Over the coming years, the world economy faces the terrifying prospect of either persistent deflation or rampant inflation - and very possibly one followed by the other. Few British investors today have much practical experience of these problems. Deflation last struck in the 1930s and inflation in the 1970s. Both falling prices and rapidly rising ones can have a devastating effect on many of the investments we rely heavily upon.
The credit crunch is, by nature, a deflationary force. Deflation is not first and foremost about declining prices, but about shrinking credit. As companies and people try to pay off their debts at the same time, they cut back on their investment and spending. This hurts economic activity, creating unemployment and further cutbacks. Assets are sold off in a bid to cut debt, which forces their values down. A vicious circle of falling prices and contracting credit takes hold.
As well as borrowers repaying debt and lenders feeling reluctant to make fresh loans, there are other powerful deflationary forces at work. In the wake of the recession, there is a lot of slack in the world economy. Factories and workers are lying idle. China has invested heavily in an attempt to stimulate its economy, creating even more spare capacity. This limits the scope for firms to raise prices or for workers to demand pay-rises.
The risks of deflation - at least over the next few years - are probably greater than many people realise. Deflation is bad for the stock market, as companies are stuck with fixed debts and narrowing profit margins. Among the winners during Japan's struggle with deflation have been healthcare equipment & services, personal goods and mobile telecoms. Banks, real estate, and construction & building materials figure as prominent losers.
Government bonds are obvious holdings for deflationary times. Longer-term paper - like 10-year bonds - performed well in the American Great Depression and also during the Japanese crisis. The best-quality corporate bonds might prosper, especially those with better creditworthiness than leading governments. By contrast, real estate and industrial commodities - such as copper - would tend to suffer. Gold is a more likely winner.
At the same time, the authorities' response to the deflationary threat risks creating the opposite problem. By keeping interest rates at record lows and by printing money, many investors fear an outbreak of upwardly-spiralling prices, as more cash chases the same amount of goods. So far, there are few signs of this. But economists reckon that it could take a couple of years before money-creation feeds through into inflationary problems.
It is possible that governments actually intend to stoke up high inflation, rather than just avoid deflation. High inflation would destroy the real value of the huge debts that countries, businesses and people built up during the boom years. This course of action would be far from painless, however. One person's debt is another's asset, so bondholders and other creditors would lose out massively. It would also undermine the credibility of governments and central banks, making it harder for them to pursue their policies in the future.
As with deflation, inflation deepens uncertainty about the outlook for the economy and for investment. Although the stock market has held its value well in the face of rising prices over the long run, its performance during inflationary bursts in the short-term has been poor. US equities fell during five of the last eight such episodes. Companies that are most able to pass on rising costs to their customers should perform best under such conditions.
Bonds would inevitably get slaughtered if inflation came back with a vengeance. Neither government nor corporate paper is safe when prices really take off. But it is not clear which other assets would necessarily prosper. While there were some clear winners and losers during the roaring inflation of the 1970s, this was but one episode. The picture becomes much murkier if we look at previous inflationary crises.
For example, it is widely believed that gold does well under inflation. But its value has fallen in five of the previous seven periods since 1775 where consumer prices have taken off. Other commodities - including copper and wheat - also have an uninspiring record in these times. The same goes for real estate. US housing fell during the early 20th century inflation and barely maintained its value in the 1970s.
While deflation and inflation are the opposite phenomena, there is nothing inconsistent about believing that we will see both over the coming years. Indeed, a likely scenario is that we continue to suffer from deflationary problems, which eventually give way to inflationary ones. In such an environment, shorter-term, opportunistic investing is likely to beat a buy-and-hold strategy. But making the correct calls will be a very difficult task.
