Deflation a likely threat to investors

Wednesday, January 13th, 2016

World equity markets continue their gyrations which have been a common occurrence throughout 2015 and more specifically in the recent December Quarter.

Specifically the Australian share market index traded through an 8% price range throughout the recent quarter. It was particularly volatile during the last two weeks of December. The market fell (once again) towards 4900 mid-month before rallying hard to reach 5300 at the end of December.

The December fall was a reaction to the decision by the US Federal Reserve to increase cash rates by 0.25%. This was the first lift in US cash rates for 9 years. Remarkably the cash rate had not moved in 7 years despite the recovery in the US economy that had been seen in the significant growth in employment over the last 3 years.

This market fall and the subsequent recovery was a rerun of many previous market moves. Indeed the monotony of market falls and recoveries and vice versa has created an unhealthy level of complacency that will surely be challenged at some point. The recurrent volatility has little to do with value and is driven by cheap and plentiful liquidity that continues to be provided by major Central Banks.

The maintenance of lax but supportive monetary policy settings across the developed world for some eight years will have consequences. The problem is that the consequences can only be speculated upon before they are ultimately felt. This is because this economic period and the economic settings are unique in world economic history. We have no historic precedent to draw upon and asset pricing is moving in uncharted waters.

We can observe that the low interest rate cycle of the last 8 years was a construct of major Central Banks. However, today’s low market interest rates are a reflection of a sober economic outlook. That outlook can be summarised as a period of both generally lower growth and low inflation in developed economies. We would therefore speculate that the most likely economic scenario for most of the developed world is “deflation”. A re-run of Japan’s decades of low growth but on a grander worldwide scale.

The inflexion point into this low growth era has been passed and markets are grappling with the reality that investment returns are now going to be low (“single digit”) and consistent with low economic growth.

Across the world there remain many economic and asset market challenges. A rising US dollar is not good for the US equity market as it constricts listed company profits. Sustained low yields in Japan reflect a demographic time bomb. Across Europe low growth and high government debt stymie recovery. Whilst in China both investor and consumer confidence is being challenged by extreme equity price volatility and a depreciating currency. The devaluation of the yuan is an unwelcome development that forces the pace of world deflation.

Australia enters 2016 with its enduring quest to transform its economy from a resources based one to a “services for Asia” focused one. It is easy to say what has to be done but the transition may require an income shock that Australians are clearly not prepared for. Further, the hope for transition is creating a two tiered pricing market for Australian equities. Companies regarded as established but low growth entities are being marked down. Younger companies that promise dynamic growth are being aggressively priced as if they have no risk of failure or disappointment.

Our job as investors is to allocate capital to companies that are fairly priced based on their real opportunity after assessing their real risk of success or failure. Today the real opportunities are limited and we caution about believing that investment success is a function of identifying companies that can achieve short term price bubbles without delivering an enduring business model. However, we acknowledge that is how the equity market is currently behaving and this is the direct result of many years of low cash rates and supportive monetary policy settings.

The ultimate effects of such policies is playing out across markets and the true investment skill will be in identifying and trading bubbles rather than investing in them.

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15 Responses to “Deflation a likely threat to investors”

  1. Peter Powell says:

    I could not agree more. People are talking about a correction in China which is simply not looking at the figures. China has gone way gone above its value with cheap money and rather inconsistent leadership and has a long way to go to go down to a realistic value. I would not be surprised if the next 2 to 5 years or more is difficult. That means a more concentrated investing approach is required in the companies that are well researched as to the management, productivity, business model and its ability to keep making money in such times. There are some companies out there doing just that but you have to do your homework. Just try and ignore all the ‘Chicken Little’s running around!

  2. Mike Hannell says:

    I agree that the risk of deflation ahead is very real, with investment opportunities only being available with careful selection.
    I also agree that Australians are not prepared for the scale and depth of the problems ahead.
    Unfortunately it will need hard times and many unpleasant shocks to face up to the reality that as a country we have been living beyond our means.

