The Hidden Threat of Deflation - What that Means for Investors
Updated: Jul 14, 2022
The current efforts by policymakers to tame inflation "expectations" are increasingly likely to overshoot and cause a recession, possibly a deep one ironically characterized by deflation rather than inflation! Consider the following demographics-based narrative for what's happening.
The economies of the developed world are aging rapidly. The baby boomers, the richest and largest cohort of the world economy, are all 58 - 76, with the bulk of us closer to 58. There have been a lot of people in the same age group to compete with all our lives, but we have established careers, so we rode out the pandemic relatively unscathed in fact, the pandemic stimulus gave us a huge boost in buying and borrowing power.
We used this newfound wealth to catch up on some things we felt we deserved but could never quite get, like bigger houses and why not at such low rates? This stock market and house price fueled wealth effect was in place until the beginning of 2022. The older baby boomers retired and the younger ones checked off the housing and durable goods on their bucket lists. This spring and summer, we booked vacations - the first time you could safely travel again - to see loved ones we hadn't been able to visit for the preceding two years. Of course, we did!
With these factors and more in play, there was an inflationary boom in prices and employment. Are these factors temporary? There are many reasons to think so, but sticking with the demographic case, now the baby boomers and other cohorts find themselves with larger debts and a renewed focus on the very short runway toward retirement. Meanwhile, the stimulus funding rapidly recedes, and the stock and bond investments have been dismal. Interest rates are rising fast against these higher debt levels, and house prices have already begun to fall. Many baby boomers are standing on top of a mountain of debt, watching interest rates creep up, thinking, "uh oh." Guess what we are going to do next?
The stock market, which could only go up for the last five years, has betrayed us in the last six months. And the cost of holding debts has now doubled and tripled. The downward trend in house prices, where the bulk of our wealth is held, is the other shoe to fall, so we are going to revert to what we were doing before the pandemic stimulus distracted us - deleveraging! toward the goal of retirement - see the link to a related article in the preceding paragraph.
The boom in housing and the stock market was fueled by an astonishing abundance of capital and low-interest rates. The coming housing price and economy-wide contraction will be fueled by reduced access to capital and rising interest rates. But this trend toward rising interest rates is sure to reverse itself in the next 12 months and not a moment too soon.
The Paradox of Savings
The only thing worse and harder to tame than inflationary expectations, the strawman the central banks are trying to fight, is deflationary expectations. Why? because inflation is forgiving and deflation is destructive. Inflation redistributes wealth and creates employment by forgiving debtors, deflation concentrates and destroys even well-managed companies that were suppliers to the debtors.
The economist John Maynard Keynes coined the term "The Paradox of Savings" in the 1930s to describe the conflict between the incentives of individual households to cut spending aggressively and pay down debts vs. the collective societal incentive of continuing to take risks and participate in the economy. We may be about to face this paradox; in fact, it's already started.
Here is a link to a recent article that spells out the case for deflation from an economic point of view.
So What is an Investor to Do when Rates are High, and Deflation is Looming?
The simple answer is - overweight income-oriented investments. Do we know for sure the accuracy and extent of the deflationary threat? nope. As loyal followers of the No Idea Approach to InvestingTM, we don't presume to know the future; however, we do respect long-term trends.
The good news is the Rigden Financial Model Portfolio is already positioned well for deflation. 31% of the portfolio is allocated toward fixed income investments (AKA Bonds), and another 25-35% is invested in companies that pay regular dividends, which also perform better under deflation. The remainder of the portfolio is invested in the new technology-heavy NASDAQ 100. Although these technology companies will suffer along with others in a slower growth environment, their bright future earnings potential will be worth more in the falling interest rate environment that comes with deflation. Why not just move everything into cash and bonds? Because what if we get stagflation instead? As Warren Buffet says, productive assets are the safest place to invest for the long run.
Here is a link to an infographic that demonstrates how long it takes for portfolios with different allocations to stocks and bonds to recover after a bear market.
There are many reasons to believe the current inflation scare is a temporary phenomenon and that aggressive rate hikes by policymakers will create a deflationary recession as supply chain issues and pandemic effects recede. The ageing demographic profile of the developed world economies creates long-term deflationary pressure as the youngest and largest cohort of the baby boomer generation shifts focus from consumption toward retirement.
Bonds and dividend-oriented investments perform best in deflationary environments, as do companies with strong future earnings growth potential. The Rigden Financial Model Portfolio is well positioned for these market conditions, with 66% bonds and dividend stocks and 34% future growth-oriented technology stocks.
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