The Most Likely Portfolio Peril — Inflation or Deflation?

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
Post Reply
User avatar
Topic Author
SimpleGift
Posts: 4477
Joined: Tue Feb 08, 2011 2:45 pm

The Most Likely Portfolio Peril — Inflation or Deflation?

Post by SimpleGift »

Many of us who lived through the runaway inflation of the 1970s believe, consciously or unconsciously, that inflation is still the greatest risk to our investments. To quote William Bernstein, author of the book Deep Risk, "Financial history suggests that in the long run, the most probable threat to your long-term wealth is inflation." In this post, we'll challenge this proposition, not just by looking at past history, but by looking at current and future demographic trends. [NOTE: This post is partly conjectural, to stimulate critical thinking and should be taken as such.]


1. The Developed Nations Have Already Used Up Their "Demographic Dividend"
A demographic dividend is realized when a country's labor force is temporarily growing faster than the population dependent upon it (chart below). In the western world (plus Japan, not shown), the young people of the post-war "baby boom" began joining the workforce in the early 1960s, and dependency ratios fell rapidly. The result was a period of strong economic growth and high inflation. As dependency ratios leveled out in the early 1980s, steady disinflation ensued. Today, with baby boomers retiring and workforces shrinking in the developed world, dependency ratios are on the rise again — leading to much slower economic growth and likely deflationary pressures.
2. Most Emerging Countries Today Are Still Enjoying A Demographic Dividend
Due to their much younger populations overall, emerging countries have seen a constant stream of young people swelling their workforces ever since the early 1970s (chart below). As a result, dependency ratios have fallen steadily and both economic growth and inflation are still high today. But their demographic dividend will also end in time as each emerging country ages. For China (not shown), that time is today, as dependency ratios began rising there in 2015. Next will come Brazil in about 2020, then Indonesia in 2025, and India around 2040.
3. We Can Test This Demographic Thesis By Looking at Countries' Inflation Rates Today
In the chart below, we regress the core inflation rates of both developed and emerging countries against the median age of their populations. Not surprisingly, there's a strong correlation (R^2 = 0.73). Those countries with the oldest populations and shrinking workforces have the lowest inflation rates, with some even flirting with deflation (on the right) — while those with youngest populations and fast-growing workforces have the highest inflation rates (on the left). China and the U.S. are currently meeting in the middle.
DISCUSSION: In the developed world, high inflation has been a serious portfolio risk in the past, but demographic trends suggest that persistent (if mild) deflation will likely be a threat in the years ahead. Most western investors will probably be well-served with a good portfolio balance of inflation hedges (equities, REITs, etc.) and deflation hedges (high-quality bonds). For investors in emerging nations, high inflation should remain the most serious portfolio risk in the immediate future — but with disinflation and even deflationary pressures coming somewhere down the road. Your thoughts on these trends?
Nathan Drake
Posts: 6201
Joined: Mon Apr 11, 2011 12:28 am

Re: The Most Likely Portfolio Peril — Inflation or Deflation

Post by Nathan Drake »

Let's not confuse equity deflation (Japan stock's P/E soaring to 100+ levels and being reduced to a fifth of that over the coming decades) and consumer prices deflation.

I see no reason why equities couldn't be a good hedge against deflation given the right set of circumstances. Total returns may be lower, but in a deflationary environment you wouldn't need as much growth and "real returns" may be roughly the same as historical norms. Also, production efficiencies can drive down costs and increase profitability, so it really depends on whether deflation is the result of lacking growth (negative effect on equities), or whether it's increased productivity coupled with growth (positive effect on equities).
20% VOO | 20% VXUS | 20% AVUV | 20% AVDV | 20% AVES
User avatar
nisiprius
Advisory Board
Posts: 52105
Joined: Thu Jul 26, 2007 9:33 am
Location: The terrestrial, globular, planetary hunk of matter, flattened at the poles, is my abode.--O. Henry

Re: The Most Likely Portfolio Peril — Inflation or Deflation

Post by nisiprius »

I'm really enjoying your thought-provoking posts, simplegift.

The question that arises in my mind is, in general, to a rough first approximation and ignoring taxation etc. what is the effect of inflation and deflation on a) real returns of stocks, b) real returns of bonds, c) the premium of stocks over bonds? There are strong psychological factors at play, money illusion is very real--as when people wring their hands over Social Security not getting a COLA adjustment in, was it 2009? but I don't see the problem with mild deflation if the relative relationship between cost of living and investment returns holds constant.

Deflation as a result of economic catastrophe is another thing. Economic catastrophe is bad for everything.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.
BahamaMan
Posts: 896
Joined: Wed Oct 01, 2014 5:52 pm

Re: The Most Likely Portfolio Peril — Inflation or Deflation

Post by BahamaMan »

nisiprius wrote: Deflation as a result of economic catastrophe is another thing. Economic catastrophe is bad for everything.
The problem with Deflation is that it can cause Economic Catastrophe. When people start hoarding money, because prices will drop next year and you can buy those items on sale, it can cause a screeching halt to the Economy. There is a 'race' to the bottom with prices. Great Depression II
Grt2bOutdoors
Posts: 25617
Joined: Thu Apr 05, 2007 8:20 pm
Location: New York

Re: The Most Likely Portfolio Peril — Inflation or Deflation

Post by Grt2bOutdoors »

BahamaMan wrote:
nisiprius wrote: Deflation as a result of economic catastrophe is another thing. Economic catastrophe is bad for everything.
The problem with Deflation is that it can cause Economic Catastrophe. When people start hoarding money, because prices will drop next year and you can buy those items on sale, it can cause a screeching halt to the Economy. There is a 'race' to the bottom with prices. Great Depression II
I agree, however there are some industries where deflation in prices would be a good thing for the economy at large. Let's start with the ridiculous education and healthcare costs in this country. The next place where a bit of deflation could help is in the level of taxation in general. We are already seeing deflation in commodity costs.
"One should invest based on their need, ability and willingness to take risk - Larry Swedroe" Asking Portfolio Questions
User avatar
Topic Author
SimpleGift
Posts: 4477
Joined: Tue Feb 08, 2011 2:45 pm

Re: The Most Likely Portfolio Peril — Inflation or Deflation

Post by SimpleGift »

It also deserves mention that, demographically, the United States is a bit unique among developed countries worldwide (in middle, chart below). Because of its somewhat higher fertility rates and its higher immigration rates, the U.S. is projected to have a slowly growing workforce for decades to come — even as its old-age dependency ratios also rise. This is in contrast with most other developed countries like Japan or Germany (on the right), whose workforces are steadily shrinking as their populations age.

