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Understanding Deflation

By Louis P. Stanasolovich, CFP®, CCO, CEO and President of
Legend Financial Advisors, Inc.®and EmergingWealth InvestmentManagement, Inc.

Deflation (It looks like Europe’s economy ismoving into a deflationary period.), although uncommon since the GreatDepression, normally occurs because there are too few customers chasing toomany goods and services, resulting in competitive price cutting that leads tolayoffs, falling wages, and a decline in business investment and consumerspending.  Consumers and businessesproject that prices will be lower in the future, therefore;they delaytheir purchases making the economic climate worse and driving prices andwages down further.  Households(decreasing wages) and companies (decreasing revenues) with extensive debtare still forced to meet their fixed monthly expenses.  Often, bankruptciesresult or spending is cut to meet their obligations. This is what happened inthe early 1930s triggering the Great Depression.  For the most part of thelast almost 25 years, Japan has faced deflationary pressures asprices fell.  This type ofdeflation is characterized as “bad deflation”.  On the otherhand, price declinesmay occur when companies find ways to produce goods and services more cheaply.  Theseproductivity gains are passed onto consumers in the form of lowerprices, onto workers as higher wages as well as onto shareholders as higher profits. This mild deflation may be considered “gooddeflation”.


Some see a strong possibility of mild deflation developingin 2014, in Europe, as the lackluster European economy continues to faceconcerns over excess capacity, weak employment growth, high levels of consumerdebt, and deflation being exported from the Pacific Rim countries.  The combination of these factors could lead to milddeflation in 2014.  However, historicallymild deflation alone has not been a negative to either the stock orbond markets.


If we face mild deflation [The Consumer Price Index(CPI) flat to down 2.4%], have no fear.  The 25 years of mild deflation in the U.S. since1872 saw the stock market rise on average by 14.6%.  Whensignificant deflation occurred (CPI was down 2.5% or more)stocks performed poorly with average total returns of just 3.9%. Periods of significant deflation are accompanied by a better“real return”, because the high deflation rate is added to the stock’sperformance.


All deflation is perceived to be badbecause it has beenassociated with past economic downturns.  However, not alldeflation occurs duringeconomic weakness.  Deflation may occur during the earlystages of an economicrebound, particularly when business confidence and inventory rebuildingadvances ahead of consumer demand. As the economyreverts back equilibrium, these deflationary pressures typicallyease.  Stock market performance tends to bebetter during non-recession years when mild deflation exists.


Long-term interest rates are typically higher duringhigh deflation periods due to weak economic conditions. Periods ofdeflation, whether mildor significant, usually tend to cause short-term interest ratesto rise to levelssomewhat higher than long-term averageinterest rates.


In summary, while serious deflation isalways of concern toeveryone, historically,mild deflation will not necessarilyprevent stocks from rising. However, not all periods achieveaverage returns either.

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