Are We In a Deflation Yet?

Most of us are used to inflation for such a long time that deflation is seen as an unlikely event. However, there are always rises and falls in business cycles which has a direct impact on inflation and deflation. After a stunning bull run up until 2007, the stock markets are now tracing out a bear market. The stock market cycle is now headed lower. Similarly, the commodities had a stunning bull run especially crude oil which jumped from 52 USD in Jan 2007 to a high of 146.65 USD in July 2008 before heading down all the way to 32.70 in Jan 2009. It then recovered back to 114.83 in June 2011 and is now heading down again to complete its bear phase. The stunning move on of the oil is captured in the below chart. The similar pattern can be seen in a lot of other commodities such as coal. The chart of Reuters/Jefferies CRB Index (courtesy of Bloomberg.com) below displays the rise and fall of the commodity price. The one asset class within commodities that is still looking strong is gold and silver but both are also in a corrective phase to lower levels for now.

Crude Oil Chart

Reuters/Jefferies CRB Index Chart

Inflation is generally regarded as increase in price of goods. If the rise in price of goods is due to real demand, then, it is a healthy inflation. Inflation that we have been experiencing for a while now is due to weakeaning of the currency. As the currency weakens, the purchasing power of the currency drops and hence, it takes more of the same currency to purchase goods. This is reflected in the rise of price of goods. This is not a healthy inflation as the rise in price of goods is due to a fall in the value of the currency. In order to illustrate this better, consider a pair of Nike shoes that is bought in Singapore and Thailand. The same model might cost 100 SGD in Singapore but it may cost 2500 Bahts in Thailand. Since the Baht is of lower value, it takes more of the baht to purchase the same product.

Currencies gain strength in a booming economy as production adds value to the economy and that is reflected in a stronger currency. Currencies could also weaken in a booming economy if the boom is driven by consumption rather than production as in the case of the US. The US economy is mainly driven by consumer spending rather than production, consumption which does not add any value. In China, its economy is driven by production which adds value. Currencies also weaken due many other reasons. It would weaken in a stagnating or contracting economy as production reduces and cost increases resulting in losses for businesses. Currencies also weaken when more of the currency is introduced to the open market by increasing the base money in circulation. This is also called printing of money. When the currency base is enlarged, it results in inflation as there is a dilution of value of the currency. In essence, inflation is caused by a weakening currency and results in increase of goods and services.

Deflation is the opposite of inflation. In a deflationary environment, the resulting effect is a reduction in the price of goods and services. This can happen in two scenarios. The first is when the demand falls below the supply for example in a recession or contracting economy. The deflation could also happen when a currency gains in value. Deflation is associated with a contracting economy and that is the reason why governments do not like deflation. However, deflation is just part of a natural business cycle. The real deflation started in the year 2000 right after the crash of the Nasdaq. The FED chairman at the time, Alan Greenspan, did not allow the natural business cycle to take effect and embarked on an easy money policy by reducing interest rates. This only helped to fuel a housing bubble and did not help in the recovery of the tech sector as can be seen in the below chart. The Nasdaq is no where near its peak of 5132.52 in March 2000. This is what happens with government interventions, it does not solve the real problem but it creates another problem somewhere down the road. In this case, it created a huge bubble in the housing market and it also fueled further speculation in share market.

Nasdaq Chart

The US housing bubble popped in 2007 and this is again, a natural case of business cycle. Everyone was already in the housing market and once the demand is lower than the supply, the price will deflate. The banks were heavily leveraged due to the housing loans and were at major risk of collapse. The FED once again came to the ‘aid’ of the housing market and the banks to try and ‘save’ them. Once again, the easy money policy of low interest rates were triggered as first salvo. It did not help as there was simply no demand for housing anymore and a large part of the loans were given to people who did not have any steady income. The government then went into high gear and bailed out the mortgage giants of Fannie Mae, Freddie Mac, Ginnie Mae and Federal Home Loan Banks.The housing market is no where near its peak of 2007. The same goes for the banks. The below chart displays the DJ US Banks Index.

US Banks Chart

All these easy money and bailouts are borne by the government and is financed through debt as the US economy is a consuming economy rather than a producing economy. Do note however that the assets purchased by the FED through the bailouts could always be sold later at value. This has resulted in further weakening of the US Dollar and a further rise in inflation. The FED then embarked on QE2 to jump start the economy. The intentions were good, but as long as the business cycle has not completed its downwards cycle, it is not going to embark on its up cycle and jump start the economy. What will happen though is that this money would result in the next big bubble.  As we have seen, the stock market has risen substantially and valuations are again on the high side.

