Why Investors Fear the Deflation Threat

Is it rational to fear deflation? It depends on the “kind” of deflation we’re talking about.

deflation-threat

Some of the greatest fortunes were predicated on deflation. John D. Rockefeller, Henry Ford, and Sam Walton all amassed huge sums by purposefully driving down costs and prices. The lower their costs, the lower the prices they charged, the more sales they generated, the higher their inventory turnover. All of which lead to more market share and more profits.

Deflation – consumer-price deflation, to be specific – in this instance is good.

It’s no secret that today’s flat-screen televisions, smartphones, tablets, personal computers, and electronic readers will be cheaper a year from now. Despite falling prices, the manufacturers of these products will make money. Yes, the manufacturers will offer more feature-endowed, higher-priced alternatives, but the falling price offerings will still turn a profit.

This predictable consumer-price inflation – the benign downward shift in the supply curve – isn’t what investors fear. They fear acute consumer-price deflation – plummeting prices conflated with a credit crisis.

In another era, investors would be celebrating falling oil prices. Such was the case in the 1990s when oil prices spent most of the decade bouncing between $10 and $30 a barrel. In 1991, the S&P 500 traded at 400. By the end of 1999, the S&P 500 traded at 1,400. Low oil prices were a godsend, not a scourge.

Things are different today. Twenty years ago we didn’t have a huge oil sector built on shale deposits. Many of these newer energy companies need high oil prices to remain profitable. High debt levels exacerbate matters. The U.S. shale sector is encumbered with $200 billion in corporate debt.

Many of these newer companies are losing money at current oil prices, but that doesn’t mean they will cease production. Many will keep producing – and rationally so – even if they are losing money. If revenue more than covers variable costs, that leaves money that can be applied to fixed costs. Yes, full costs are not covered, but as long as variable costs and a portion of fixed costs are covered it’s reasonable to continue to produce.

Of course, if a money-losing oil producer continues to produce, it continues to add to supply. Elevated levels of supply ensure prices remain low. This can lead to a vicious downward cycle: Debt-laden companies eventually go bankrupt, assets hit the market on the cheap, valuations free fall. The need to service debt accelerates the spiral.

Because of high debt levels in the energy sector, investors and central bankers fear a contagion. This occurred in 2008 when the collapse (acute deflation) in housing prices threatened the financial sector, and the economy as a whole.

The Federal Reserve responded with money pumping. It bought depressed assets with new money to attempt to nominally maintain prices. The Fed was so panicked it took the unprecedented step of buying mortgage-backed securities after the collapse in bank valuations in 2008. It continued to buy these securities through the first three quarters of 2014.

So one type of deflation should be feared, but another should be embraced. Deflation driven by productivity and efficiency is good. Deflation driven by a credit-induced crisis is bad.

In short, consumer-product companies and retailers can prosper in a deflationary environment. Many U.S. shale producers, on the other hand, will go bust.

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Published by Wyatt Investment Research at