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Is there a risk of deflation?

Is there a risk of deflation?
Tilman Friedrich is a qualified chartered accountant and a Namibian Certified Financial Planner ® practitioner, specialising in the pensions field. Tilman is co-founder, shareholder and managing director of RFS, retired chairperson, now trustee, of the Benchmark Retirement Fund.

Tilman Friedrich is a qualified chartered accountant and a Namibian Certified Financial Planner ® practitioner, specialising in the pensions field. Tilman is co-founder, shareholder and managing director of RFS, retired chairperson, now trustee, of the Benchmark Retirement Fund.

Volatility in global equity markets has declined substantially since the advent of the global financial crisis. The US S&P 500 moved from as high as 80 points volatility to hovering around 20 points since 2012. This indicates that investors believe markets are stable – or does this indicate that we are in the eye of the storm?
Well looking at what is happening in the world around us we note that the Chinese economy is slipping further. Interest rates have not turned the corner and are at unsustainably low levels. This in our view is indicative of trouble brewing somewhere in investment markets. There is upheaval all around the Mediterranean, there is the threat of a Brexit, there is the European refugee crisis, an economic and political crisis in Brazil, the Ukrainian crisis, the US presidential elections, the unpredictability of the oil price and more. All of these present uncertainty and thus risk for the investor that should manifest in market volatility. This is not the case though and it appears that investors are unperturbed by all this uncertainty, going by the subdued equity market volatility. Price: earnings ratios in the US and SA continue to climb, meaning that investors are paying ever more for the same profit generated by companies. The US S&P 500 1 year trailing p:e was at 19.2 at the end of April, which is the highest level since April 2010, after it had declined to 12.4 in September 2010. SA Allshare 1 year trailing p:e was at 21.3 at end April, after it had declined to 12.1 in September 2010. SA equity investors are thus prepared to pay on average 21 times companies’ annual earnings.
And what about any risk of deflation? With interest rates as low as they are and have been since the end of the global financial crisis without having achieved the desired result of creating consumer demand and creating inflation with increasing demand, deflation could actually do the job of letting the air out of asset bubbles that were blown up by the artificially low interest rates. This would be bad news for owners of shares, property and other assets and could impact negatively on consumption. If you will be able to buy more for your Namibia Dollar in 6 months’ time than you can today, you will no doubt delay buying, particularly when its non-essential purchases such as capital goods. Sellers would obviously have the opposite purpose which will lead to declining demand and increasing supply and to further deflation. Now what about fixed interest assets?
The intervention of central banks has disabled the free market mechanism and has caused investors to ditch fixed interest investments for other assets, primarily equities. Pensioners whose capital is locked up in annuity funds so far had to bear the brunt of this distortion of market forces.
But why should the risk of deflation concern us here in Southern Africa where our inflation is running ‘nicely’ at around 7% now? Our governments certainly will not complain as there takings from the tax paying populous increases while the real value of their obligations is shrinking. The problem is that our economies will not evade the knock-on effect of deflation in the US and elsewhere, if it happened. Consider you owning a US Dollar asset of 1,000 that has decreased in value to 800. At an exchange rate of 15 the asset that was worth N$ 15,000 will now only be worth N$ 12,000.
If I as investor in a share considered the value of my N$ 1,000 in that share to be equivalent to the value N$ 1,000 invested in a bond yielding say 1%, I should be happy to buy the same quantity of bonds for say N$ 800 if my shares had declined in value to N$ 800 as the result of deflation. I would earn interest of N$ 10 on my bonds that I would purchase for N$ 800, which now represents a yield of 1.25%. This effect could correct the imbalance between fixed interest assets and other assets over a period and lead to the downward adjustment of equity prices. For the issuer of the bond this would of course have the opposite effect as his interest cost will increase.
Continues in next week’s edition.

Download the complete Benchtest fund investment overview at http://www.rfsol.com.na/benchmark

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