Deflation, I’m sure, has been around since the dawn of man, though records going back past a thousand years are spotty, at best. Increased supply relative to demand or an abrupt shift in consumption always generates some form of price reduction. The root cause of the European Central Bank’s finally acting on its intention to begin quantitative easing is a direct result of deflation taking root in Europe. This call to action is quite pronounced considering the anxiety that the European region has regarding any uptick in prices due to historical ravaging from inflationary pressures.
Deflation is a widely used term in financial circles; however, its popularity is dwarfed by that of its brother, inflation. The average citizen is probably unconcerned about deflation and would probably be in favor of an environment that has falling prices every month. This positive mood is contingent obviously on income staying the same or rising, which cannot occur should prices and corporate profits be under pressure every month. Consider the inflationary degree of the use of “deflation” in the headlines. So far, we are on track to use “deflation” in headlines by a whopping 350% more in 2015 than 2014.
First, let’s attempt to define deflation; since knowing the term and comprehending the concept are two completely different things. There are many great ways to define it: “a period of declining prices, a lack of induced consumption based upon being rewarded for patience, a fearful pragmatic consumer more concerned with the future than the present.” All of these definitions work to some degree; however, the best technical definition I’ve heard was from Morgan Stanley: “…The origin of global deflationary pressures is an excess of desired savings over desired investment.” This describes the current form of deflation almost perfectly considering the coordination of global central banks to inject liquidity into nearly every corner of the globe to inflate assets. There are several forms of deflation (which we won’t really delve into here) such as price, credit, asset and currency. As we see it, there are at least two ingredients required for deflation: a supply-and-demand imbalance and a permeating and dominant form of fear.
The reason deflation is the “boogeyman” to economists is the psychological cycle that is set forth. The world is currently in the throes of deflationary pressures, especially in Europe and Asia. It is important to understand that this perspective is relative, as deflationary pressures for one country might appear as inflationary or disinflationary to another country.
The most well-known and recent bout of deflation has been in Japan which has been in the throes of deflation for nearly 25 years. During that timeframe, a once thriving and soon-to-be-dominant economy slipped to a distant third behind the United States and China. Japan’s decline is multi-faceted and only spells out the difficulty in pulling a country out of this vicious cycle.
For further evidence, consider the impact on yields; look at what has happened in Germany and the United States over the last 15 years. The two historical curves are derived from taking the average yields over the last 15 years and compared to current levels. Your eyes are not deceiving you, yields on the German Bund market are actually negative and the 10-year currently yields 0.46%. You could not only get a return of 0.46% annually on 10 years, but is also denominated in euros, which have lost 27% from its all-time highs and appears to be on track to lose another 10%. That combination only helps if a client is in dire need of tax losses.
Deflation is the dirtiest of “D words” for economists as it seems to defy logic, especially in free market systems where supply-demand balance is orchestrated on large changes in consumerism and corporate desire for profits. However, the culture issue must come into play when looking at cross-country comparisons. The duration of the current deflationary environment, at least domestically, appears to lie in the wage pressure that is slowly building in the system. History has shown that when output gaps shrink, demand for product increases the need for more skilled labor and employment slack begins to unwind, wage pressure can often spike and then slows to a more acceptable pace.
With consumption numbers showing resilient growth and an increased backstop in the form of balance sheet liquidity and net worth, the United States’ deflation experience may not be similar to the ones currently seen in Europe or in Japan. Deflationary and inflationary cycles always have momentum that maintains a trend long after the pressures may be abating. They also have some lagging components. Once the general public begins to use the new lexicon, it often begins its move toward the exit, allowing its antithesis to enter. Buying inflationary protection is very counterintuitive and cheap, two qualities we look for in all value-oriented plays. We believe investors should consider some positions in inflationary-protected assets.
Deflation doesn’t just impact economics and markets, but now we see it encroach on New England Patriots’ game preparation who have fully embraced deflation.
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