In the previous articles of this series I dealt with what deflation is, where it comes from, what “good” and “bad” deflation is, and when and where deflation has occurred. We took a closer look at deflation in the United States in the 1930s, in which excessive debt led to debt deflation and, ultimately, to the Great Depression. For more background, we discussed the two theories of Keynesianism and monetarism, which also serve as user’s guides on how to prevent depressions in the future through central bank or government intervention.
We are now in a structurally deflationary environment, due to weak global growth, overcapacities in many industries, and considerable gains in efficiencies through information technologies. Heavy global debt burdens therefore pose a very great danger of debt deflation, with all its dramatic social and economic consequences.
In the conclusion of my previous article I promised that in the last instalment of this series I would examine the repercussions of this deflationary environment for the financial markets and reflect on what steps an investor should take.
Before going into how the various asset classes have behaved in a deflationary environment, here are some preliminary remarks.
First of all, long-term, sustained deflation is not at all inevitable. It is, in fact, far less than likely, as central banks worldwide are aware of this risk and are conducting a very expansive monetary policy in response. And if, as in past years, this is not insufficient, they have resorted to unconventional measures, including aggressive liquidity programmes for banks, sovereign bond purchases, negative deposit rates, corporate bond purchases and, in Japan, even equity purchases.
Suggestions of releasing so-called helicopter money, i.e., “dropping” freshly minted money from a “helicopter” into consumers’ waiting arms, may now seem far-fetched, but they clearly show that those in charge will not shrink from taking extreme measures to ward off (debt) deflation or to cushion its impact so that their economic and social consequences are manageable.
Nor is it certain how long deflation would last, how global it would be in scale and what impacts it would have. Most of the largest national economies could no doubt withstand a short bout of deflation lasting one or two years. But the longer deflation lasted, the more likely debt deflation would be, which might lead to a depression. But even that is not certain. The example of Japan shows that moderate deflation even over 20 years does not necessarily have the effects that the Great Depression had in the US. Likewise, Switzerland has been living through deflation for more than 10 years, and that doesn’t seem to have bothered anyone too much.
But even if deflation did occur globally or at least in one large currency region, the reaction of asset classes on the financial markets would be only somewhat predictable.
For one thing, the markets might not be able to price in, or price in fast enough, this fundamental shift in paradigm. But, mainly, the interventions of central banks or governments, which are driven not by economics but by politics, could have a heavy impact on price formation. On top of the direct buying and selling on the financial markets that they already practice, this could be in the form of restrictions on the movement of cash, capital market controls, currency reforms, debt haircuts, special taxes on certain asset classes (such as real estate), or restrictions on holding or trading certain forms of investment such as equities, structured products, gold, currencies or cash.
As things now stand, such measures look extreme but consider this: 1/ I also recently regarded negative interest rates as an extreme measure and could never have imagined that they could last this long; and 2/ most of the aforementioned instruments have been used, at least indirectly, in at least one of the G7 countries since the Second World War.
In reaction to this implied threat, investors must draw the first and most important conclusion: to diversify their holdings, so as to limit the impact of a political measure, if any is taken.
For my further reflections on how asset classes are likely to perform amidst deflation, I have made three assumptions:
- Deflation increases the value of money. That means that even a negative nominal return represents a real gain for the investor, as long as it is lower than money’s increase in value.
- Debt and debt interest rates are normally nominal and fixed. Debtors are therefore the big losers from deflation and – as long as debtors pay – creditors are the winners.
- As there has been (moderate) deflation in Japan over the past 20 years, the performances of various asset classes there can serve as a reference point.
Based on the first assumption, cash, obviously, is the most reasonable asset class in a deflationary environment. When prices of goods and services fall, a zero-rate deposit at the central bank is risk-free and earns a positive real interest rate. Keep in mind, however, the costs incurred in transporting, storing and insuring cash, costs that are subtracted from the real interest rate. Other barriers to the practical use of cash deposits are money-laundering laws that, for example, restrict the amount of cash transactions and make large cash transactions almost impossible.
Of course, deposits on current, savings and term deposit accounts can be classified in the same category as cash, as long as the fees and interest that the investor must pay are no higher than the deposits’ increase in value. However, be careful where you park your money. Here is where the second assumption comes in: a financial establishment that has lent out too much that is not repaid can become insolvent. In this case deposits at these establishments that surpassed the insured amount are in great jeopardy.
During past deflationary phases, bonds from issuers that, even in extreme conditions, were able to honour their commitments, were still a better investment than cash. As a rule, these are government bonds, which are an attractive investment precisely during a long, drawn out period of deflation. An example of this is the performance of Japanese government bonds in recent decades. Despite a low initial yield of 3.07% [1][1] on 10-year Japanese bonds at the end of 1995, the index rose by 2.81% annually in yen terms until the end of May 2016 with little volatility.
JP Morgan GBI Japan
Compared to the current 0.01% p.a. yield on 10-year German government bonds (as of 17 June 2016), the 3.07% earned on 10-year Japanese governments bonds in late 1995 is almost heavenly, and it is worth asking whether it is already too late to achieve a positive real yield after fees and taxes, even amidst moderate deflation.
