NEW YORK (TheStreet) -- With low inflation in the U.S. and Europe flirting with deflation, the Federal Reserve is focused on making sure the U.S. doesn't fall into a deflationary spiral.
What does that mean and how might it affect your investments?
The Federal Reserve has several objectives for the economy that it seeks to achieve, one of the more important ones being its target for inflation. Largely derived from the CPI, PPI, and PCE indices, the Fed has a goal of 2% inflation. Right now, U.S. inflation is at 0.0%.
Inflation means the buying power of your dollars is eroding. Why is this an objective for almost all central banks? Because inflation's antithesis, deflation, is a far more deleterious force for markets. Europe in particular has been struggling to avoid it and has even begun its own quantitative easing stimulus to help combat deflationary fears and anemic growth.
During deflation, your dollars increase in worth and prices fall, so why is this so insidious for economies that are subjected to it? Well, if deflation occurred in a vacuum perhaps it wouldn't be so harmful, however there are numerous externalities that exert pernicious effects on markets as a result. Understanding why this is so is quite helpful for investors and may make for better asset allocation if we ever experience it.
Deflation's Negative Effects
1. Prices fall and the value of the dollar increases as a result of deflation. Viscerally these may appear as good things, however it's highly counterproductive for spending, which is the very action that buttresses economies -- especially the U.S. economy. Holding cash actually becomes an investment with a real yield. Coalesce this with the prices of goods and services falling, and it becomes prudent to put off purchases as you'll be able to procure them for less if you wait.
2. It stymies credit markets. The burden on debtors is compounded during deflationary periods as they now not only must pay interest on their loans, they must do so with dollars that will become more expensive to come by. This makes for a material increase in one's propensity for defaulting. It also makes borrowers far less likely to seek out loans, even for productive economic purposes. This elevated burden on debtors in addition to dissuading borrowing curtails investment-led activity and constrains growth.
3. In addition to falling prices, wages and employment fall with them. However this doesn't happen in linear fashion; a theory called Downward Nominal Wage Rigidity explains it well. What this is referencing is an employer's reluctance to cut wages to save costs. They would rather lay off employees instead. Theoretically it would make more sense that wages would be reduced to maintain parity with buying power, however the human element to this makes it not the case. Even if the new wage after a pay cut has more buying power (real wage), people rather superficially tend to be more concerned with the raw dollar amount (nominal wage). So employers, rather than insult or experience resistance from their employees by lowering their pay, tend to just cut workforce. Any new hires are also given a wage indicative of the deflationary environment. As a result you see both decreased aggregate income and employment.
Now, equipped with an understanding of how deflation exerts its detrimental externalities, let's examine some asset classes that generally do and don't weather these inclement conditions.
How Asset Classes Perform Under Deflation
Commodities: These are traditionally a poor choice, including gold. While typically a solid hedge against inflation as commodities maintain their value relative to an eroding currency, a deflationary lack of aggregate demand from decreased spending, coupled with the dollar they're pegged to growing stronger, can catalyze a drop in price.
Equities: This is a bit more nuanced, as mild deflation hasn't necessarily impaired markets historically. Deflation above 2.5% has however been an impetus for disintegrating share prices as price-to-earnings ratios begin to materially decline as earnings abate. High-quality blue-chip companies with low payout ratios for their dividends not only tend to hold up better, but the dividends mean more in real terms, so long as they're not reduced.
Bonds: Interest rates fall during deflationary periods, as the Fed institutes monetary easing to facilitate borrowing and spending -- though, if we experienced deflation now, it would be difficult to combat, as the Fed has rates quite low as it is. Long-term bonds are generally advised in periods of falling interest rates to lock in a more appealing coupon. This rationale is no different here, as not only would a bond you hold appreciate in price if yields fell, but its real-yield and basis would increase as well: a win all around for the bond holder.
One very critical addendum to this bond recommendation, however: a bond's coupon and yield mean absolutely nothing if the issuer defaults. Remember, there is an increased burden on debtors during these times that may leave companies insolvent; treasury securities are your only entirely safe bet. If you venture into corporate debt, be sure the company has a predictable cash flow and manageable liabilities so it can actually make good on its obligations.
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.