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Deflation: What Investors Need to Know

Key Points
  • Deflation can hurt economic growth, borrowers, and corporate earnings.

  • We believe economic expansion is likely to continue, so we see global deflation as unlikely.

  • We suggest sticking with your long-term asset allocation, as stocks historically have performed well during times of low-but-stable inflation.

Concerns about potential deflation—that is, a sustained and broad price decline—have begun to outweigh inflation worries in global markets. Why does the D-word strike such fear?

Deflation is painful

If consumers and businesses believe prices and demand in the future will be lower, they may postpone spending and investment decisions, creating a downward spiral of economic contraction.

Historically, stocks have tended to perform well during times of low but stable inflation. If inflation starts to wane, markets can become concerned about future corporate earnings power. Businesses may start to compete on price due to the dual problems of excess capacity and insufficient demand, which means profits, and eventually business investment, may suffer. Borrowers also are hurt by deflation, as incomes shrink but debts don't.

Deflation is hard to control

Central banks have familiar tools for controlling inflation, such as raising interest rates or selling government securities (by exchanging bonds for cash, it effectively decreases the money supply, which diminishes inflationary pressure).

However, deflation, once it has taken hold, can be difficult to tame. Although negative interest rates are possible, they’re potentially highly disruptive. Central banks can buy government bonds, thereby increasing the money supply—the Federal Reserve engaged in this form of “quantitative easing” for several years following the 2007-08 financial crisis—but it doesn’t work very well if banks are reluctant to lend the money they receive from selling bonds and if demand for loans is weak due to an economic contraction.

Deflation vs. disinflation

Disinflation—that is, a decline in the rate of change in inflation, which remains positive—is relatively benign compared with deflation. The world has been grappling with disinflation for years, due to a number of forces:

  • Slow economic growth. A general trend toward deleveraging has kept a lid on global economic growth in recent years, as consumers and companies focused on paying down debt accumulated before the 2007-08 financial crisis. Slow responses by Japan and Europe to the global downturn created economic vulnerability and one of these economies has been in recession every year for the last five.
  • Excess factory capacity and underemployed workers. When productive capacity is underutilized, it is difficult for businesses to raise prices or for workers to ask for higher wages. Unemployment remains high in Europe and the ranks of underemployed in the U.S. remain elevated. Within parts of Europe and Japan, employers have awarded temporary contracts but been slow to grant permanent employment.
  • Surplus commodity production. High commodity prices during China's boom encouraged increases in production, but Chinese demand is now slowing. Additionally, because most commodities are priced in U.S. dollars, a strong dollar means that it takes fewer dollars to purchase the same quantity of commodities, pushing commodity prices lower. Reduced commodity prices lead to lower global inflation.
  • Global currency weakness. The euro, Japanese yen, and other major currencies have weakened relative to the U.S. dollar, due partly to diverging economic growth and monetary policies. The U.S. economy has been growing faster than other economies and the Federal Reserve is closer to raising interest rates than providing more monetary stimulus. Meanwhile, the European Central Bank and the Bank of Japan are still pursuing easy money policies designed to stimulate lagging economic growth. Higher interest rates tend to increase the value of a country’s currency because investors want to save money in countries where it earns a better return. A strong dollar has decreased the price of imported goods into the U.S., subtracting from inflation in the U.S.

Inflation remains below target globally

Inflation remains below target globally

Horizontal line at 2% indicates the targeted inflation rate of the respective central banks. A Consumer Price Index (CPI) measures changes in the price level of a market basket of consumer goods and services purchased by households.

Source: FactSet, U.S. Department of Labor, Eurostat, Japan Ministry of Internal Affairs and Communications. Data as of 9/25/2015.

Deflation can hurt earnings and depress stocks

Deflation can hurt earnings and depress stocks

The Nikkei 225 is a price-weighted index of Japan's top 225 blue-chip companies on the Tokyo Stock Exchange.

Source: FactSet, Japan Ministry of Internal Affairs and Communications. Data as of 9/25/2015.

Eurozone stocks have moved with inflation post-debt crisis

Eurozone stocks have moved with inflation post-debt crisis

MSCI EMU Index is a market-capitalization weighted index maintained by Morgan Stanley Capital International that measures the performance of stocks based in the European Economic and Monetary Union.

Source: FactSet, Eurostat. Data as of 9/25/2015.

Our views on deflation

Despite the forces keeping inflation low, we believe deflation is unlikely on a global basis. We expect a continued modest global economic expansion to keep goods and service prices from falling outright. A few points to consider:

  • The decline in inflation over the past year was largely due to a sharp fall in global oil prices. If energy prices stay relatively stable, the year-ago drop in oil prices will work its way out of the headline inflation figures. If food prices also stay stable, headline inflation rates (depressed by the decline in energy prices) could start to converge with the higher core inflation measures in the fourth quarter of 2015 and first quarter of 2016.

Fall in oil pushed inflation lower

Fall in oil pushed inflation lower

WTI Crude Oil is the price for West Texas Intermediate, a grade of crude oil used as a benchmark in oil pricing.

Source: FactSet, U.S. Department of Labor. Data as of 9/25/2015.

  • Leading economic indicators suggest the global economy will continue growing modestly—and that could keep goods and services prices from falling outright. Lower oil prices could begin to support consumer spending. Full employment in the U.S. and U.K., as well as declining unemployment in Germany, could sow the seeds for future wage inflation.
  • Goods prices have remained low due to excess factory capacity, non-U.S. currency declines, and lower commodity prices. Prices for services, on the other hand, have been more resilient. The service sector accounts for 70% to 80% of gross domestic product in Europe, Japan, and the U.S.1 yet its importance is underappreciated. Services are more domestic-based and labor-intensive than manufacturing, and could tend toward price increases in economies with low unemployment. Surveys still indicate an expectation for modest inflation over the intermediate term.

Service prices not headed for deflation

Service prices not headed for deflation

Source: FactSet, U.S. Bureau of Labor Statistics, Eurostat, China National Bureau of Statistics. A Consumer Price Index (CPI) for services measures changes in the price level of a market basket of consumer services purchased by households. Data as of 9/25/2015.

  • There is the risk that a sharp and significant decline in the value of the Chinese yuan could put further downward pressure on global goods prices, but we don't believe this is likely. We believe a slowly depreciating yuan is more likely than a sudden sharp decline, as China doesn't want a destabilizing fall in its currency. Even though there are some liquidity constraints in accessing its reserves, China has $3.6 trillion in foreign exchange reserves2 that can be used to stabilize its currency.

What does it mean to me as an investor?

If deflation becomes a threat, tactical investors—those who make decisions based on three- to 12-month time horizons—may want to review their asset allocations.

However, because we don't believe deflation is a current threat, we recommend sticking with your long-term asset allocation. Volatile markets can fuel an urge to make changes, but sometimes the hardest—yet ultimately most successful—action is to stay put.

Next Steps

Talk to Us
To discuss how this article might affect your investment decisions:
-          Call Schwab anytime at 877-338-0192.
-          Talk to a Schwab Financial Consultant at your local branch.

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