Therefore, if it's lucky, the U.S. may stand a better chance of avoiding the worst negative growth, deflationary scenarios of Japan and Germany and perhaps instead chart a "middle path" of slow growth and low inflation.
PS. Kindly remember that comments about U.S. immigration policy are not acceptable on the Forum.
ourbrooks
Posts: 1575
Joined: Fri Nov 13, 2009 3:56 pm

Re: The Most Likely Portfolio Peril — Inflation or Deflation

Post by ourbrooks »

You might want to choose a different country for comparison than Germany; it's the second most frequent destination for immigrants after the U.S. Relative to the native population, it has a higher rate. The large number of immigrants has been a cause of social friction recently. The amount of immigration is the result of intentional policy to cope with the ageing of the population and the decline of the workforce.
dkturner
Posts: 1936
Joined: Sun Feb 25, 2007 6:58 pm

Re: The Most Likely Portfolio Peril — Inflation or Deflation

Post by dkturner »

I'm looking at an August 22, 1992 article (The zero option) I clipped from The Economist dealing with the impact of price stability on equity and bond returns. The article references research from Morgan Stanley covering the years 1871-1991 which breaks down price movements into deflation, price stability, low inflation and high inflation. The MS findings conclude that equities produce very high returns (19.0%) during periods of relative price stability and high returns (11.8%) during periods of low inflation. Equities produce below average returns (4.9% on average) during periods of deflation and high inflation. Bonds produce very good returns (5.8%) during periods of price stability and low returns (1.8%) during low inflationary periods. As you already know, bonds produce high returns (8.1%) during deflationary periods and negative returns (-.4%) during periods of high inflation.

I tried to find this article in The Economist database but couldn't. Maybe someone more adept at online research than I am can locate it.
User avatar
Topic Author
SimpleGift
Posts: 4477
Joined: Tue Feb 08, 2011 2:45 pm

Re: The Most Likely Portfolio Peril — Inflation or Deflation

Post by SimpleGift »

nisiprius wrote:The question that arises in my mind is, in general, to a rough first approximation and ignoring taxation etc. what is the effect of inflation and deflation on a) real returns of stocks, b) real returns of bonds, c) the premium of stocks over bonds?
Dimson, Marsh and Staunton reported on the real returns of stocks and bonds during various inflation/deflation scenarios in their 2012 Yearbook (chart below), which summarized research from their 19-country global database with 112 years of annual asset returns from 1900-2011:
  • • Deflation. In times of very low inflation, especially during periods of strong disinflation or even mild deflation, both equities and bonds had high real returns. However, bonds significantly outperformed stocks during periods of severe deflation.

    • Inflation. In all other cases besides severe deflation, however, the real return of stocks are higher than those of bonds — but the level of real returns depends largely on the inflation rate. The perfect condition for real returns from stocks seems to be very low inflation rates that do not fluctuate greatly and avoids slipping into severe deflation. As inflation rises, real equity returns decline.

    • Equity Premium. Real equity returns were always greater than those of bonds during high inflation, and the equity risk premium tends to rise with the inflation rate. The real returns of stocks are basically positive in almost all inflationary scenarios, except during times of extreme inflation. In extreme inflation, the real returns of both stocks and bonds are negative.

    Image
    Source: 2012 Global Investment Returns Yearbook
Last edited by SimpleGift on Fri Mar 20, 2015 4:23 pm, edited 1 time in total.
itstoomuch
Posts: 5343
Joined: Mon Dec 15, 2014 11:17 am
Location: midValley OR

Re: The Most Likely Portfolio Peril — Inflation or Deflation

Post by itstoomuch »

Short term= Deflation. I had thought that with Economic Stimulus Acts of 2001 and 2002 that we would see inflation but we only saw it in housing and credit markets. Likewise with TARP and the QE1,II, III, I had thought that M1, M2, M3 would dramatically increase but wrong again.

My guess is that the liquidity is being destroyed by those who have the wealth (10% of pop, the investors & savers) faster than the Fed can increase the money supply. Velocity is way down from what it used to be. In our situation, we are light spenders because of our seniors' care and BIL. But wait until those responsibilities cease, Spending will create shortages and inflation.

:annoyed
Rev012718; 4 Incm stream buckets: SS+pension; dfr'd GLWB VA & FI anntys, by time & $$ laddered; Discretionary; Rentals. LTCi. Own, not asset. Tax TBT%. Early SS. FundRatio (FR) >1.1 67/70yo
User avatar
nedsaid
Posts: 19249
Joined: Fri Nov 23, 2012 11:33 am

Re: The Most Likely Portfolio Peril — Inflation or Deflation

Post by nedsaid »

Simplegift, another item that should be considered is the credit expansion that took place after World War II and probably peaked in 2008. How much more can the average American afford to leverage themselves?

Three percent real economic growth is considered good. My guess is that population growth accounted for 2% real economic growth and perhaps 1% real economic growth came from credit expansion. Of course productivity improvements have to be factored in there as well. My guess is that whatever economic growth in Europe is coming from productivity.

Why not add credit expansion and productivity to your scenario. This is a very interesting discussion.
A fool and his money are good for business.
User avatar
Topic Author
SimpleGift
Posts: 4477
Joined: Tue Feb 08, 2011 2:45 pm

Re: The Most Likely Portfolio Peril — Inflation or Deflation

Post by SimpleGift »

nedsaid wrote:Why not add credit expansion and productivity to your scenario. This is a very interesting discussion.
Ned, I doubt we can discuss credit expansion and inflation without inviting spirited comments about the U.S. government's monetary and economic policies — which would likely violate the Forum's guidelines. However, we did have a discussion topic just a month ago on the aging of the world's population and its implications for global productivity growth and future stock returns, which might be of interest:

Future Stock Returns in an Aging World?
User avatar
nedsaid
Posts: 19249
Joined: Fri Nov 23, 2012 11:33 am

Re: The Most Likely Portfolio Peril — Inflation or Deflation

Post by nedsaid »

I am just saying that credit expansion is a big factor. A discussion is possible without being political or getting into economic policy. All other things being equal, credit expansion will aid economic growth. Credit contraction will hinder economic growth. This is a factor. I suppose an aging population would by itself would not foster credit expansion. For one thing an aging population is not looking for larger houses and with emptying or empty nests might be interested in downsizing.

Also a discussion of productivity improvements does not get into political discussions. A lot of this happens because of advances of technology or work process efficiencies. Productivity improvements would tend to drive inflation lower. Perhaps in countries with level or declining work forces, technology (robots) will be counted on to keep enough goods and services available for everyone.

