
5. Look for competitive advantage or moat
Certain companies or industries have natural competitive advantages that protects their pricing power. In many cases, these competitive advantages arise from their strong brand. Some of the industries that produce consumer essentials will do better than the market due to the fact that consumers will need to continue buying these products/services. These products and services tend to be relatively price inelastic. Also regulated industries such as utilities are safer investments.
Safety in these kind of stocks tend to be maintained only to a certain level. Depending on the severity and the length of deflation, you should expect consumers to shift their buying habits to of-brand products, deciding to start forgoing some essentials. In the longer term there will also be demographic shifts such as larger family units that would start cutting into utilities revenues.
What Happens After Deflation?
Deflation is not good for the economies and the governments and central banks will do everything in their power to prevent it from happening. If it does happen, expect large interventions in the markets to shore up the economic activity and re-inflate the market. We are more likely to see short lived depressions than a full fledged deflation. We have learned quite a bit from deflations past and the recent Japanese experience.
One of the dangers is that when the economy rebounds, there is a greater possibility of rapid inflation that will quickly make all your deflation measures counter productive. Therefore, if you have a longer term outlook, any changes you make should be gradual. Sticking to proven value investing fundamentals will help you navigate these economic conditions better, if they were indeed to occur.