The question of whether we are seeing deflation or not appears in much of the west and Florida as well deflation re-defined.
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Could Japanese-style deflation happen here? And if so, what would it mean for you and your money? Can you prepare in case it hits?
Let's take these in turn.
Is Deflation a Risk?
You'll hear plenty of voices on Wall Street telling you there's no serious chance of deflation. Trouble is, they have a terrible track record of predicting these big, paradigm shifts. Over the past decade, few predicted the bear market, the housing collapse or the financial crisis. Their assurances need to be taken with a fistful of salt.
Indeed, depending on how you measure it, deflation may already be here. According to the Department of Labor, consumer prices have been flat over the past three months. Hourly wages fell 0.7% from the first to second quarter. Those in manufacturing fell nearly 2%.
Housing, the most important asset by far to most people, has been in steep deflation for years.
Our chart below shows the median inflation index produced by the Federal Reserve Bank of Cleveland. At least by this measure underlying inflation has now collapsed to dangerously near zero.
Naturally the future is unknowable. We may well dodge the bullet. Fed chairman Ben Bernanke has already vowed to do everything he can to prevent a deflationary spiral from developing.
But one would scarcely want to ignore the danger completely.
In deflation, prices and wages fall. Japan has suffered this since the mid-1990s. The U.S. suffered it severely in the early stages of the Great Depression. Periods of deflation were more common before the First World War, when most of the world had currencies pegged to gold.
If It Happens, What Does It Mean for Your Money?
David Rosenberg, the chief economist at Gluskin Sheff in Toronto, puts it best. In deflation, cash wouldn't be king. Income would be king.
Investors would be struggling to find safe, dependable sources of income.
So top-quality bonds, which provide that income, would boom. Bond prices would rise, and the yield, or interest rate, falls. (In Japan, at one point, long-term government bonds yielded nearly nothing).
That would be good for Treasurys, especially longer-term bonds, as well as for better quality municipals and corporates.
Cash would still be prince, though. If a savings account earns you zero percent interest, but prices fall 2%, you've still made 2% in real terms. And it's tax free. (Contrast that with earning 4% interest in an era of 2% inflation).
Gold would probably benefit. If deflation hits, Mr. Bernanke will set world records for printing money to stave it off. Logic says that would help gold, which can claim to be a monetary asset of limited supply.
Most analysts will tell you deflation is typically terrible for the stock market. Look at Japan over the last two decades, where the market has plummeted by about three quarters. Look at Wall Street in the early 1930s, which collapsed by about nine-tenths. Deflation hurts stocks because companies see their prices collapse faster than costs. Where companies are also leveraged, they also suffer because their debts don't deflate with everything else.
Not all stocks need suffer. A few years ago James Montier, a former strategist at SG Securities in London (and now working for Boston's Jeremy Grantham at GMO), looked at what investment strategies actually worked in Tokyo after 1990. He found that most of the stock market's slump came from the sinking of the overpriced "glamour" stocks–in this case, the country's big banks. Meanwhile many underpriced, good quality, so-called "value" stocks actually fared much better. Mr. Montier concluded that a Japanese investor who had invested in the value stocks, and shorted, or bet against, the glamour stocks could have made good money even through those two decades–even in the midst of deflation and a terrible bear market.
If income would be king and cash would be prince, in an era of deflation, debt would be the devil.
Your credit card bill. Your car and student loans. Your mortgage. As incomes and prices fall, the bills stay the same, which means they grow in real terms. It gets harder and harder to pay them off. "You're paying down debts but your income is falling," says SG strategist Albert Edwards. "So you have to pay down your debt even more quickly. You get into a vicious cycle."
Naturally what makes this even harder is that everyone else is trying to do the same. The economy struggles to get out of a downward spiral. Company cutbacks keep unemployment high. Japan has been in and out of recession over the past two decades. House prices have sunk for most of that time.
What Can You Do To Prepare
Making wholesale changes to your finances based on the assumption that deflation is coming would probably be a mistake. It's not certain. And if the economy recovers instead you may be invested in exactly the wrong things.
Anyone thinking of loading up with Treasury bonds needs to be aware that their price has already risen a long way. The yield on the 30-year bond is a mere 3.8%. That will prove a great deal if deflation develops, but you'll get your fingers slammed in the door if the economy recovers instead and inflation perks up.
Top-quality corporate bonds and municipals may offer somewhat more value, but they, too, are looking pricey.
There are steps you can take that will help in all circumstances.
Paying off your debts as fast as possible is the most obvious. It's a no lose. One exception might be the mortgage, because of the tax break, but even there the picture is no longer so clear.
Take a look at your stock portfolio. If you are carrying a lot of equities, especially those in "glamour" stocks, be aware that in many cases they are offering an asymmetric risk: The downside probably outweighs the upside. Ask yourself if your personal finances could survive a 30% drop in your portfolio. If not, scale back, or move more money into blue chips.
And consider buying some insurance. For the sophisticated, that might include buying out of the money "put" options on the Standard & Poor's 500 index. Those are like long-odds bets on a crash. They'll pay off big in a crash, without risking too much money.
For mainstream investors Treasury Inflation-Protected Securities, so-called TIPS bonds, will work out OK in deflation or inflation, or anything in between. They aren't great value at the moment. The 30-year TIPS bond yields 1.8% above inflation. Typically, you're better off trying to buy them when this "real" yield is well above 2%. At these levels, they won't make you rich, but they won't make you poor either.
Write to Brett Arends at firstname.lastname@example.org