Client Corner: Understanding Deflation

In Investments by Brad Stark

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In the last Client Corner article, we addressed questions pertaining to inflation. Now, we are going to flip the script and cover the counter view inquiries we receive from clients.

By: Brad Stark, CFP®, AAMS®, CMFC℠

If deflation is trending, can government intervention (or lack of intervention) stop it or accelerate it?

Unlike inflation, deflation is much harder to control. If prices are declining rapidly, there is no incentive for people to buy goods and services as they are less costly the next day. If left unchecked, the decline can feed upon itself and gain momentum. Deflation is a topic that the Fed, governments and central banks around the world want to stave off at all costs. The tools most commonly used to prop up prices are: lowering interest rates, lowering taxes, increased government spending and quantitative easing (i.e. monetary policies). These are all levers that were pulled during the 08/09 crisis and most recently this year.

financial planningWho does deflation hurt and who does it help? If deflation comes and I am in all cash, will I be able to buy a Ferrari for $20,000?

Deflation adversely impacts virtually all items of value. It hurts those with the most toys and assets but it also harms the lower end workers as unemployment tends to rise as economic activity slows. High quality bonds and cash do well during times of deflation (but that only lasts so long and you have to be buyer of assets at some time to profit). On the flip side, cash and high quality bonds are the two assets which tend to do poorly during times of inflation. One may argue that the younger generations who can’t afford to buy a house or those starting to invest would benefit from deflation but that is to the detriment of those on the other side of the transaction. I presume you are asking for a new Ferrari for $20,000? No one reading this would ever want to see that happen - only occurs in massive recessionary times (i.e. Great Depression).

What countries have experienced deflation and how did they dig out?

The United States has experienced several periods of prolonged deflation (1890, 1893, 1907, 1930 to 1933) but only slight recent periods such as 2008-2009. To dig out of deflation, money “velocity” has to increase as discussed above. A lot of lessons from the past have been learned and we are seeing faster and more aggressive government and monetary moves when economic upheaval is upon us. Some argue those interventions disrupt the natural path of free markets. Others argue it is necessary to keep order and to protect the interwoven financial structure. Some will say propping up prices makes the rich wealthier while others argue that jobs are not lost due to business closures or societal monetary value disappearing (only to be filled by the government / taxpayer).

Other historical examples can be found in Hong Kong 1997-2004 (following the Asian Financial Crisis), Ireland 1960 and 2009, Japan 1990’s, United Kingdom 1921 (10% drop) followed by -14% in 1922 and another 3-5% in the early 1930’s. Most of these deflationary periods were triggered by an “event” and are either left to their own path to sort out or government intervention takes place. Over the past 100 years, governments have been more proactive to try to stop these types of events early before they can take hold (harder to fix once it sets in).

If I know deflation is coming, what steps can I take NOW to make money on it (regardless of the misery it causes)?

One can short the market (not recommended). Sell all real estate and virtually all assets of value, sit in cash and wait. Invest in more “alternative” investments not completely tied to the markets. Go higher upon the capital structure and own more debt vs. equity. Buy 30 year government bonds that pay hardly anything as the perceived “safe” play but that comes with substantial risks (read the inflation article). If you go down the path of playing it too conservatively and you are wrong, the misery of making that decision can be hard felt down the road. Always keep in mind that the entire world is trying to avoid this from happening (CEO's, every government, every shareholder, every worker, every central bank).

What are the risks of planning for deflation if it ends up not arriving?

Asset values get ahead of you and your net worth in relation to the world declines. You could turn moderate, normal inflation into a personal hyperinflation situation as you fall behind everyone else. This is fine for the short term but psychologically going down this path is damaging as it becomes a cycle people can fall into and hard to exit. For the super affluent, they can afford to be aggressive or conservative as a decline in value or missing out on upswings will not adversely impact their lifestyle. For most people however, we find the comfortable zone and highest probabilities for success in our stress testing happens by playing the middle ground.

If I'm uncertain about whether deflation is in the offing, how can I safely hedge my bets?

Diversify. Very few of our clients are 100% equity based in stocks and or real estate. Implementing a combination of assets that consist of 5-10 year investments coupled with short term liquidity plays that kick off income helps even out the bumpy road and provides for the needs of today but also addresses the future.

How Mission Wealth Can Help

We are always ready to meet with clients and tailor strategies. We continue to advise clients to have a balanced approached and one that provides for immediate cash flow needs while also preparing for what the future might bring. Call your Mission Wealth advisor anytime you want to review your current and future investment strategies. It's what we do.

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