    Mike Hannell

  3. Tim Farley says:

    If you believe Harry Dent and Marc Faber then even these good companies will be heavily marked down

  4. Johnny Falcon says:

    Deflation has only just begun, and Australia’s already grossly overvalued residential housing market is finally about to correct. EVERY boom ends in a bust. No exceptions. The financial and psychological effect will be catastrophic over the next few years. And as I said in the December 2015, avoid banks like the plague.

  5. John Bristow says:

    I assume from your comments that share values are going to deteriorate further and that it would be wise to sell any stocks which have already devalued as they will go further. Would this include resources stocks such as BHP and RIO and FMC

    • john Abernethy says:

      Hi John,

      We cannot give specific stock advice but I think it is fair to say that the prices of resource shares will continue to be pressured by the deflationary affects of low energy and commodity prices.

      From this point it is important to monitor the cash flows of resource companies. How much free cash is being generated and where is it going? Is there a heavy debt load to service? Is capital investment capable of being curtailed are dividends to be maintained?

      It is important to investigate the financials of each company and judge them on their individual merits.


      • i agree john it is importaint for one to look into the financial credentials of the company its annual report/statements before one parts with any of their hard earned good advice cheers regards stewy:)

  6. Phil Crichton says:

    Doomsday writers…… they are flourishing in a jittery world.
    But I prefer facts. Good dividend shares with strong balance sheets and enticing yields should gradually retain their values. Earning far more than bank interest or bonds, their share values have to eventually reflect their superior returns , and if they are franked, even more so. Shares not paying dividends are speculative and dangerous in these volatile conditions.
    Investors beware!

  7. Peter Turnbull says:

    It has been the worst start to a calender year that i can remember in 55 years The Chinese economy is contracting , Saudi Arabia is pumping out oil in quantity possibly in an attempt to wreck the Iranian economy as they again start producing oil by keeping the price down , and it is of course the age old Sunni verses Shia game Stock-picking is the go for 2016 Peter Turnbull

  8. Mick Hedt says:

    Our economy is currently experiencing low interest rates, low dollar, low fuel prices, low wages growth – all positive factors. What is low (but could be higher) is confidence. Also Australia’s population growth forecasts are positive which will generate the need for housing, infrastructure, retail sales, etc etc. Whilst many countries, including our most important trading partners, have significant financial issues we should not lose sight of the fact that there are still significant opportunities in Australia and our near region.
    By the way Berkshire Hathaway doesn’t pay dividends.

  9. matthew says:

    Deflation. Don’t believe it for a minute! In the short term money will tighten up as a few of the idiots “get caught”. But there is no way with the proliferate governments (all just not western democracies – Arabia is a prime case in point) that we are in for deflation. Try inflation.

  10. Anthony says:

    One factor regularly overlooked, with respect to the equity market, is that we have an ageing population. On the one hand, yes, the dividend yield is enticing. I wonder at what point retention of capital clicks in. Currently folk may retire at 65 years of age. They will likely live until 90. That’s 25 years. Watching their base capital disappear – yet their dividend yield satisfyingly rise – will surely reach a point where folk en masse will prefer fixed income. The current scenario is a very clever, and subtle, way to transfer wealth from the ageing baby boomers to following generations. The following generations will still inherit the family homes, which won’t be worth what they currently are.

  11. Kevin Jennings says:

    All very interesting . I will keep my spare cash in the bank for the next few months.

  12. Steve Sitko says:

    The comment by Phil about good dividend paying companies stands. Berkshire Hathaway is a US company, and US companies typically don’t have high dividend yields at all. Australia has an imputation system that encourages higher dividends, and a significant portion of the returns to investors in our sharemarket can be attributed to dividends.

  13. charles says:

    When is someone going to take up the cudgel to support super pensioners who are facing a requirement to deplete their fund faster than ever thanks to declining share values and low interest rates. At the very least we need to reintroduce the discount on the minimum withdrawal requirements as occurred under the Labor government during the GFC.

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