In the mean time, the European debt crisis has spread like wildfire and Greece has clearly lost its ability to pay its debts. Technically, Greece is in default and it is only able to move forward with bailout money from the rest of the Eurozone countries. Portugal, Italy, Ireland and Spain are also in deep debt and the Eurozone is trying hard to help address the debt problem. There will come a time when people will simple lose confidence in offering debt to these nations and the clear sign of that would be reflected in the cost of borrowing. The recent debt offered to Spain was at a whopping 7% interest rate which is not sustainable. This is a clear signal of loss of confidence in the Eurozone countries. Most likely the ECB backed by Germany would come up with some form of ‘QE’ of their own to address this problem. A debt pool is being mentioned frequently which would be shared by all the Eurozone countries. That would cheer the markets for a while before the reality starts to set in again.

All these easy money has created the housing bubble, commodity bubble, and the stock market bubble. The commodity prices have come down heavily from its peak of 2008 and recovered a part of that drop for form a lower high in April 2011. Since then, it has been on a steady decline indicating that the business cycle has yet to run its course. And yet, we are still experiencing inflation which is likely caused by a weakening currency rather than due to real demand. It is just a matter of time before the next phase of the bear market starts. In such times, the consumer would rather hold onto cash than spend. In this final phase, there would be a collapse of consumer confidence that would result in demand falling further and prices coming down hard. That would create a deflationary environment and as we have seen before, the goverments will once again intervene to distort the natural business cycle. They are likely to fail to stem the deflationary mood and will only succeed in creating the next big problem, quite possibly hyper-inflation.

The question is how do we then prepare ourselves for this deflationary bear phase and the hyper-inflation that is expected to result after the deflationary environment. The deflation will result in an environment of reduced prices in property, vehicles, stock prices and general goods. The price of gold is inversely proportional to the value of the currency and hence, it might not drop to an extremely low level considering that the currency value is still expected to be weak. It would be a time when interest rates would be high to support the currency from further weakening. During this time, it would be best to purchase a property as well as a vehicle. It is also advisable to invest in high dividend yielding stocks in the consumer staple sector and defensive REITS (healthcare sector) as the valuation of the asset of REITS would be low and the price of the REITS would also be low in line with its asset valuation with a reasonable dividend yield. The precious metals sector is also another asset class that must be considered.

During the deflationary phase, the governments will go into high gear and provide further easy money to prop up the economy because that is all they can do at the time. But, they would be working against a strong business cycle tide. This would then result in hyper-inflation as too much money in circulation will result in a drastic drop of the value of the currency and the purchasing power of that currency. In an hyper-inflation scenario, the consumer staples such as food, clothes and fuel will be very expensive. It would also result in a very high rental rate of apartments and houses. Transport costs would also be very high. That is the reason why it is important to get a property and a vehicle in a deflationary period. In a hyper-inflation, it would be important to have a steady income and thus, investments in high dividend yielding stocks in consumer staples and defensive REITS (healthcare sector) would provide that. Precious metals are a store of value. During hyper- inflation, the price of gold and silver and other precious metals will rise in line with the hyper-inflation and provide protection of currency value. As and when a trade is needed to be performed, such precious metals could be used to buy the necessary things that is needed. During hyper-inflation, it would also be advisable to grow your own food so that you would not need to spend money to purchase it. It would not be possible to grow all the food but you can certainly grow some of it.

Another option would be to relocate temporarily to a region of which has a lesser degree of impact due to deflation and hyper-inflation. There are plenty of other actions that can be taken to protect oneself from the deflation and hyper-inflation which would be an article by itself.

In summary, the goverment interventions of easy money normally does not result in solving the problem that it set out to do, rather, it would result in creating another problem down the road. In such times, it is important to be prepared in case the economy takes a bad turn. Inflation and deflation are just part of business cycles and one can only be prepared for such occurances if one understands both the cause and effect of inflation and deflation. This article was written to present these topics in a simple manner as well as to provide a guideline of what to look out for and how to survive in such environments. In the following weeks and months, we will keep a watchful eye as the events unfold and publish articles to provide insight into what is happening and how to be prepared in such situations.