Tuesday, March 31, 2009

DDD: Deflationary Death Decline

In the last market drop in 2001-2002 after the bursting of the tech bubble, the financial press had a field day suggesting that deflation could be near. Even a certain Ben Bernanke then offered his few cents worth when he made his famous remarks on the helicopter drop of money to reflate the US economy. That then was but a scare. Today, the deflationary threat is more real than ever. Case in point are the recent CPI figures for many countries around the world: from US, to China, Japan and even Singapore, the CPI is either flat or registered a yoy decrease. In Singapore, a deflationary trend seems to have been established with four consecutive months of decline?

But you ask: what's wrong with things getting cheaper? It should be great for consumers except that deflation brings about major challenges for businesses and is a heady and toxic mix with high debt levels. Deflation leads to the necessary deleveraging in order for businesses to right size their heavily geared balance sheets. Fire sales would occur in today's market where sellers outnumber buyers. This in turn leads to a sharp marking down of capital values of assets. And businesses scramble to maintain banking covenants in yet another round of asset sales or equity raising. I think you will see where this is leading to: a self reinforcing death spiral. Well, we weren't the geniuses that came up with this sequences of events for the deflationary death decline. It was first introduced by Irving Fisher in his seminal paper "The Debt Deflation theory of Great Depressions. Fisher had published it in Econometrica during the depths of the Great Depression in 1933.

In a nutshell, Fisher postulates that over indebtedness acts in conjunction with deflation to produce a contracting economy. This in turn causes bankruptcies, rising unemployment and falling profits. Given that inflation has been kept somewhat low due to the ability to rely of cheap Chinese produce, the strong growth in corporate and consumer debt has brought back the relevance of Fisher's theory and is triggering fears of a debt-deflation induced depression.

The possibility of such a scenario manifesting is not lost on the IMF. In a recent report, the IMF reckoned the following: "Considering this, risks for sustained deflation are appreciably greater than in 2002-2003, particularly in several G7 (Group of Seven) economies" due to anemic global demand and falling asset prices.

With the threat of deflation hovering, investing is difficult. Whilst brokers are peddling statistics that show that equities are cheap or at least fair valued these days, the whole game will be thrown out of the window if the deflationary seeds take root. So, buy only if you think it is really cheap or if you have established a more than adequate margin of safety. That is the only way to protect your individual investments from this ugly beast. Otherwise if you are not confident, our suggestion on what to invest in this year remains: love, kinship and friendship.



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