My best guess is that aging populations would have a deflationary effect on the world economy and would also be a drag on stock market returns.
A fool and his money are good for business.
alex_686
Posts: 13286
Joined: Mon Feb 09, 2015 1:39 pm

Re: The Most Likely Portfolio Peril — Inflation or Deflation

Post by alex_686 »

Grt2bOutdoors wrote:I agree, however there are some industries where deflation in prices would be a good thing for the economy at large. Let's start with the ridiculous education and healthcare costs in this country. The next place where a bit of deflation could help is in the level of taxation in general. We are already seeing deflation in commodity costs.
You are confusing falling prices with deflation. A common misconception but wrong.

Inflation = Change in supply of money / change in demand for money.

When productivity increases, prices fall, this is true. However, it also means that economy is becoming more efficient and is probably growing. The falling price of computers has greatly enhanced the productivity of the economy so there is a net increase in demand for money.

Deflation is different. It is not just lower prices but also lower demand for money. Why would people need less money? A stale and stagnate economy.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
stlutz
Posts: 5585
Joined: Fri Jan 02, 2009 12:08 am

Re: The Most Likely Portfolio Peril — Inflation or Deflation

Post by stlutz »

Interesting post. The 1970s had some additional very specific things going on that are worth noting:

1) zero productivity growth, which means that wage increases had to lead to price increases. (Was the large growth of the labor force related to the lack of productivity growth?)
2) The energy crisis.
3) The move from fixed to floating exchange rates which resulted in a large decline in the value of the dollar.

1&2 can certainly happen again. #2 was certainly a part of the relatively high inflation we had back in 2006-7. Overall, I think you're on track that the threat of inflation is lower. I think a key reason for this is that older people have less need/desire for credit than younger people do, which means that there is a lot less money creation. The Fed's 2% inflation target certainly is more of a ceiling than a floor nowadays.

Getting to practical investing, I think one of the harder things is convincing people that getting 3% return on a bond with 1% inflation is a better deal than getting 5% return with 3% inflation, just as it's better to get a 0% COLA with 1% deflation than a 3% COLA with 3% inflation.
cbeck
Posts: 640
Joined: Sun Jun 24, 2012 1:28 am

Re: The Most Likely Portfolio Peril — Inflation or Deflation

Post by cbeck »

alex_686 wrote:
Grt2bOutdoors wrote:I agree, however there are some industries where deflation in prices would be a good thing for the economy at large. Let's start with the ridiculous education and healthcare costs in this country. The next place where a bit of deflation could help is in the level of taxation in general. We are already seeing deflation in commodity costs.
You are confusing falling prices with deflation. A common misconception but wrong.

Inflation = Change in supply of money / change in demand for money.

When productivity increases, prices fall, this is true. However, it also means that economy is becoming more efficient and is probably growing. The falling price of computers has greatly enhanced the productivity of the economy so there is a net increase in demand for money.

Deflation is different. It is not just lower prices but also lower demand for money. Why would people need less money? A stale and stagnate economy.
This is the very much minority (some would say "crank") attempt to redefine inflation as an increase in the money supply trumpeted by the Austrians. No one else believes this. Krugman, for example.

http://krugman.blogs.nytimes.com/?s=def ... n+austrian

Nor does it pass the smell test. Do you hear people complaining that their latest raise doesn't keep pace even with the increase in the money supply?
2comma
Posts: 1241
Joined: Thu Jul 15, 2010 11:37 pm

Re: The Most Likely Portfolio Peril — Inflation or Deflation

Post by 2comma »

Thanks for posting this, certainly good food for thought.
If I am stupid I will pay.
User avatar
nisiprius
Advisory Board
Posts: 52105
Joined: Thu Jul 26, 2007 9:33 am
Location: The terrestrial, globular, planetary hunk of matter, flattened at the poles, is my abode.--O. Henry

Re: The Most Likely Portfolio Peril — Inflation or Deflation

Post by nisiprius »

Simplegift wrote:
nisiprius wrote:The question that arises in my mind is, in general, to a rough first approximation and ignoring taxation etc. what is the effect of inflation and deflation on a) real returns of stocks, b) real returns of bonds, c) the premium of stocks over bonds?
Dimson, Marsh and Staunton reported on the real returns of stocks and bonds during various inflation/deflation scenarios in their 2012 Yearbook (chart below), which summarized research from their 19-country global database with 112 years of annual asset returns from 1900-2011:
  • • Deflation. In times of very low inflation, especially during periods of strong disinflation or even mild deflation, both equities and bonds had high real returns. However, bonds significantly outperformed stocks during periods of severe deflation.

    • Inflation. In all other cases besides severe deflation, however, the real return of stocks are higher than those of bonds — but the level of real returns depends largely on the inflation rate. The perfect condition for real returns from stocks seems to be very low inflation rates that do not fluctuate greatly and avoids slipping into severe deflation. As inflation rises, real equity returns decline.

    • Equity Premium. Real equity returns were always greater than those of bonds during high inflation, and the equity risk premium tends to rise with the inflation rate. The real returns of stocks are basically positive in almost all inflationary scenarios, except during times of extreme inflation. In extreme inflation, the real returns of both stocks and bonds are negative.

    Image
    Source: 2012 Global Investment Returns Yearbook
Just to be clear then... isn't this exactly what I'd have thought?

Deflation is not a problem for either stocks or bonds. Deflation benefits anyone who's a net creditor, anyone who owns securities. Returns of everything increase in deflation. Anyone sitting on a nice portfolio that is reasonably liquid is fine--unless the general malaise of deflation spreads and creates societal chaos ("Sorry, we're cutting social security..." "Sorry, we're suspending redemptions on your mutual fund...")

It's only an issue if you're a competitive investor who want to adjust asset allocation so as to get the maximum real return at all times.

Yes?

(Added: tip of the hat for Silence Dogood for PM-ing me about a typo which I've corrected)
Last edited by nisiprius on Sat Mar 21, 2015 1:00 pm, edited 1 time in total.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.
User avatar
nisiprius
Advisory Board
Posts: 52105
Joined: Thu Jul 26, 2007 9:33 am
Location: The terrestrial, globular, planetary hunk of matter, flattened at the poles, is my abode.--O. Henry

Re: The Most Likely Portfolio Peril — Inflation or Deflation

Post by nisiprius »

cbeck wrote:
alex_686 wrote:...Deflation is different. It is not just lower prices but also lower demand for money. Why would people need less money? A stale and stagnate economy.
This is the very much minority (some would say "crank") attempt to redefine inflation as an increase in the money supply trumpeted by the Austrians. No one else believes this. Krugman, for example.

http://krugman.blogs.nytimes.com/?s=def ... n+austrian

Nor does it pass the smell test. Do you hear people complaining that their latest raise doesn't keep pace even with the increase in the money supply?
To be fair, in the 1920s and the era of the gold standard, "inflation" meant an increase in the government exchange rate between dollars and gold, the same weight of gold backing a larger number of dollars.

