In its almost 250-year history, the United States has experienced more phases of inflation than deflation. The last great period of deflation occurred during the Great Depression.
There was another minor period during the Great Financial Crisis. Both coincided with a recession. During a recession and deflation, people lose their jobs, demand falls, and so do prices.
But for those able to hold onto their jobs and invest in what should they look out for in a deflationary time for some of the best investments? In this article, we explain how deflation works and offer some strategies to defend against it.
What is deflation?
While inflation is a rise in prices, deflation is a fall in prices.
As mentioned in the introduction, deflation usually occurs during a recession. As the layoffs begin, demand falls. As a result, companies lower prices in order to attract customers. However, due to their depressed prices and profits, companies are also more inclined to cut their wages or lay off even more employees.
Even if the products are cheaper, if customers earn less money or have no jobs at all, they can no longer shop as they used to. This means that sales remain depressed or can even decline further.
The above scenario can create a viscous supply and demand cycle. When companies cut prices, their profit margins go down. This leads to the need to cut costs, which leads to more layoffs. But more layoffs will further reduce demand and fuel the cycle.
Japan’s “lost decade” from 1990 to 2001 is perhaps the best-known example of how deflation can decimate an economy. The Federal Reserve Economic Data (FRED) chart below shows the steady rise in Japanese unemployment during these difficult years.
Should US investors be concerned about future deflation?
Deflation is not a problem in the US right now. In fact, the Federal Reserve has recently become more focused on curbing inflation problems caused by pandemic-induced supply chain problems in several industries.
Related: These are the best investments for inflationary times
However, some economists fear that once these supply issues are resolved, demand may still not return to pre-pandemic levels. Unemployment and consumer anxiety are two of the biggest contributors to deflation. And both could stay high even if the companies are producing at full capacity again.
There is still a great chance the United States could avoid deflation. And the Federal Reserve will certainly take all measures to ensure that this happens. Still, it’s a potential threat that investors will want to keep an eye on for the next three to five years.
3 best investments for deflationary times
For many, periods of deflation are marked by conservation and even survival. But for some, they are able to keep their investments up and move on without significantly affecting their lifestyle.
Deflation may sound like a good time to investors as prices are falling. But the problem is that prices can keep falling. There is no way of knowing for sure when the bottom will be reached.
Instead of chasing prices, it may be better to look for assets that will hold their value, or at least not fall as quickly. The following are three examples of investments that tend to remain permanent during periods of deflation.
1. Investment grade bonds
Investment grade bonds include government bonds and bonds from top blue chip companies. These types of bonds work well in a deflationary environment due to the quality of the company behind them.
The government won’t go broke, which means investors can be confident that they will continue to receive regular payments and eventually their principal.
It is similar for high-quality companies. These companies have been around for a long time, have great management and solid balance sheets. Your products are in demand. These companies are unlikely to go out of business, even during a recession.
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2. Defensive stocks
Defensive stocks are those of companies that sell products or services that we humans cannot simply remove from their lives. Consumer goods and utilities are two of the most common examples.
Think of toilet paper, food and electricity. Regardless of the economic conditions, people will always need these goods and services.
If you don’t want to invest in individual stocks, you can invest in ETFs that track the Dow Jones US Consumer Goods Index or the Dow Jones US Utilities Index.
Popular consumer goods ETFs include iShares US Consumer Goods (IYK) and ProShares Ultra Consumer Goods (UGE). Utility ETF options include iShares US Utilities (IDU) and ProShares Ultra Utilities (UPW).
3. Dividend paying stocks
Dividend stocks remain in demand during a recession for their income. While the stock price can go down, investors can count on the dividends to continue generating steady passive income.
Investors should focus on high quality dividend paying companies rather than just looking for companies with high dividend yields. An unusually high dividend yield can actually be a warning sign as it could indicate that the stock price has recently taken a nosedive.
If you’re looking for strong, dividend-paying companies, the Dividend Aristocrats can be a good place to start. Dividend Aristocrats are companies that have increased their dividends for at least 25 consecutive years. As of September 2021, 63 companies met these requirements.
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3 other ways to defend against deflation
Investing is not the only way to weather a deflationary event. People who can’t invest can make things a little easier by following two key strategies:
1. Build up cash reserves
Holding cash should be high on your list during a period of deflation. This is because as prices fall, cash will have more purchasing power. Deflation is a contraction in the amount of money and credit. That increases the value of the dollar.
Anyone who’s tried to get a loan during a recession knows that it can be very difficult. It is all the more important that your emergency fund is fully financed. And you might want to save even more money knowing you are about to have big expenses.
Are you earning enough interest on your savings?
2. Keep cash
Holding liquid funds such as certificates of deposit (CDs) or money market accounts (MMAs) is also important as investors can easily convert these into cash.
Yes, liquid assets also lose value during deflation. But unlike illiquid assets like real estate, cars, and collectibles, liquid assets can quickly become a source of money in an emergency.
3. Pay off debts
Debt does not depreciate due to deflation. In fact, it often only becomes a major burden in deflationary phases.
Wages typically stagnate or decrease during deflation, while debt levels either stay the same or increase due to accumulated interest charges. And remember if someone loses their job and is forced to become unemployed during a cycle of deflation. Your income will be much lower while your debt burden will remain the same.
We would say that deleveraging is almost always a great strategy regardless of the economic environment. But this is a smart idea, especially in a deflationary environment.
For many, deflation means pulling the reins and closing the hatches. And that’s fine when it comes to avoiding unnecessary spending. But investing for your retirement and future goals aren’t things to cut off your budget during deflation when you can possibly prevent it.
If you keep investing during the downturn, you will be in even better shape when prices rebound. In the meantime, knowing what is working and what is not can make all the difference between maintaining some level of stability in your investments or watching them completely crash and burn up.