Investing during deflationary times is a big challenge. Thankfully, such episodes have not occurred too often. But we can study the experiences of US and UK investors in the early 1930s and from those of the Japanese in the 1990s to identify which assets may do better and worse than others.
Equities
Apart from hyperinflation, deflation is the single worst environment for shares. Deflation took hold in the US in early 1930 and ended in late 1933. During that time, equities lost almost 60 per cent of their value, and far more at various stages within that period. And from the time that consumer prices first went negative in Japan until the present, the stock market there has fallen by one-half.
Falling prices mean that companies' profit margins are constantly squeezed. Weakly growing or shrinking profits are unattractive to investors, who award shares lower valuation multiples. Firms with large debts should most likely suffer worst, as the cost of servicing their liabilities would remain fixed while the profits they generate to meet those payments shrivel.
If deflation does take hold, the outlook for equities is likely to be absolutely dire. The Elliott Wave Institute – one of the few major financial forecasting firms to have consistently predicted deflation – is calling for a multi-year bear market in stocks, of which the most savage stage of declines is probably just around the corner.
I agree that if we enter a prolonged deflation, the path for equities will be sharply downwards. My own technically-derived view highlights the risk of the FTSE 100 eventually declining to 2250 and perhaps even lower still.
As a rough guide to which sectors might fare best – or less badly, at any rate – I have looked at the performance of Japanese shares during their deflationary crisis since the 1990s. Somewhat arbitrarily, I have divided the period into sections depending on the direction of the inflation rate.
Among the industries to have done best compared to the wider stock market during the worst bouts of deflation in Japan are oil & gas, chemicals, healthcare equipment & services, personal goods and mobile telecoms.
Cash
Holding plain old cash during a deflation is not a bad idea at all. Whereas in normal times, cash is steadily losing its value because of inflation, the opposite is true under deflation. As time goes by in such episodes, your money has more buying power rather than less as prices go down. As a result, people may delay purchases in expectation of a better deal later on, which may exacerbate the economic slowdown and deepen the deflation.
It's always important to focus on the real interest rate you are earning on your holdings of cash, rather than the nominal one. In a really sharp deflationary period, official interest rates may dictate that banks may end up offering zero per cent on savings accounts – or perhaps even a negative rate of interest. However, even losing a couple of percent a year on your savings could be a far more attractive option than holding equities or other risky assets that are collapsing at double-digit rates!
Government bonds
Because they pay out a fixed income and return a set amount at the end of their lifetime, government bonds are an obvious investment during deflation. The value both of the interest you receive and the bond itself are likely to rise.
During the 1930-33 deflation in the US, long-dated Treasury bonds returned 18 per cent even before taking into account the positive boost from increased purchasing power. Japanese 10-year government bonds have fairly reliably beaten the stock market during each of the dips into deflation over the past decade or more.
However, at moments of extreme economic turbulence during a deflation, even government securities can come under pressure. In late 1931, US government bond yields jumped – and hence prices fell – as Britain's devaluation of sterling spooked world markets.
Whether you consider German Bunds, US T-Bonds or UK Gilts today, you may be put off by the low yields available on these instruments. However, this is a mistake, as these instruments can still produce excellent returns even when the interest rate they offer is low.
A Japanese investor in 1993 may well have turned his nose up at the offer of buying a 10-year bond yielding 3.7 per cent – the same yield on offer on UK gilts at the time of writing. After all, in the previous five years, the average rate on Japanese government bonds had been 5.6 per cent. However, yields subsequently fell to just 0.8 per cent over the next 10 years. So, an investor who had bought at 3.7 per cent made a positive total return of 62 per cent over the period, whereas an investor in the stock market lost 17.2 per cent.
If the world slips into a prolonged period of even mild Japanese-style deflation, therefore, today's yields on German, UK and US government bonds may seem like a steal within a few years.
Corporate bonds
The best-quality corporate bonds – those with top scores from rating agencies – might seem as attractive a proposition as government bonds during deflationary times. Indeed, with some companies in better financial shape than some of the world's leading governments, there is even a case that they may be better during such times.
Triple-A rated bonds performed reasonably well during the worst of the 1930s deflation, their yields slightly declining from 4.7 to 4.5 per cent, implying an increase in their values. But it was not a smooth ride, with prices falling somewhat around the middle of period.
The best approach would be to be selective when picking corporate bonds, sticking only to the highest-rated bonds issued by firms in defensive industries, such as food, beverages, pharmaceutical and tobacco.
Commodities
Commodities are best known for keeping their value well during times of inflation or expected inflation. But they don't seem to do so well when the general price level is falling. Copper and oil both fell during the 1930s deflation, as well as during previous episodes.
By contrast, gold and silver have done somewhat better during deflationary periods. However, this is not to say they would necessary do so again were deflation to strike in today’s world. Formerly, both metals were used as currency. As such, they rose during deflation, as their purchasing power was increasing. Nowadays, there is no such link between money and currency, and hence less likelihood they might retain their value.
Real estate
Long-term records for property are somewhat patchy, but the price of British houses did decline by more than the general price level during the deflationary years of the early 1930s. With valuations still close to historically high levels both in the UK and elsewhere, the outlook for residential real estate is probably poor in any event. In an outright deflationary environment, the price of homes is likely to do very badly indeed.
Foreign currency
We have already established that cash is an obvious holding during times of deflation. Doing so via different currencies might be a logical approach. The biggest winner of all could be the US dollar, in which most of the world's debt in denominated. In a situation where debt is being paid off everywhere, there would be therefore demand for dollars in order to meet those obligations. As a result, those who fear deflation tend to be dollar bulls.