But since I remember newscasters in the 1950s talking about "inflation" during the Korean War, with graphics--and they didn't do a lot of graphics then!--of a shrinking dollar bill buying fewer things, I think "inflation" has meant the same thing as "cost of living" for over half a century.

Quick reality check, ahdictionary.com

in·fla·tion (ĭn-flāshən)
Share:
n.
1. The act of inflating or the state of being inflated.
2.
a. A persistent increase in the level of consumer prices or a persistent decline in the purchasing power of money.
b. The rate at which this increase occurs, expressed as a percentage over a period of time, usually a year.

No other meaning given.

"Inflation" now means cost of living, the thing CPI-U tries to measure, the actual practical economic effect, regardless of the supposed cause.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.
User avatar
Topic Author
SimpleGift
Posts: 4477
Joined: Tue Feb 08, 2011 2:45 pm

Re: The Most Likely Portfolio Peril — Inflation or Deflation

Post by SimpleGift »

nisiprius wrote:Deflation is not a problem for either stocks or bonds. Deflation benefits anyone who's a net creditor, anyone who owns securities. Returns of everything increase in inflation. Anyone sitting on a nice portfolio that is reasonably liquid is fine--unless the general malaise of deflation spreads and creates societal chaos ("Sorry, we're cutting social security..." "Sorry, we're suspending redemptions on your mutual fund...")

It's only an issue if you're a competitive investor who want to adjust asset allocation so as to get the maximum real return at all times.

Yes?
I'm not sure one can be quite so sanguine about asset returns during deflation — despite the Dimson, Marsh and Staunton long-term average returns shown upthread.

Certainly any part of the economy dependent on long-term loans would suffer in a deflationary environment, since the dollars being paid back are more valuable than the ones that were borrowed. We know from the 2008 recession that home prices can fall and deflation would, in all likelihood, take them lower. Some stocks would be more vulnerable than others. Companies sitting on piles of cash would actually benefit, but highly-leveraged companies involved in areas like commodity production would be vulnerable. Similarly, consumer goods makers (especially in non-essential, luxury products) would likely lose their power to raise prices. Declining sales and profits would put downward pressure on their share prices.

Conversely, any investment that pays you a fixed income over the long term would be a big winner, including high-quality bonds. Treasuries will certainly have the lowest risk, but high-quality corporates and munis should also work, especially in a diversified bond fund that spreads the default risk. Even plain vanilla, FDIC-insured certificates of deposit would shine, even at low yields. During deflation, it's the real rate of return that counts: if prices are deflating at 2% per year, a 2% CD is actually paying you 4% real.
User avatar
Oicuryy
Posts: 1959
Joined: Thu Feb 22, 2007 9:29 pm

Re: The Most Likely Portfolio Peril — Inflation or Deflation

Post by Oicuryy »

nisiprius wrote:"Inflation" now means cost of living, the thing CPI-U tries to measure, the actual practical economic effect, regardless of the supposed cause.
That is the problem. The OP asks us to calculate the likelihood of an effect with an undefined cause. Good luck with that.

For a look at what the word inflation used to mean see this paper from the Cleveland Fed now hosted by the Swedish central bank.

On the Origin and Evolution of the Word Inflation

Ron
Money is fungible | Abbreviations and Acronyms
stlutz
Posts: 5585
Joined: Fri Jan 02, 2009 12:08 am

Re: The Most Likely Portfolio Peril — Inflation or Deflation

Post by stlutz »

Certainly any part of the economy dependent on long-term loans would suffer in a deflationary environment, since the dollars being paid back are more valuable than the ones that were borrowed. We know from the 2008 recession that home prices can fall and deflation would, in all likelihood, take them lower. Some stocks would be more vulnerable than others. Companies sitting on piles of cash would actually benefit, but highly-leveraged companies involved in areas like commodity production would be vulnerable. Similarly, consumer goods makers (especially in non-essential, luxury products) would likely lose their power to raise prices. Declining sales and profits would put downward pressure on their share prices.
I think it's important to distinguish between a sudden bout of deflation (e.g. the "panics" of the 1800s) and a steady, small, persistent fall in the overall price level.

When we didn't have a central bank and we were on the gold standard, a financial panic would cause all trust in the financial system to fall away and there was suddenly no credit which created a sudden fall in economic activity and the price level. That's bad for indebted people/companies.

Your OP was highlighting long-term trends. As you note, if we have a an average of 1% deflation per year, then interest rates will be very low (or even zero and below). As long as the psychology of the marketplace adjusts to the new normal (which takes time), then economic activity will hum along just fine.

Indeed, the reverse has happened in the past. Again in the post-Civil War era, deflation was considered normal. (As an aside, an inverted yield curve was also normal back then). Overall, the economy boomed during this time. In the 20th century we moved to a world where inflation was the norm. The economy still boomed.

I guess I'm making the fairly unremarkable point that that problems occur when there are sudden, unexpected swings between inflation and deflation.

From an investing perspective, that's been one of the problems more recently, I think. In hindsight, some bad (in my opinion) judgments have been made in fixed income by a lot of people (e.g. "keep durations short") over the past 6 years because their expectations were anchored to a higher inflation world. Other people are taking a lot more risk in fixed income because 2-3% Treasury yields "don't even match inflation," by moving into junk bonds or complaining that the Total Bond index doesn't contain enough corporate bonds. In these cases, if inflation and rates were both 2% higher, there would no concerns expressed at all. As noted, adjusting to what the new mean is does take time--the mean is a longer-term average after all.
User avatar
Topic Author
SimpleGift
Posts: 4477
Joined: Tue Feb 08, 2011 2:45 pm

Re: The Most Likely Portfolio Peril — Inflation or Deflation

Post by SimpleGift »

stlutz wrote:Your OP was highlighting long-term trends. As you note, if we have a an average of 1% deflation per year, then interest rates will be very low (or even zero and below). As long as the psychology of the marketplace adjusts to the new normal (which takes time), then economic activity will hum along just fine.

Indeed, the reverse has happened in the past. Again in the post-Civil War era, deflation was considered normal. (As an aside, an inverted yield curve was also normal back then). Overall, the economy boomed during this time. In the 20th century we moved to a world where inflation was the norm. The economy still boomed.

