Deflation - bad for equities in general, an opportunity for some
While there is little historical evidence to go on, our analysis suggests that equities in general would suffer poor returns in a deflationary environment. However, such an environment would not be devoid of opportunities.
There has only been one episode where core inflation in the US fell below 1%, namely 1961-63, since records began in 1957. In that period of very low inflation, US equity returns were below average, although this doesn’t give any conclusive indication of how equities would perform in a deflationary period.
Japan has had substantial experience of actual deflation, and can on that basis be used as an example to gauge potential equity performance. However, there are several characteristics that are unique to Japan’s experience that make it problematic in terms of predicting what might happen elsewhere. Japan has an aging population, the earlier part of Japan’s ‘lost decade’ of deflation coincided with the Asian crisis, Japan’s experience was unique among global developed countries, the yen was strong despite deflation and Japan has a more independent and less accountable central bank than the US.
Given the lack of real deflationary periods and problems of comparison with Japan’s example, we need to have an alternative approach. We have used large negative deviations, or gaps, from prevailing inflation trends to simulate deflationary shock periods. This analysis highlights the double digit returns for equities during periods of high inflation, as they act as a hedge against rising prices. The large negative inflationary gaps, however, were where equities tended to have the poorest forward returns.
With little actual data to analyse, this analysis is only a "best guess." Nevertheless, the tendency of returns to decline as inflation moves lower does imply low or negative equity returns in a deflationary environment. This is also in line with a theoretical view of the negative impact that falling prices would have on profitability and overall equity returns.
Although the overall impact of deflation appears likely to be negative, there do appear to be areas of opportunity. In the inflation-gap analysis, defensives sectors such as healthcare, consumer staples and telecoms were least impacted by negative inflation shocks. Cyclical areas such as consumer discretionary, information technology (in part due to the tech bubble) and industrials tended to fall furthest short of their average 12-month returns during these periods.
Specific investment styles also appear to have the potential to outperform in a period of deflation. As deflation drives investors to hunt for yield, higher-yielding income stocks tend to outperform. Conversely, growth stocks, which typically pay little or no dividend, tend to underperform.
Given the limited historical experience of deflation, anticipating potential problem areas in equities is largely a theoretical exercise. Another appropriate approach would therefore be to identify the theoretical economic consequences of deflation and its potential impact on specific sectors and investment styles.
While labour costs have become more flexible in recent years, they remain rigid enough that companies with large labour forces will be reluctant to hire new workers in a persistent deflationary environment. Deflation would also exacerbate large pension deficits, and we would therefore expect companies with wage-intensive cost structures and large pension obligations to underperform. Falling prices would also cause consumers to delay spending on durable goods, and cyclical sectors in general are likely to underperform defensive areas.
Deflation brings out the best in some
Companies with an inelastic revenue base, such as monopolies or those with dominant positions in their industry, would tend to outperform. Regulated monopolies, whose prices are linked to the consumer price index, would not have this advantage, however. Companies with strong balance sheets would also outperform those with weaker balance sheets, as investors seek companies in a secure financial position. Other potential beneficiaries include large multinational companies with a high proportion of foreign revenue. They would be boosted by a weak domestic currency, which normally accompanies deflation, and can effectively import growth. Additionally, companies exposed to areas of the world without deflation would also outperform. In Japan’s example, exporting companies with over 50% of their revenue derived from abroad have been one of the strongest-performing areas during deflation. And that has been despite strength in Japan’s currency.
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