Definitions of inflation, hyperinflation and deflation from the last blog (Inflation - March 21, 2010)
Definition of inflation from Yahoo Education: “A persistent increase in the level of consumer prices or a persistent decline in the purchasing power of money, caused by an increase in available currency and credit beyond the proportion of available goods and services.”
Definition of hyperinflation from Yahoo Education: “Extremely high monetary inflation.”
Definition of deflation from Yahoo Education: “A persistent decrease in the level of consumer prices or a persistent increase in the purchasing power of money because of a reduction in available currency and credit.”
Deflation can be caused by the following:
1. Increase in the supply of goods is growth deflation. This can lead to a decrease in the Consumer Price Index (CPI). A good example of this is Natural Gas (NG). Recent technological advancements have allowed the development of NG deposits previously thought to be unreachable and this has led to a decline in the price of NG. The Exchange Traded Fund (ETF) that tracks the future one month contracts of NG (UNG – United States NG Fund) is down from $60 in June 2008 to the current price of around $7. This can be good for the economy - when prices go down because of the increase of goods everyone’s wealth can increase. Since you are now paying less for NG, you can buy other goods or invest the money you saved.
2. Reduction in spending of consumers. When people refuse to spend money on goods it can lead to a decline in prices unless the money supply increases faster than the economy is growing. For example, when the unemployment rate increases consumers will start saving more money (the saving rate goes up) and the only way goods sell is if the price is decreased (i.e. the store has a 50% sale on goods to reduce their inventory). This can have a circular effect the result of which is to drive down prices. The consumer will not buy anything unless it is on sale (price reduction). For example, I will not buy a new automobile unless there is $3000 rebate and zero percent financing.
3. Reduction in investment value or liquidity in the market. For example, the stock market or real estate has a significant decrease in value, and consumers have less money to spend. For example, the home owner can no longer use his house as an ATM (take out money) because its value has decreased. He can’t go buy a new BMW by refinancing his house.
4. Bank credit deflation. Reduced availability of bank credit because of new rules regarding credit worthiness, the high bankruptcy rate, and central bank policies can make it more difficult for businesses and consumers to get loans. I cannot get a loan to buy a new automobile, house or start a small business. A corporation cannot get a loan to buy capital equipment. This can spur the decrease of the price of goods.
5. Reduction in government spending. For example, the federal government has to decrease spending on goods because its debt load (payments) makes up an increasing part of the budget. There is also a reduction in tax collection (the unemployed/underemployed pay less taxes, spend less on taxable goods, etc.) The resulting decrease in demand for goods feeds into a downward trend in prices. For example, states’ budgets have decreased because of lower tax collection, which can drive down the price of goods and services, and in turn drives unemployment higher.
The best investments for periods of deflation are the following:
1. Medium to long duration bonds. The Feds may reduce interest rates with the intention of stimulating the economy; this would drive up the value of a bond as interest rates decline. (Paradoxically, while this is usually one of the best investments for deflation, it would not work well now with interest rates at historic lows.)
2. Currencies, stock or assets of countries that do not have deflation. If you own assets or currencies in countries that do not have deflation, your assets will increase against the currency decreasing. For example, if you own the currency of Brazil which does not have deflation, you will have more money to purchase assets in the US.
3. Short Equities. During deflation companies have decreasing revenue and lower margins. This usually leads to decreasing stock prices for the majority of stocks. You could use ETFs to short or leverage short (i.e. 3X short) the market. For example, you could short the S&P 500 using ProShares Short S&P500 ETF (SP) or leverage short the S&P 500 using ProShares UltraShort S&P500 ETF (SDS).
4. Short leverage assets (for example real estate). As prices collapse the value of the asset will continue to decline. You will want to short any company or asset that is highly leveraged. The value of the asset will continue to unwind and companies or assets that are highly leveraged will continue to decrease in value.
5. Cash is king. You want to raise cash and have less debt. Assets will decrease over time and will become cheaper. If you have cash you will be able to buy a lot of assets at reduced prices.
6. High paying annuities. If you can lock in a high paying annuity it will continue to pay cash as interest rates decline and the value of the annuity will increase.
The worst investments for deflation are the following:
1. Highly leveraged assets. As the value of an asset is decreasing, it gets more costly to pay the debt. This is the worst investment that you can be in during deflation. For example, you own a house that is 100% financed, the value of the house is decreasing and it is more costly to pay the debt (woe to you if you will not be getting a raise or if your pay actually decreases!). You do not want to be forced to sell assets to generate cash during deflation.
2. Debt. Any debt will be more costly to pay off during deflation. Remember cash is king in deflation periods. If you have cash you can buy a lot of reduced cost assets.
3. Long Stock. You have to be very selective in the stocks you buy. There will be revenue, profit and margin pressure during deflation which will drive down stock prices. Companies that are highly leveraged (have a lot of debt) will not be good investments (it is more difficult to pay for debt when there is deflation).
Please add your insight. For example, when will the US have inflation or deflation? I would like to have an on-going discussion of financial and investing ideas.
Next week, I will write about when I think we will have inflation, deflation or stagflation. Future topics may include:
- What investments will be good investments with rising inflation and interest rates?
- Warning signs of inflation or deflation
- Shorting US currencies
- What sector will do the best in 2010?
- Update on performance of blog trades
- Financial rules / lessons (school of hard knocks)
- Other topics
In April I will be starting a financial website (www.paulsgang.com) and in the summer I will be kicking off a financial podcast with Fullstacks, Mr. C and C4.
© 2010 Paul Cusick
My favorite financial books that I have read in the last 3 months:
The Ascent of Money: A Financial History of the World
The Greatest Trade Ever: The Behind-the-Scenes Story of How John Paulson Defied Wall Street and Made Financial History
The Big Short: Inside the Doomsday Machine
Paul
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