Investing in a deflationary world

by Rob Davies, Fund Manager

Inflation has been such an ingrained element of most major economies for so long it is assumed to be the normal state of affairs. Certainly, central banks and governments would like that to be the case and most of them are making vigorous efforts to get back to a situation where inflation is running at 1% to 2%.  

This is mainly being done through Quantitative Easing (QE) in which governments simply invent money by printing more of it. The scale of this is truly staggering, albeit hard to quantify but seems to be about $4.5 trillion in the US, £375 billion the UK, €360 billion Europe and ¥240 trillion in Japan. 

Despite this QE hasn’t worked. Growth is low in these major economies, even after six years of this stimulus, and inflation is either zero or barely positive.   The only bright spot had been China which had been growing at double or high single digits for over a decade.

However, even here recent events suggest that its own, hard to measure stimulus from large scale borrowing is having less effect and it has now resorted to devaluing its currency to stimulate growth to make exports cheaper. Lower prices from cheaper white goods and other manufactured products will, effectively, export deflation to the West by undercutting competitors.  Good news perhaps for commodity producers if not for washing machine repair men and economic growth in those countries. 

This new development is happening when the economic recovery in the UK is already six years old (which is longer than normal) and interest rates are still at rock bottom. That means central banks can’t cut rates to tackle this new threat and governments may be reluctant to restart QE. 

Outright deflation may now occur despite all the efforts to prevent it.

If deflation does happen should investors adopt different strategies? An obvious answer is to buy fixed income which will at least preserve capital values, as cash becomes more valuable, even if the return is miniscule.  Investors need to commit a lot of capital to get a reasonable income. Conversely, low interest rates might mean debt is superficially cheap for borrowers, in nominal terms, but in real terms, when the value of money is rising, deflation makes debt repayment harder. This is the opposite of what has been the norm for so long when inflation gradually reduced the burden of mortgages and loans.

Fixed income might be attractive asset class for capital preservation but the returns are low. An alternative is to invest in equities but, in an environment of low growth and an inability to raise prices, this asset class will struggle to generate capital growth.  It is hard to think of any goods or services that are actually suffering from shortages and where prices might rise.  Worse, the ever expanding utility of the Internet has not only made price discovery easier it has increased the number of potential suppliers from a handful in the local area to, potentially, the whole world courtesy of UPS and the Royal Mail.  A repair to a broken down washing machine is no longer dependant on the cost and availability of local providers if the alternative is to buy a new Chinese made one (now even cheaper after the devaluation) on the Internet that will probably arrive before the repair man.  

And it is not just blue-collar workers in manufacturing and services who are threatened. The ability to ping a spreadsheet or a drawing to India at 5pm and have a completed version back at 9am the next day is putting cost pressure on white collar technology workers too. 

So if returns don’t come from capital growth they have to come from cash flow.

While it may be easy to get depressed about these threats to incomes there is an analogy with railways in the nineteenth century. That technology also widened markets and competition but it created some of the fastest growth ever seen, without much inflation, in a period of fixed exchange rates.

Businesses that prospered then were the ones that should do well now. Companies that do not rely on external finance but generate enough cash internally to fund their own growth and have a surplus to return it to shareholders for them to reinvest as they think fit.  

The dramatic cuts in interest rates, both real and nominal, at the start of the financial crash had the logical result of increasing capital values of assets; tangible and intangible. But that was a one-off effect. 

Now, capital appreciation of fixed, or even intellectual, assets will become harder because interest rates cannot go any lower. It is the cash flow those assets can generate that will become more important. In a rational world that ought to focus attention, and value measurements, away from assets to operating cash flow, retained income and dividends. But that may not happen quickly.