I guess I'm making the fairly unremarkable point that that problems occur when there are sudden, unexpected swings between inflation and deflation.
Your post makes an excellent point, that economies can and will adjust to a new deflation/inflation regime, if given sufficient time to adapt. In fact, what we have today in the case of Japan and the Eurozone, I believe, is a real-world experiment in nations' ability to adapt to aging populations, shrinking workforces and persistent (if mild, so far) deflation.

In all of human history up to this point, populations have generally been growing and workforces have been expanding. Most of our knowledge about economic growth and all of our historical investment return data is based on expanding populations. But we have entered a new era within our lifetimes, where population growth is slowing, societies are aging worldwide and dependency ratios are rising, almost across the board. A new world is upon us — one to which we can hopefully adapt — but with uncertain effects on our future investment returns.
Last edited by SimpleGift on Sat Mar 21, 2015 2:26 pm, edited 1 time in total.
alex_686
Posts: 13286
Joined: Mon Feb 09, 2015 1:39 pm

Re: The Most Likely Portfolio Peril — Inflation or Deflation

Post by alex_686 »

cbeck wrote:This is the very much minority (some would say "crank") attempt to redefine inflation as an increase in the money supply trumpeted by the Austrians. No one else believes this. Krugman, for example.

http://krugman.blogs.nytimes.com/?s=def ... n+austrian

Nor does it pass the smell test. Do you hear people complaining that their latest raise doesn't keep pace even with the increase in the money supply?
As for the theoretical base, I am not sure I would call all Austrians and Milton Friedman cranks.

But that being said, I think you missed my argument. It was not about the money supply but the demand for money. Change in demand and supply is a basic econ 101 definition of what inflation is. Deflation can be a sign of a weak economy.

Have I seen people complain about dropping prices in a single sector? No. Because that is not a sign of deflation, it is a sign of increased productivity. Have I seen people complaining about overall price level drops? Yes. Take a look at Japan.

I will point you to Larry Summers's Secular Stagnation.
http://www.voxeu.org/content/secular-st ... -and-cures

Or Mohamed A. El-Erian and Bill Gross's New Normal
http://www.pimco.com/en/insights/pages/ ... ormal.aspx

I am not sure if either of these scenarios would come to pass. However, if they did there is a decent chance we will have a long term deflation period like Japan.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
roflwaffle
Posts: 440
Joined: Mon Mar 02, 2015 9:08 pm

Re: The Most Likely Portfolio Peril — Inflation or Deflation

Post by roflwaffle »

nedsaid wrote:Simplegift, another item that should be considered is the credit expansion that took place after World War II and probably peaked in 2008. How much more can the average American afford to leverage themselves?

Three percent real economic growth is considered good. My guess is that population growth accounted for 2% real economic growth and perhaps 1% real economic growth came from credit expansion. Of course productivity improvements have to be factored in there as well. My guess is that whatever economic growth in Europe is coming from productivity.

Why not add credit expansion and productivity to your scenario. This is a very interesting discussion.
A quick search indicates real per capita economic growth is at ~2.3%/year since 1960.

http://research.stlouisfed.org/fred2/series/USARGDPC

The ratio of household debt to wages also looks to be pretty consistent.

Image

IIRC, public debt is similar to post WWII levels as well, but unlike private debt, there was a sustained effort to pay it off after WWII, so over the past half century plus it's looked more like a "U" than the steady increase in private debt/wages.

For deflation, we need either a demand side or supply side cause. I think the Fed is pretty good at managing the supply side, which they did during the Great Recession.

This implies we would need a demand side cause, which is either growth deflation, or cash hording, or both. Growth deflation is likely self-limiting, because there are lower bounds to the costs of goods, so my guess is that cash hording is the most likely threat.

There are anecdotal examples, but I'm not sure if a big enough set of the same conditions that led to Japan/South Korea hoarding cash would be likely here.

http://www.economist.com/news/leaders/2 ... urts-their

On the other hand, inflation may still be an issue. The monetary policy of the fed coupled with loose regulation and the coupling of lending/securitization in terms of housing could have led to the Great Recession, and I think would be an example of demand-pull inflation. On the flip side, the OPEC embargo in the 70s resulted in cost-pull inflation. Built in inflation in possible too, but I can't think any examples in America's recent history, especially since real wages relative to GDP have been flat or declining.

In this context, I think that individual investors should look for the likely drivers of each of these inflationary and deflationary examples and compare those to current market conditions.
garlandwhizzer
Posts: 3562
Joined: Fri Aug 06, 2010 3:42 pm

Re: The Most Likely Portfolio Peril — Inflation or Deflation

Post by garlandwhizzer »

Great thought provoking post, Simplegift. Also enjoyed nedsaid's comments about debt. Debt levels including mortgage debt, other personal debt, and governmental debt have provided tailwinds for developed economies for decades. That engine is running out of steam. The problem is that debt used to give a lot of bang per buck into GDP growth but it is clear that adding additional debt now provides less and less growth per unit economic stimulus than in the past. The recent history of the current world wide post Great Recession recovery, now 6 years old and still weak by historical recovery standards in spite of unprecedented monetary stimulus, demonstrates this clearly. Adding more debt now doesn't push the needle much at all. We cannot count on debt to be our source of our economic growth going forward. Nor can we count on favorable demographic trends in developed markets to be the engine of DM economic growth as Simplegift points out.

Some argue that increased labor productivity and technological advances can make up for that slack, as it has in the past. The problem here is that in the US after decades of increasing labor productivity in the US, a new trend has developed over the past year. For the full calendar year of 2014 labor productivity in the US actually declined by 0.1%. In Q4 of 2014 it declined by 2.2% YOY. It is not clear whether we have hit a wall in productivity growth or if this is merely a bump in the road of progress, but it is worrisome. Perhaps this is due to the increasing exit from the labor force of highly skilled and experienced workers due to retirement and their replacement by less skilled and less experienced workers. I don't know. In past years we have become accustomed to ever increasing productivity gains which allowed for wage growth and economic growth without corresponding rises in inflation. If productivity growth fails now and is added to our worry list of demographics and debt the future of our economy may not be nearly as bright as its past. Perhaps these considerations are partly responsible (along with generous current valuations of all asset classes) for the many rather low estimates of future equity returns going forward from here.

After pondering all of this I think it's time for a strong cocktail.