Before you dismiss this assumption by saying “In that case I can just park my money in cash”, you should remember that government bonds will perform well during financial crises and that we in the euro zone is in a special situation that is making German government bonds attractive despite their low nominal yields.
As countries have relinquished their money-creation sovereignty to the European Central Bank, an overly indebted country could also default. For example, during the Greek crisis of 2011 even solid financial establishments encountered difficulties and there is no reason this couldn’t happen again. An apparently safe current account could actually become a risky investment, unlike German government bonds.
In addition, there is a risk in Europe that the single currency could give way to various national currencies. In this case, German government bonds offer reasonable protection even at negative yields.
If, moreover, another, even worse crisis of confidence were to occur, in which even German government bonds could not provide adequate protection, it would make sense to invest in precious metals. Mainly for lack of any alternatives, gold and silver would rise in value. However, as there has been no measurable correlation between inflation/deflation and gold prices since the end of the gold standard, I believe that an investment in precious metals is not very reasonable as a hedge of such a disaster scenario.
But back to the scenario of how various asset classes would behave amidst a long, drawn out phase of moderate deflation. In addition to government bonds, there are, for example, corporate bonds. Under my second assumption, this seems to be a good idea, except that the number of defaults tends to rise in a deflationary environment. So investors must be sure to invest their funds in highly rated borrowers.
In the hope of achieving better returns particularly in times of extremely low interest rates, many investors invest in higher-yielding foreign-currency bonds. This is dangerous over the long term, precisely in a deflationary environment. Since the end of 1995 (i.e., for about 20 years) the Japanese yen has been almost unchanged vs. the US dollar, albeit within a wide fluctuation range of more than 30%. Investments in foreign currencies should therefore be moderate, closely supervised and, perhaps, hedged for currency risk.
JPY / USD
Equities are clear losers in a deflationary environment. Consumption shrinks during deep recessions even though goods are cheaper. Companies therefore invest less, their profits suffer and so do their share prices. Because of the loss of confidence that always comes with deflation, investors will also demand a higher equity risk premium, and price-earnings ratios will therefore fall. This has been especially apparent during economic slumps, when equity markets crashed. From the very start, share prices fell about 33% from September 1929 to November 1929. In the medium term it got worse: on 8 July 1932 the index bottomed out at 41, corresponding to a drop of 89% from September 1929. Not until November 1954 did the index revisit its level of 1929.
Performances on the Japanese markets also show that equities can drop in value amidst deflation. At the end of 1989 the Nikkei hit 38,915 points. By the end of February 2009 it had fallen to 7568, or about 20% of its high-water mark. Even today, at about 16,000 points, it is still far from its level of the end of the 1980s.
Nikkei 225
You often read that, in reaction to low interest rates, uncertain economic prospects and volatile financial markets, real estate is the easy way out. But I would warn against such an “easy” route, precisely in a deflationary environment. For example, a Bank Sarasin study found that the Japanese real-estate market had fallen by 80% since the deflationary period began in Japan, in 1989/90.
Most of this drop is clearly due to the bursting of the real-estate bubble back then. But it also makes sense that real-estate prices should fall during deflationary periods. As wages and, therefore, income available for rent, is squeezed, rental income and, hence, real-estate prices will fall on average. In commercial property, as well, falling prices mean that companies have less money for real-estate financing. So real estate does not provide blanket protection from nominal losses in value in a deflationary environment.
I would like to warn particularly of the dangers of a debt-financed real-estate acquisition amidst deflation. While the value of the real estate falls, the value of the loan rises. If equity in the property is too low, it is entirely possible that the value of the bank loan will ultimately be greater than the property’s value.
The above statements have been quite sweeping in nature and are based on a static reaction of passive investments, for example in index funds. But in most asset classes there are always opportunities (and risks) in active management – i.e., skilful timing in buying and selling the asset class, particularly by picking individual shares within an asset class – and through patience.
In retrospect, market timing may look easy for one or more asset classes, e.g., buying shares low and selling them high. But, in reality, I don’t think there is anyone who can do this on a regular basis. Moreover, the phases of over- and undervaluation of an asset class are simply too long. Remember when Alan Greenspan, the then-chairman of the US Federal Reserve warned of “irrational exuberance” on the equity markets? Well, over the next four years the S&P 500 rose further, in fact doubling, because the market mood had simply not taken rational valuations into account.
Individual picking of securities is more worthwhile, more sustainable and also more feasible, but requires much patience and time for research. Take the share price performance of Fanuc, a long-time producer of automation and robots, mainly for the auto industry and a technology and market leader in its segment. The Japanese company is almost debt-free and has over many years won over believers through its products, customer service and solid management – the best prerequisites for achieving good results and making money for shareholders, even during a long period of deflation.
And indeed, an investor who bought the share at the end of 1995 and then reinvested all dividends into buying more shares earned 7.9% p.a. in Japanese yen terms. Over the same period the Nikkei 225 returned 0.5% p.a. An impressive outperformance by Fanuc shares. But the investor did first have to find the share and then, right off the bat, be very patient as the share price dropped more than 16% in that first year, 1996, while the index was down less than 2%. Most investors would have thrown in the towel after such an underperformance and missed out on the performance of the following years. And, of course, the investor not only had to hold the share patiently for more than 20 years but also reinvest its dividends in more shares. Very few people have this much patience and conviction.
