Thursday, November 19, 2009

What Deflation Looks Like

Bert Whitehead, M.B.A., J.D.

For years we have been told about the evils of inflation. But now we are witnessing deflation, which most people have never experienced since 1950. What does deflation mean for you today? How is the economy affected? How bad can it get?

Inflation is an economic phenomenon that has been described as too many dollars chasing too few goods. Deflation occurs when the opposite happens -- too few dollars are being used to buy the available goods.

For most of this decade credit has been abundant and too much money was lent, especially to people without a strong financial foundation. It was easy to buy houses, cars, take trips, etc. As borrowers defaulted en masse on mortgages, student loans, car loans, etc., the banks and other lending institutions curtailed lending to consumers and to businesses. This resulted in an alarming drop in sales of cars, houses, etc. Retail sales across the board have shrunk as people became very frugal.

The downturn is compounded by a significant increase in the average family savings rate from about 1% of household income a few years ago to 6%+ now. The stock market dropped to the lowest level in 50 years, which caused working people to be alarmed about their retirement prospects. Seeing your house drop in value along with your 401-k is gut wrenching. So people are improving their “balance sheets” by paying off debt and increasing their savings at a feverish pitch.

These developments are good in many ways because we are weaning ourselves off the spending binge that lasted until about 2007. The downside is that companies have trouble making a profit because they have to cut their prices so much to sell their goods and services. This impacts suppliers. New orders for their products drops. To survive, all businesses are cutting staff. Then unemployment rises, there are even fewer purchasers, and people refrain from buying things because they either don’t have the money or they expect prices to drop further. This cycle creates a vicious vortex which sucks the wind out of our economy and causes deflation.

The big danger is that this downward spiral can worsen over time. As more people lose their jobs they can’t buy goods and services, sales continue to drop, and employers lay off more people, etc. Economists call this a drop in ‘velocity of money’ and, if it continues, it could cause a severe depression. At that point, it is very difficult to regain economic momentum. The Great Depression of the 1930’s only ended when we went to war in 1941. War increases employment, and creates a strong demand for armaments (which keep getting blown up and have to be replaced).

Deflation also causes the value of our dollar to drop against other currencies. For American workers, this means that the price of imports and the cost of travel abroad increases. For non-U.S. residents this situation is a bonanza: for example, Europeans can not only buy more dollars with each Euro, but those dollars will buy more U.S. goods, and travel to the U.S. is a real bargain. As foreigners buy more U.S. goods and services and travel here to spend their money our balance of trade is favored.

Swings in economic activity are often self-correcting. As prices drop during deflation, the value of the dollar for U.S. residents actually increases and we can buy more for less money. For example, the price of real estate has plummeted in many areas, the negotiated price of cars has dropped, and most retail stores, restaurants, etc. are offering enticing specials.

The U.S. is not the only country facing this situation: the whole world is experiencing deflation. But a free market economy like ours is affected sooner because a higher degree of our spending is non-governmental compared to many other mature economies. To address the danger of deflation, the U.S. government had to inject money into the economy using stimulus spending. Most countries have a stronger social ‘safety-net’ like unemployment benefits and free health care. They have decided that, for now, additional government spending in the form of a stimulus is not necessary.

Most of the U.S. stimulus money, however, is being spent on government jobs that do not create additional employment. The ‘TARP’ money earmarked to shore up our banking system isn’t being lent out by banks to create economic activity, as was expected, but is rather being used by the banks to repair their own balance sheets and recapitalize. So the ‘law of unintended consequences’ has kicked in to further complicate the situation.

Investors are faced with very low interest rates on their savings. Series I Savings Bonds, which accrue interest on an inflation-adjusted basis, are now paying zero interest due to deflation. As you well know, it’s all but impossible to find bank savings accounts or money market accounts that even pay 1%!

What can you do to combat deflation? The best hedge is U.S. Treasury bonds, which have a fixed interest rate over the life of the bond and are non-callable (i.e. cannot be paid off earlier than the original maturity date). Including them in your portfolio preserves your purchasing power when equities in your portfolio decline.

Although infrequent, deflation has its particular perils and it is important that you build protection into your portfolio to shield you from its devastating effects. It is actually more important to protect a portfolio against deflation with fixed rate Treasuries than to try to sidestep inflation by filling a bond portfolio with TIP’s (inflation adjusted Treasuries) that leave no defense against deflation.

We are a resilient nation, and we will survive this economic cycle. Indeed there are simple, sensible approaches you can take to ready yourself for all economic environments - deflation, inflation, or prosperity. The key is to build and maintain a balanced approach that positions you for any economic scenario. You’ll be able to stop trying to predict what might happen because you’ll know that you are prepared to face whatever does happen. Isn’t that one of the best “returns” your portfolio could ever provide?

I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.

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