Garland Whizzer
User avatar
Topic Author
SimpleGift
Posts: 4477
Joined: Tue Feb 08, 2011 2:45 pm

Re: The Most Likely Portfolio Peril — Inflation or Deflation

Post by SimpleGift »

garlandwhizzer wrote:In past years we have become accustomed to ever increasing productivity gains which allowed for wage growth and economic growth without corresponding rises in inflation. If productivity growth fails now and is added to our worry list of demographics and debt the future of our economy may not be nearly as bright as its past. Perhaps these considerations are partly responsible (along with generous current valuations of all asset classes) for the many rather low estimates of future equity returns going forward from here.
This is a good and concise summary, GW. As the global workforce grows at a slower and slower pace in the decades to come — an inexorable reality at this point (darker blue, chart below) — the entire onus is then placed upon productivity growth to drive increases in global GDP. But even if global productivity were to grow at the (relatively rapid) 1.8% average rate of the past 50 years, the annual rate of world GDP growth would decline by almost 40% by the year 2050:
If interested in more about future prospects for productivity growth, the McKinsey Global Institute recently published:
Global Growth: Can Productivity Save the Day in an Aging World?
User avatar
nedsaid
Posts: 19249
Joined: Fri Nov 23, 2012 11:33 am

Re: The Most Likely Portfolio Peril — Inflation or Deflation

Post by nedsaid »

garlandwhizzer wrote:Great thought provoking post, Simplegift. Also enjoyed nedsaid's comments about debt. Debt levels including mortgage debt, other personal debt, and governmental debt have provided tailwinds for developed economies for decades. That engine is running out of steam. The problem is that debt used to give a lot of bang per buck into GDP growth but it is clear that adding additional debt now provides less and less growth per unit economic stimulus than in the past. The recent history of the current world wide post Great Recession recovery, now 6 years old and still weak by historical recovery standards in spite of unprecedented monetary stimulus, demonstrates this clearly. Adding more debt now doesn't push the needle much at all. We cannot count on debt to be our source of our economic growth going forward. Nor can we count on favorable demographic trends in developed markets to be the engine of DM economic growth as Simplegift points out.
Garland, we did get a benefit from the increased government debt in that it helped reflate the real estate and financial markets. In essence, it was a swap of government debt for private debt. I believe that debt is money. The write-off of subprime and other mortgage debt took a lot of money out of the economy. You can't borrow against home equity that isn't there anymore. When many homeowners went underwater on their homes, many of them simply turned the keys over to the bank. Abandonment of homes did not enhance real estate prices. All the stimulus from government spending and Fed action replaced the money destroyed by all the debt destruction in the private economy. A pretty good argument can be made that this saved us from a second great depression. I will leave to the economists to argue whether or not a better solution was out there.
garlandwhizzer wrote: Some argue that increased labor productivity and technological advances can make up for that slack, as it has in the past. The problem here is that in the US after decades of increasing labor productivity in the US, a new trend has developed over the past year. For the full calendar year of 2014 labor productivity in the US actually declined by 0.1%. In Q4 of 2014 it declined by 2.2% YOY. It is not clear whether we have hit a wall in productivity growth or if this is merely a bump in the road of progress, but it is worrisome. Perhaps this is due to the increasing exit from the labor force of highly skilled and experienced workers due to retirement and their replacement by less skilled and less experienced workers. I don't know. In past years we have become accustomed to ever increasing productivity gains which allowed for wage growth and economic growth without corresponding rises in inflation. If productivity growth fails now and is added to our worry list of demographics and debt the future of our economy may not be nearly as bright as its past. Perhaps these considerations are partly responsible (along with generous current valuations of all asset classes) for the many rather low estimates of future equity returns going forward from here.
I have heard people say, and I believe this to be accurate, that computers really did not add to productivity for about 10 years until after they were introduced to small business. Once people figured out how to use these darned things and enough people felt comfortable with them then productivity surged. You needed a critical mass of people with computer skills. It was a 10 year learning curve for the economy and that sounds about right. So even when brilliant new technology comes along it might be years before you see the productivity enhancements. It took a few years for the business potential of the internet to really develop. I am optimistic about productivity gains in the future.
garlandwhizzer wrote: After pondering all of this I think it's time for a strong cocktail.

Garland Whizzer
I am almost a teetotaler but perhaps my posts would be better if I got myself really sloshed. :D :D
A fool and his money are good for business.
cbeck
Posts: 640
Joined: Sun Jun 24, 2012 1:28 am

Re: The Most Likely Portfolio Peril — Inflation or Deflation

Post by cbeck »

roflwaffle wrote: IIRC, public debt is similar to post WWII levels as well, but unlike private debt, there was a sustained effort to pay it off after WWII, so over the past half century plus it's looked more like a "U" than the steady increase in private debt/wages.
We never paid down any of the WWII debt, i.e. the dollar value of the debt never went down at all. The national debt went from around 125% of GDP at the end of the war down to 40% of GDP in twenty years, but only because GDP grew so much, not because any of it was repaid.

Households have to repay debts; governments don't. It doesn't mean that level of public debt never matter. It is just another example of thinking of the national economy or the government as like a big household is hopelessly flawed.
roflwaffle
Posts: 440
Joined: Mon Mar 02, 2015 9:08 pm

Re: The Most Likely Portfolio Peril — Inflation or Deflation

Post by roflwaffle »

That's true, although I think that a government that isn't maintaining inflation adjusted spending levels is paying down the debt, but that's just a tomato/tomato thing I guess. I also think that governments do have to pay down debts to some degree, or at least not allow them to expand past some reasonable point depending on the economy, because after that point additional debt will be very expensive and hamper the government's ability to function.
toto238
Posts: 1914
Joined: Wed Feb 05, 2014 1:39 am

Re: The Most Likely Portfolio Peril — Inflation or Deflation

Post by toto238 »

cbeck wrote:
roflwaffle wrote: IIRC, public debt is similar to post WWII levels as well, but unlike private debt, there was a sustained effort to pay it off after WWII, so over the past half century plus it's looked more like a "U" than the steady increase in private debt/wages.
We never paid down any of the WWII debt, i.e. the dollar value of the debt never went down at all. The national debt went from around 125% of GDP at the end of the war down to 40% of GDP in twenty years, but only because GDP grew so much, not because any of it was repaid.

Households have to repay debts; governments don't. It doesn't mean that level of public debt never matter. It is just another example of thinking of the national economy or the government as like a big household is hopelessly flawed.
Agree. A big household with $124trillion of net worth and you're allowed to tax any of them as much as you want whenever you want, you get to borrow at 1% interest rates, and you're also allowed to print as much of the currency as you want.

