December 8, 2014
by Michelle Perry Higgins
An environment of low inflation can be quite different in its effect on companies and the economy than an environment where deflation rules. Low inflation can be quite favorable to economic growth and the stock markets. It allows companies to predict and control prices for inputs to their businesses, including labor costs, and makes earnings more predictable. In a low-inflation and low interest-rate environment like the one we have experienced over the past few years, investors have done well in equities compared to fixed income. This was also true during the bull market of the 1980s and ’90s, when equities went on their epic run after inflation was crushed by the Federal Reserve under the leadership of Paul Volker.
However, even though interest rates have been lagging, investors need to keep in mind the need to adequately fund the fixed-income component of their defensive barriers. Investors also need to consider that no one knows how long this period of very low inflation will continue and they should use longer run estimates of inflation in their financial plans.
On the other hand, deflation can cause severe problems for the economy and equity markets. When deflation hits, companies and individuals put off purchases, waiting for prices to go lower. This reduces economic activity and forces companies to reduce prices, impacting profits. There is, therefore, an impetus to lay workers off and close or mothball factories and other facilities. This process can result in a downward spiral as lower prices confirm the value of waiting to participants in various markets. This is the specter that currently haunts the European Central Bank.
Once a deflationary spiral has started, it is extremely difficult to stop. For investors, the deflationary scenario really presents a very simple choice; with asset values and interest rates tanking, cash is king.