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5 tips for surviving a period of deflation

Consumer demand, Currencies, Economic growth, Futures trading, Oil markets
By Paul Hodges on 10-Aug-2010

Burst balloon.pngThe blog has been revisiting the Bank of England’s 2008 analysis of the likely impact of the financial Crisis.

This reviewed 33 banking crises between 1977-2002 and found that:

• The average length of each crisis was 4.3 years
• The median loss of GDP was 7.1%
• Major crises (such as today’s) caused GDP losses of at least 10%.
• GDP losses can double if the banking crisis leads to a currency crisis

The study also found that it was initially easy for Governments to borrow, but that (like Greece this year) they faced the risk of a currency crisis if foreign lenders began to suspect they would never be able to repay the money borrowed. Companies would also find it more difficult to borrow, as banks “de-risked” their balance sheets.

Meanwhile Consumers faced an increased risk of unemployment, and so tended to save more, rather than spend money. In turn, this reduced demand – further pressuring companies, and government’s ability to provide fiscal stimulus.

As a result, whilst government intervention could mitigate a crisis, the study found that credit crunches are deflationary.

18 months later, it appears (to the blog, at least) that we are following the text-book pattern. Clearly this is still not the consensus view. But helpfully, the Wall Street Journal has provided 5 useful investment tips for dealing with deflation:

Stocks. It notes that “deflation is generally bad news for stocks, since a period of falling prices and weak demand tends to weigh down corporate earnings and, therefore, share prices“. However, it says that companies that dominate an industry can do well, as might those “with plenty of cash, low debt, steady dividends and products that people will buy even in tough economic times“.
Bonds. The WSJ suggests that “in a deflationary environment, longer-term government bonds tend to do well. As investors rush to the safety of Treasuries, yields drop and prices jump, resulting in higher total returns“. However, “inflation-linked securities could lose value in a period of sustained deflation“.
Cash. It notes that “cash is king in a deflationary world. While investors may not earn much interest, cash gains in value as prices fall“.
Hard Assets. It suggests that “deflation generally means falling prices for commodities, real estate and other hard assets. But as with stocks, investors shouldn’t write off the category altogether. Gold, which many investors consider an inflation hedge, also can be a useful deflation-fighting tool. The government tends to respond to deflationary concerns by printing money, which in turn can spark fears of inflation and drive up the price of the metal. Gold is a hedge against financial stress.”
Debt. It notes that “deflation generally isn’t kind to debtors” as the value of the debt remains steady, whilst prices generally are falling.