Obviously you don't want to print massive amounts of new currency and obviously you don't want to tax 100% of wealth. But with unlimited taxation and unlimited printing power, you can't really compare the U.S. economy or the government to a household. It's a completely different entity.
Johno
Posts: 1883
Joined: Sat May 24, 2014 4:14 pm

Re: The Most Likely Portfolio Peril — Inflation or Deflation

Post by Johno »

cbeck wrote:
roflwaffle wrote: IIRC, public debt is similar to post WWII levels as well, but unlike private debt, there was a sustained effort to pay it off after WWII, so over the past half century plus it's looked more like a "U" than the steady increase in private debt/wages.
We never paid down any of the WWII debt, i.e. the dollar value of the debt never went down at all. The national debt went from around 125% of GDP at the end of the war down to 40% of GDP in twenty years, but only because GDP grew so much, not because any of it was repaid.

Households have to repay debts; governments don't. It doesn't mean that level of public debt never matter. It is just another example of thinking of the national economy or the government as like a big household is hopelessly flawed.
Households in aggregate also don't necessarily have to pay down debt, they can increase income, and/or the number of households increase, which are two ways of saying the economy grew, which is the same reason the same nominal (or even real) debt of the govt can shrink as % of GDP. Also the govt's supposed 'unlimited' ability to tax is actually significantly limited by the impact on growth, plus the fact that there is no independent sentient entity 'the govt'. The public has to accept what 'the govt' does (to varying degree depending on the political system, but seldom is public sentiment 100% irrelevant). Likewise this gives lie to the oversimplification that the govt's credit quality is absolute if it can print money: only insofar as unlimited money printing is the path of least political resistance. In Russia in 1998 it wasn't. The path of least resistance was to stiff (the often foreign, and in any case generally better off) holders of local currency debt, rather than subject the public as a whole to hyper-inflation.

The govt and a single household are very different in the short run. The govt and private sectors in aggregate in the long run are a lot less different as debtors though still obviously not identical. IOW there's basic validity to looking at the total debt load in the economy, not assuming that negative effects of excessive debt in the private sector can be permanently alleviated by just shifting debt to the public sector. The latter would be a hopelessly flawed concept.

Cyclically speaking there's room for debate either way IMO about increasing public debt to offset *sudden decreases* in private debt (2008-9 and follow on period). But in the long run there's a limit to running up total debt relative to the economy. So if and to the extent 'trend' (heretofore) growth in the developed countries has relied on expansion of total debt as % of GDP, with an apparent gradual reduction in the amount of growth 'bought' per unit of debt expansion, that's a problem. You can't increase that % forever, and there's no magic exemption just by shifting the debt to the public sector. Moreover, the same issue is seen in some developing countries:China's recent growth seems to have the same characteristic of less growth per unit pump up in total debt (though the central govt there isn't particularly heavily indebted, at least not directly).
garlandwhizzer
Posts: 3562
Joined: Fri Aug 06, 2010 3:42 pm

Re: The Most Likely Portfolio Peril — Inflation or Deflation

Post by garlandwhizzer »

nedsaid wrote:

Garland, we did get a benefit from the increased government debt in that it helped reflate the real estate and financial markets. In essence, it was a swap of government debt for private debt. I believe that debt is money. The write-off of subprime and other mortgage debt took a lot of money out of the economy. You can't borrow against home equity that isn't there anymore. When many homeowners went underwater on their homes, many of them simply turned the keys over to the bank. Abandonment of homes did not enhance real estate prices. All the stimulus from government spending and Fed action replaced the money destroyed by all the debt destruction in the private economy. A pretty good argument can be made that this saved us from a second great depression. I will leave to the economists to argue whether or not a better solution was out there.
Totally agree, nedsaid. Fed action was critical at the time and it has worked to get us to where we are today, not perfect but in better shape than those countries who didn't take such aggressive actions initially and keep them going for years. I'm just suggesting that although aggressive monetary policy was the right thing to do I believe that there are risk/reward limits to how much it can achieve going forward from here. At some point monetary policy easing gets a bit like pushing on a string.

Garland Whizzer
Johno
Posts: 1883
Joined: Sat May 24, 2014 4:14 pm

Re: The Most Likely Portfolio Peril — Inflation or Deflation

Post by Johno »

nedsaid wrote: Three percent real economic growth is considered good. My guess is that population growth accounted for 2% real economic growth and perhaps 1% real economic growth came from credit expansion. Of course productivity improvements have to be factored in there as well.
For the US 1950-2013 real GDP per capita grew at 1.99% (population ~1% pa, real GDP ~3% pa). Per Conference Board data GDP per hour worked grew at 1.84% pa. Hours worked per capita only increased 0.04% pa. So by that (perhaps oversimplified, comments welcome) analysis productivity explains almost all GDP per capita growth in that period in the US. This isn't to say increase in total debt isn't a secondary causal factor, but it doesn't seem to be needed as a separate factor over the whole 'postwar' period.
http://www.usgovernmentspending.com/spe ... DP_History
https://www.conference-board.org/data/e ... m?id=27762
selters
Posts: 702
Joined: Thu Feb 27, 2014 8:26 am

Re: The Most Likely Portfolio Peril — Inflation or Deflation

Post by selters »

http://www.federalreserve.gov/boarddocs ... efault.htm

Ben Bernanke thinks deflation will never become a serious problem under fiat currency system. This belief is called 'the bernanke doctrine'.
Boglegrappler
Posts: 1489
Joined: Wed Aug 01, 2012 9:24 am

Re: The Most Likely Portfolio Peril — Inflation or Deflation

Post by Boglegrappler »

The problem with Deflation is that it can cause Economic Catastrophe. When people start hoarding money, because prices will drop next year and you can buy those items on sale, it can cause a screeching halt to the Economy. There is a 'race' to the bottom with prices. Great Depression II
True enough, but its true as well that there are past examples of inflation breaking the backs of economies and people. This happened in Germany in the 20s, if I recall correctly, and has happened in other places as well.

Its always a matter of degree, and time.

