Is there a risk of deflation? Part 2

Continues from last week’s edition
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.
With monetary aggregates being at historically high levels, interest rates at historically low levels and asset values being artificially inflated as the result of money printing by many reserve banks across the world, equilibrium will only be attained either through a slow adjustment in the value of fixed interest assets relative to that of other assets over a very protracted period or through another crisis that will lead to a rapid correction. Latter is similar to the cycles companies typically go through. Their share price increases rapidly above all fundamentals (and with it the CEO’s compensation) until they reach a point where the CEO’s run out of ideas to push the price any further. The result will be the departure of the CEO. The new CEO will now clean up by writing down inflated asset values, writing off doubtful amounts etc. that caused the artificial growth in the share price immediately. The share price will consequently drop steeply and the new CEO will now once again be able to push the share price and consequently his compensation package too.
What should we expect to happen? A distinct possibility is that a Donald Trump as next US president, and as a political outsider, may well have the courage to act as if he is the new CEO of company America, not being loaded with the political baggage of the candidates that participated in so many previous elections – take the pain now and move forward! Such a scenario really spells doom for debtors whose liabilities of course will retain their value while their assets will experience a decline in value.
Conclusion
Considering the risks looming for investors in global financial markets as sketched above, first and foremost, one should get rid of debt as quickly as one can. There is nothing one can do about a decline in asset values and if this happened as the result of deflation and also caused a decline in the cost of goods and services and the cost of living, one should be o.k. A deflation would impact all assets and there will be nowhere to hide. The best the investor can do is to invest selectively in high yielding assets that should be impacted less by a rapid de-rating. At the end of the day it’s the income you get from your investments that will determine whether you will survive or not, not the underlying value of the asset. Investors should thus be extremely cautious under current circumstances and protection against downside may not be a bad strategy.
Barring a shock to the global financial system that will lead to a rapid correction of the prevailing imbalances, we expect to see significantly lower returns on all asset classes than we have seen over the past 5 years and it should be quite difficult to achieve real returns over a protracted period.

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