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Understanding Deflation

Deflation, although uncommon since the Great Depression, normally occurs because there are too few customers chasing too many goods and services resulting in competitive price-cutting that leads to layoffs, falling wages, and a decline in business investment and consumer spending.  Consumers and businesses project that prices will be lower in the future, therefore; they delay their purchases making the economic climate worse and driving prices and wages down further.  Households (decreasing wages) and companies (decreasing revenues) with extensive debt are still forced to meet their fixed monthly expenses.  Often, bankruptcies result or spending is cut to meet their obligations.  This is what happened in the early 1930’s triggering the Great Depression.  Japan has faced for the past twelve years and continues to experience deflationary pressures as prices are falling.  The forecast for 2003 is expected to be a decrease of approximately one percent per year.  This type of deflation is characterized as “bad deflation.”  On the other hand, price declines may occur when companies find ways to produce goods and services more cheaply.  These productivity gains are passed onto consumers in the form of lower prices, onto workers as higher wages as well as onto shareholders as higher profits.  This mild deflation may be considered “good deflation.”

Some see a strong possibility of mild deflation developing in 2003, as the lackluster U.S. economy continues to face concerns over excess capacity, weak employment growth, high levels of consumer debt, and deflation being exported from the Pacific Rim countries.  The combination of these factors could lead to mild deflation in 2003.  However, historically mild deflation alone has not been a negative to either the stock or the bond markets.  The last time that the year over year rate of change for the Consumer Price Index (CPI) ended down was in 1954 (-0.7%).

If we face mild deflation (CPI flat to down 2.4%), have no fear.  The 24 years of mild deflation since 1872 saw the stock market rise on average by 14.6%.  When significant deflation occurred (CPI 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’s performance.

All deflation is perceived to be bad because it has been associated with past economic downturns.  However, not all deflation occurs during economic weakness.  Deflation may occur during the early stages of an economic rebound, particularly when business confidence and inventory rebuilding advances ahead of consumer demand.  As the economy reverts to equilibrium, these deflationary pressures typically ease.  Stock market performance tends to be better during non-recession years when mild deflation exists.

Long-term interest rates are typically higher during high deflation periods due to weak economic conditions.  Periods of deflation, whether mild or significant, usually tend to cause short-term interest rates to rise to levels somewhat higher than long-term average interest rates.

In summary, while serious deflation is always of concern to everyone, historically, mild deflation will not necessarily prevent stocks from rising.  However, not all periods achieve average returns either.

For further information, contact Louis P. Stanasolovich, CFPÔ at (412) 635-9210 or mailto:legend@legend-financial.com.




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