Deflation and investing is a subject that is not given enough thought. The purpose of this post is to examine six indicators to analyze the probability of deflation and how they relate to your investment analysis.
A favorite quote of mine comes from contrarian investor Humphrey Neill, who said, “when everyone thinks alike, everyone is likely to be wrong”. There is an almost universal belief that we are headed towards inflation because of the Federal Reserve and their expansionary monetary policies. I contend it would be prudent to keep an eye on deflation too, especially since it is the most destructive inflation trend.
What is Deflation?
Deflation occurs when the general price level of goods and services decrease. This is the opposite of inflation, where price levels increase. Deflation increases the value of money or cash because it allows you to buy more with the same amount.
Deflation is the most dangerous inflation trend. Deflation is connected with a shrinking economy, high unemployment, collapsing revenues and profits, falling wages, and a propensity to hoard money instead of investing for the future.
Possible Causes of Deflation?
1. Decreases in the Money Supply
Many economists believe the Great Depression of the 1930s was exasperated by the Federal Reserve reducing the money supply. A falling money supply translates into less money in the pockets of consumers and investors, causing economic activity to diminish.
2. Too Much Debt
Leverage works both ways. It can boost returns in good times and magnify losses in bad times. An economy, government, industry, company, or family can be destroyed with too high a level of debt.
If an entity can not service its debt because of rising interest rates or falling revenue it will have to default or implement austerity measures. Either option reduces economic activity and can put downward pressure on prices.