Disinflation or deflation?

Zoomer | November 28th, 2008

The dreaded “D” words are back. The precipitous 1 per cent decline in the U.S. Consumer Price Index in October set off a flurry of speculation that we could be entering a deflationary spiral. The last time that happened in North America was during the 1930s. It is certainly not an experience anyone wants to revisit.

It would be foolish to rule out deflation as a possibility, especially in treacherous times such as these. It happened in Japan in the 1990s and to this day, the Japanese have not completely recovered from that experience.

Once deflation takes hold, it is difficult to stop. Consumers simply stop buying in expectation that prices will be even lower in a few months. As a result, inventories accumulate, manufacturers stop producing, people are laid off, and unemployment rises. Government revenues dry up, forcing leaders to choose between ever-rising deficits or spending cuts which will exacerbate the problem.

As jobs disappear, domestic pressures mount for higher tariff barriers and legislative policies to artificially create employment at home. We saw the tip of this protectionist iceberg in the Congressional hearings into a possible bail-out of the U.S. automobile industry. There is much more of this rhetoric to come and it remains to be seen whether President-elect Obama and his new Administration will have the will or the clout to resist.

So it is feasible we could stumble into deflation through a combination of bad luck and worse management. However, it is more likely that what we will experience is a period of disinflation that may extend through 2009. That has happened before, as recently as the early 1990s. Then, as now, there were widespread fears that disinflation would deteriorate into deflation and the world would wallow in depression for a decade. Fortunately, it didn’t happen then and, while I am not feeling particularly optimistic these days (who is?), I do not believe it will happen now.

There are a lot of parallels between what is taking place today and the events of the 1990s. In both cases, stock markets crashed and the world economy fell into recession. Interest rates were slashed as central banks tried to respond. The housing market collapsed; between 1986 and 1991, new home construction in the U.S. fell by 45 per cent. There was even a banking crisis as the American savings and loan industry (S&L) hit a wall. Almost 750 S&Ls failed, leaving Congress to pick up the pieces with a $124 billion bail-out package. History tells us that one of the main reasons for the crisis was deregulation which resulted in S&Ls taking on billions of dollars in bad loans. Does any of this sound familiar?

So what happened to investors during this period? Stock prices fell, as you might expect, although the decline was nowhere near as severe as the one we are currently experiencing. Real estate and precious metals values dropped (gold bugs, take note). Oil prices fell by almost 50 per cent between 1990 and 1998, bottoming out at an average of US$11.91 a barrel.

Money flowed into GICs, savings accounts, and bonds. In fact, bond investors generally did very well as demand and low interest rates drove prices higher. In my book Low-Risk Investing in the ’90s , I cited the example of a Government of Canada bond purchased in July 1991 and maturing June 1, 2010. The price at the time was $952 per $1,000 bond. By early 1994, the same bonds were trading at $1,320 for a capital gain of 38.7 per cent. But before you rush to fill your portfolio with Canada bonds, you should know that at the 1991 price the bond was yielding 10.27 per cent. You won’t find any government bonds yielding that today nor any quality corporate bonds for that matter. But the spreads on highly-rated corporate issues are unusually high right now, offering good capital gains potential down the road.

Recently, my broker offered me several high-quality corporates with maturities between 2012 and 2015 that were trading at deep discounts and had yields to maturity of 6.5 per cent to 7.2 per cent. Since bond inventories vary from one brokerage house to another, ask what’s available where you trade. Stick with top-rated bonds and ignore anything with less than a BBB rating as well as any company that is on credit watch with negative implications.

Some of the GICs on offer today also look attractive in a disinflationary environment. We’ve seen special rates of 4 per cent+ from some of the major banks as they seek to raise capital and conservative investors should take advantage of them. I doubt they will be around very long.

But what if the worst happens and we slip into a depression? For starters, it is important to understand there are really two types of depression. The more common one is sectoral depression. We experienced that in the late 1980s and early 1990s and again in 2000-2002. In these conditions, specific sectors of the economy enter a depression phase but not the economy as a whole. In the ’80s and ’90s, commercial real estate was the sector most affected and fear of a repeat is one of the factors suppressing REIT valuations today. In 2000-2002, the high-tech sector lapsed into a depression scenario as hundreds of companies failed. We are now seeing sectoral depression in the U.S. financial sector and the automotive sector is rapidly heading that way.

At this point, the economy as a whole is not in the same kind of distress and hopefully it will not get there. If the unthinkable should happen, then cash is king and quality bonds are princes. Anyone with large cash reserves can sit on the sidelines and watch as valuations continue to fall and valuable assets become available at give-away prices. A few brave people became multi-millionaires by buying real estate and blue-chip stocks in the darkest days of the Great Depression and then waiting until the cycle inevitably turned back up again.

As I said at the outset, I don’t believe it will get that bad. But there are certainly buying opportunities emerging and there will undoubtedly be more before we’re done.