Living in deflationary times

If we were to enter a period of deflation, and I’m not necessarily saying we will, cash would become a growth asset, in real terms.

We know that inflation depreciates the real capital value of cash or fixed-term investments (ignoring the interest received). Conversely, deflation would cause its real value to appreciate.

It is said that inflation transfers wealth from the lender to the borrower, as they can repay in cheaper dollars. Deflation would transfer wealth from the borrower to the lender.

Banks would know that if they took a $100,000 three-year deposit, the real value of the principal they repay would be greater. They would pay little interest for the ‘privilege’ of losing money in real terms — perhaps no interest and charge bank fees, that is, an effective negative interest rate.

Before you scorn this as unthinkable, note that Japan, the world’s leading expert in deflation, has had occasional negative short-term bond rates (cash rates there today are virtually zero). Why would anyone make deposits under such circumstances? They would achieve a small real capital gain in conditions where this would be difficult for most alternative investments.

How would the stock market cope with deflation? We need to recognise that not all deflationary pressures are destructive. A productivity increase simply means creating more output for the same input, which is inherently good economically. It is also inherently deflationary, that is, a falling cost of production.

By contrast, the deflation of the Great Depression era was negative in every sense. Clearly the stock market would behave differently under these scenarios.

Sustained deflation could be a real challenge for corporate profits. If a company’s costs and prices were both reducing it could still maintain a healthy profit margin. The challenge would be to bring down employment costs. Employment law in Australia has never contemplated deflation and it is illegal to reduce salaries for employees.

Until this is resolved there would be a real likelihood of a profit squeeze, which could hardly help the stock market.

Further, how should equities be valued on a PE/dividend/ cashflow basis if interest rates were negligible, say, one per cent? Recent history suggests that, no matter what interest rates are, dividend yields will be lower. In Australia, the current gap of around 0.25 per cent is its lowest for decades.

Does this suggest that dividends would be less than one per cent in a deflationary environment? Highly unlikely. The idea that dividend yields should be less than cash rates has been borne in an inflationary era. At earlier times in the 20th century the reverse applied. The theory was that shares were riskier than bonds, so a higher income yield was required to invest in them — not an entirely ridiculous concept. It is easy to imagine substantial volatility while markets struggled to assess appropriate price/earnings (PE) multiples for deflationary periods.

Over a very long-term time frame, when businesses and legislators fully adapted to the new environment, one would again expect equities to be a very competitive asset class. The reality that companies grow because effort and intelligence are being applied to create wealth would still apply.

It is the transition into deflation that would be challenging, and more of that later.

How would property cope? For much of the high inflation 1970s and 1980s, listed property trust yields were less than bond yields. With inflation in double-digits it was assumed that rents would increase at a similar rate and capital gain was assured. Thus investors would accept less income than from nil growth bonds.

In the 1990s this reversed. In low inflation the prospects for growth from property are reduced, and the income is riskier than bonds, so investors demand a higher yield.

Now contemplate a situation where rents decline annually in line with the deflation rate and consequently property prices would be expected to follow a long-term downward drift. Everyone would rather rent, with rents declining, than own, with values declining. However, if we all want to rent, someone has to own.

Investors would only hold assets with negative growth prospects if the yield was really high. We might find ourselves with residential property as the highest income asset class! I have already said that dividends could be more than interest rates, so cash and bonds (traditionally called ‘income’ assets) shape up as the least income-oriented investments.

The most significant issue in regard to the onset of deflation would be the transition process. Fortunes would be made and lost depending on how well individuals understood what was happening.

Say bond yields fell from around five per cent today to two per cent in the future. It would generate very strong gains. Bonds would probably be the bull market of the transition period. If you wish to make allowance for the possibility of deflation in portfolios, keep some bonds.

The stock market would be buffeted during the transition. Profits may be squeezed and markets would struggle to work out how equities should be priced.

We’ve hypothesised that dividend yields would be greater than interest rates, but by how much? If bonds were at two per cent and dividends required a premium of several per cent, PEs might remain around current levels.

Alternatively, interest rates might be less than that, and a smaller premium applied, suggesting a possible re-rating up. Or very low PEs might be required, reflecting profit risk, suggesting a re-rating down.

There are many unknowns in this mix, but it would be hard to feel too optimistic.

The outlook for property would seem to be bleak. Property trust yields would need to be relatively high to offset falling prices. But how high?

If current yields were considered adequate in a minimal interest rate environment, then current values could be preserved (for a time). If a five per cent or six per cent yield was adequate they could appreciate during the transition. If markets anticipated the declining long-term growth, prices might slide in anticipation.

Residential property could only fall. With a net rental yield of less than three per cent in Sydney, values would have to fall heavily to produce an appropriately attractive yield.

It is hard to be optimistic at the prospect of a profit squeeze.

Deflation forces a re-thinking of established financial behaviours. I suspect that it would take a decade for people to learn to change their thinking. This occurred in the transition to high inflation early in the 1970s and also in the transition back to low inflation in the 1990s.

The lag between inflation and bond yields can be seen in Graph 1, which shows Australian inflation and 10-year bond yields advanced eight years. In this time, bond yields rose well after inflation took off, peaked eight years after inflation had peaked, and have lagged materially on the decline since then. Even today we are told that rates are low compared to the last 30 years. Of course! It was a high inflation environment.

Ten-year bond yields between four and six per cent are normal compared to the low inflation 1950s and 1960s. It is an example of how slow people are to learn to think in low inflation terms.

Why would the world be any quicker to adapt if we were to transition into deflation?

I stress that I am not making a forecast that deflation will occur. I am simply analysing how planners might need to operate differently if we find ourselves in a set of economic conditions that are outside the experience of us all.