Investing and Deflation - dummies

By Tony Levene

Inflation – rising prices – has been the norm for around 70 years. This will have an impact on your investments. Prices have doubled since 1990, gone up 20 fold from 1960 and stand 35 times higher than in 1947. In the 1970s, some salaries increased monthly as the cost of living soared. For most adults, prices today bear no resemblance to those of their childhood. But in 1900, the price of staples such as bread and beer were easily recognisable from 1800 or even 1700.

Rule number one in investing is that nothing is forever. Currently, inflation is down to 0.5 per cent, which equates to prices doubling about every 144 years.

And now there is a ‘new’ word for investors to discover – deflation. This is where prices fall – some economists so hate the word they substitute ‘negative inflation’.

Economists say deflation is bad. They say it brings stagnation – or worse – as spending decisions are put off until a ‘cheaper tomorrow’. They have a point. Why would shoppers – and we live in a consumer-led economy – buy something today which will soon cost less?

But in investing, what’s bad for some, can be profitable for others. It all depends on your personal mix of borrowing, saving and investing, and spending. The other important variable is how price falls are driven.

Our current price drops are driven by the collapse in oil prices coupled with substantial falls in other commodity prices.

So investing in companies that make goods that are dependent on raw materials could work out well. Putting your faith in oil and mining companies is likely to be less successful.

The economists’ argument that falling prices defer spending until ‘tomorrow’ (which never comes) is both true and not true. Take computers and other electronic goods. Consumers keep buying them even though they know next year’s models will be cheaper and faster. There has been deflation in this sector for years, yet the world’s most profitable company – Apple – makes phones, tablets and computers.

Where it is true is in areas where we can just carry on – optional replacements like a new carpet. So tread carefully. Shares won’t carry on rising just because the value of money falls.

The other driver of falling prices is the supermarket price war. Supermarket shares are generally doing poorly – but there are other factors at play such as changing shopping patterns and the stores’ use of property and land.

There is a silver lining. Shoppers expect prices to be unchanged. Falling prices can help push up profit margins – pound shops will still charge £1 even if the goods on offer are now cheaper to source.

Deflation makes the low returns on cash deposits and bonds look attractive. If inflation runs at 10 per cent, your money loses value even if you can get a 10 per cent return, thanks to tax. But if prices fall, money gains, even at 1 per cent.

It’s great news for retired people living on fixed incomes such as annuities – and bad for those pensioners who took a lower return in exchange for future ‘inflation proofing’.

But where deflation will be most noticed is in property purchases. Inflation in the 1970s to the 1990s was the home buyers’ best friend. Mortgages stayed the same but were paid back in devalued money. A £10,000 mortgage in 1970 cost around £1,500 (in 1970 values) to repay 20 years later. Despite high interest rates, buyers could often repay huge chunks of capital – many could afford to upscale properties every eight to ten years, good news for the home improvement industry and estate agents. Now, a 25 year loan will be hard work even if interest rates are lower.

Still, no one knows how long ‘negative inflation’ will last. Again, nothing is forever.