Deflation today, but is it here to stay?

April 15, 2015

Today's CPI inflation showed average prices static in the UK for the second month in a row. This may turn out to be a temporary low largely caused by a combination of declining oil and food commodity prices and a supermarket price war. Indeed underlying inflation is still at 1% and it would not be surprising to see inflation return towards 2% by mid-2016, as these recent prices changes fall out of the calculation.

It is therefore tempting to think it is not something to be worried about and we should all enjoy the benefits of wages increasing faster than inflation while it lasts. However research that I have been conducting for my latest book suggests that this may be just the first time of many that we see deflation in the UK over the coming century.

Price changes over the centuries

Historically the price rises seen over the last 100 years have been unprecedented. Prices have risen literally almost 100 times. This contrasts sharply with the previous century where they actually declined by about a third.

The cost of things is rising over time but it follows a wave-like pattern. Not only is this evident in the UK data (above), but a similar pattern was seen in Ancient Rome. Prices rise for a period of a hundred or so years and then consolidate over the best part of another century. The pattern is not dissimilar to that seen in many growth shares (although the time scale there is much shorter).

What is happening is that there is an underlying factor driving prices higher. It is more than just the money supply as many economists might assert. It appears related to population and demographic changes. All the previous inflationary phases have been triggered by population increases causing demand to exceed supply. However once prices start rising, man intervenes to exploit the situation. Investors buy assets that will keep their value during the inflation i.e. property/land and shares. They borrow money to invest, knowing that inflation will erode the true value of their capital and repayments. However that borrowed money increases the money supply which then fuels more inflation in the economy. Governments also join in and encourage inflation, as it allows them to spend more and let inflation deal with their deficits.

But there comes a point when this inflation gets too far away from the underlying trend. We are experiencing that now. Some estimate that world population may peak by 2050. Even if that does not happen, the population is ageing in virtually all countries. Older people consume less and therefore the underlying demand curve is changing direction and with it in time, also prices I suspect.

The three stages of future investing

Investing over the coming decades is going to be challenging. A traditional buy-and-hold approach or standard diversified portfolio may not produce the best returns, as some assets might be severely affected. I foresee, three distinct stages which will each demand a different strategy.

Currently we are still in the inflationary phase. Prices are being supported by governments and central bankers who are keeping the money supply increasing. This is ensuring that assets such as shares and property continue to grow.

But at some point something will trigger a change in trend. This is often a turbulent time. Historically we've experienced some form of deflationary shock when prices have collapsed by about a half in a space of 5 years or so. Thereafter has followed a bounce back in prices but they never reach new highs. Over time prices then gradually decline as technology and productivity improvements reduce the costs of production.

It is impossible to predict exactly when this will happen or what will trigger it. Having said that, a bond market crash looks like the primary candidate. When that debt bubble finally collapses it risks bringing down a large proportion of the financial system with it. That means very significant declines for share prices and property.

During that time, the best asset to hold would probably be gold. However it is not impossible we'll see a repeat of the 1930s and government controls on gold ownership. Digital currencies might do well if they have credibly established themselves by that point. Cash also ought to sensible, but the size of the crisis may be such that bail-ins are forced upon most depositors. The ideal strategy at that time might be to be in cash and swiftly convert it to shares during the collapse but before the bail-ins take place.

Indeed once we emerge into the consolidation phase, shares will again be the choice asset. Capital returns might well be limited but a dividend yield of 3% could be worth 4-5% assuming mild deflation, i.e. not far off what the long-term yield has been over the last century.

Investing over the coming decades is going to be a challenge, but not an impossible one if you understand the bigger picture. Inflation matters.

Pete Comley's book Inflation Matters: Inflationary Wave Theory, its impact on inflation past and present … and the deflation yet to come is available in Kindle format and in hardback from Amazon. You can download a free Lite version of it featuring key chapters at: inflationmatters.com/moneyobserver.

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