As difficult a concept as deflation may be for educated folks to wrap their minds around, I will try to simplify its insidious nature. For public corporations, falling prices typically mean lower profits, and that is often bad for their share prices as well plans to spend on R&D or HR or equipment. When corporations get squeezed, they cease wage increases at best and they may lay off workers and/or impose wage declines at worst.
For borrowers, inflation makes debt repayment easier since you are paying the money back with cheaper dollars, whereas deflation makes debt servicing more difficult; that is, you are repaying debts with more expensive dollars. For consumers, when people expect falling prices they become less willing to spend as they hold out for even lower prices.
Already in the United States wages are declining for the 90-plus million unemployed and under-employed; 2013 global inflation chimes in at its second-lowest level since World War II. This is taking place at a time when the Federal Reserve has been unable to achieve price stability/inflation targets, in spite of nearly $4 trillion in existing QE dollar creation.
This is occurring in spite of the fact that the European Central Bank cut its benchmark lending rate to a scant 0.25% due to what President Mario Draghi describes as "a prolonged period of low inflation." With European unemployment near a record 12.2%, you can be sure there's very little prospect of wage growth occurring.
So with all of this deflation talk, you might think that this places me in the bearish camp on equities. Not so.
For one thing, all of the money printing efforts by the world's central banks (e.g., Federal Reserve, Bank of England, Bank of Japan, etc.) have not ended, even with so-called tapering by the Fed. In fact, U.S. monetary stimulus through a variety of tools is roughly the same going into 2014.
By the same token, the Japanese government believes its campaign of QE has succeeded in pushing prices higher as its core inflation measure logged a year-over-year 1% for the first time since the financial meltdown of 2008. Japan's not about to slow down its electronic money creation with this perceived success.
And Europe? Sooner or later, the ECB will decide to cut its benchmark lending rate to zero, and eventually, join Japan, England and the U.S. in quantitative easing, money creating endeavors. Everyone will fight deflationary pressure.
Understanding the most probable course of action by the most influential institutions, I see reasons to be optimistic in two key areas: dividend-paying U.S stock assets and dollar-hedged foreign stock assets. Keep in mind, I am a money manager who respects the enormous power of trend-following and stop-limit loss order protection. Therefore, I like the aforementioned areas as long as a representative exchange-traded fund remains above its long-term trendline.
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