The Bernanke Doctrine would suggest that Warren Buffett's advice from a few letters ago is probably pretty good. It was that you should sidestep owning "promises" that are denominated in currencies, and instead own enterprises that did/made things that people were willing to buy with some of their daily wages, regardless of what the "currency" was that the wages were paid in.
User avatar
nedsaid
Posts: 19249
Joined: Fri Nov 23, 2012 11:33 am

Re: The Most Likely Portfolio Peril — Inflation or Deflation

Post by nedsaid »

garlandwhizzer wrote:
nedsaid wrote:

Garland, we did get a benefit from the increased government debt in that it helped reflate the real estate and financial markets. In essence, it was a swap of government debt for private debt. I believe that debt is money. The write-off of subprime and other mortgage debt took a lot of money out of the economy. You can't borrow against home equity that isn't there anymore. When many homeowners went underwater on their homes, many of them simply turned the keys over to the bank. Abandonment of homes did not enhance real estate prices. All the stimulus from government spending and Fed action replaced the money destroyed by all the debt destruction in the private economy. A pretty good argument can be made that this saved us from a second great depression. I will leave to the economists to argue whether or not a better solution was out there.
Totally agree, nedsaid. Fed action was critical at the time and it has worked to get us to where we are today, not perfect but in better shape than those countries who didn't take such aggressive actions initially and keep them going for years. I'm just suggesting that although aggressive monetary policy was the right thing to do I believe that there are risk/reward limits to how much it can achieve going forward from here. At some point monetary policy easing gets a bit like pushing on a string.

Garland Whizzer
Any monetary or fiscal tool to manage the economy has its limits and you eventually get to a point of diminishing returns.

I am a good Reaganite and a free-market type of guy but even I realize that the answer to everything isn't a capital gains tax cut!

The effects of Fed action have been mostly stimulative to the economy but low interest rates also depress the economy to the degree that savers get very little interest on their money. This is a terrible problem for retirees. There is also the issue of public confidence, if Fed and Government policy actions are too dramatic it can have the "Ye Gads, it must be worse than I thought" effect on the public.

It is hard to get these things exactly right.
A fool and his money are good for business.
staythecourse
Posts: 6993
Joined: Mon Jan 03, 2011 8:40 am

Re: The Most Likely Portfolio Peril — Inflation or Deflation

Post by staythecourse »

Simplegift wrote: Some stocks would be more vulnerable than others. Companies sitting on piles of cash would actually benefit, but highly-leveraged companies involved in areas like commodity production would be vulnerable. Similarly, consumer goods makers (especially in non-essential, luxury products) would likely lose their power to raise prices. Declining sales and profits would put downward pressure on their share prices.Conversely, any investment that pays you a fixed income over the long term would be a big winner, including high-quality bonds. Treasuries will certainly have the lowest risk, but high-quality corporates and munis should also work, especially in a diversified bond fund that spreads the default risk. Even plain vanilla, FDIC-insured certificates of deposit would shine, even at low yields. During deflation, it's the real rate of return that counts: if prices are deflating at 2% per year, a 2% CD is actually paying you 4% real.
This all makes sense as a sniff test of common sense, but do we have the data to support it? Do you have a chart/ graph of different stock sectors (including REITS) and different bonds during these different levels deflation/ inflation rates? Like how energy stocks do during deflation through high inflationary periods or high yield debt during the same periods?

Also I would like to see the effects of high inflation divided into periods of expected and unexpected inflation.

Also if we have concluded (if we have??) that high inflation is in fact the biggest threat to a long term portfolio then should we start talking about how to protect one self against it? Do we go out and buy a bigger house or rental property? Do we buy TIPS even though they have never been test driven in the U.S. or elsewhere (not sure about that one)? Do we buy gold or timber?

I remember Vanguard had an excellent paper looking at inflation hedges and different asset classes. It seemed the best hedges for Unexpected inflation in the short run was CCF, but in the long run was TIPS and some improvement in the short and long run with gold.

Good luck.
"The stock market [fluctuation], therefore, is noise. A giant distraction from the business of investing.” | -Jack Bogle
User avatar
Topic Author
SimpleGift
Posts: 4477
Joined: Tue Feb 08, 2011 2:45 pm

Re: The Most Likely Portfolio Peril — Inflation or Deflation

Post by SimpleGift »

staythecourse wrote:This all makes sense as a sniff test of common sense, but do we have the data to support it?
Good question. From what I've seen, there's a vast body of literature and historical research about asset returns (including stocks, bonds, REITs, commodities, etc.) during inflationary periods, both expected and unexpected. Rather than try to summarize that research here (which would make a nice discussion topic all on its own), I'd suggest doing an online search for whatever asset class you're interested in, plus inflation, and you'll find many helpful search results.

For deflationary periods, much less is known about asset returns as best I know, as there just haven't been that many periods of severe deflation in the U.S. during the modern era. One study I ran across did summarize asset returns during the six U.S. deflationary shocks since 1900 (table below). As might be expected, stocks did not perform well. But both 3-month Treasury bills and 10-year Treasury bonds proved to be decent deflation hedges — which suggests to me that holding long-term bonds as a deflation hedge (and taking on their long-term interest rate risk) may not be entirely necessary.
  • Image
    (Note: For the six deflationary periods taken together, average returns were
    5.6% for the 3-month Treasury bills and 7.3% for the 10-year Treasury bonds).
    Source: AllianceBernstein
Of course, if a "deflationary shock" turns into a "deflationary decade" or longer (as in Japan's recent experience), then 30-year Treasuries would look very good, as investors will have locked in a fixed interest rate and minimized the risk of re-investing at low or even zero nominal rates.
Last edited by SimpleGift on Mon Mar 23, 2015 12:15 am, edited 1 time in total.
Angst
Posts: 2968
Joined: Sat Jun 09, 2007 11:31 am

Re: The Most Likely Portfolio Peril — Inflation or Deflation

Post by Angst »

selters wrote:http://www.federalreserve.gov/boarddocs ... efault.htm

Ben Bernanke thinks deflation will never become a serious problem under fiat currency system. This belief is called 'the bernanke doctrine'.
I found this paper to be really interesting, and I can't help quoting Bernanke's explanation:
Ben Bernanke wrote:
The conclusion that deflation is always reversible under a fiat money system follows from basic economic reasoning. A little parable may prove useful: Today an ounce of gold sells for $300, more or less. Now suppose that a modern alchemist solves his subject's oldest problem by finding a way to produce unlimited amounts of new gold at essentially no cost. Moreover, his invention is widely publicized and scientifically verified, and he announces his intention to begin massive production of gold within days. What would happen to the price of gold? Presumably, the potentially unlimited supply of cheap gold would cause the market price of gold to plummet. Indeed, if the market for gold is to any degree efficient, the price of gold would collapse immediately after the announcement of the invention, before the alchemist had produced and marketed a single ounce of yellow metal.

What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.
User avatar
Topic Author
SimpleGift
Posts: 4477
Joined: Tue Feb 08, 2011 2:45 pm

Re: The Most Likely Portfolio Peril — Inflation or Deflation

Post by SimpleGift »

selters wrote:Ben Bernanke thinks deflation will never become a serious problem under fiat currency system. This belief is called 'the bernanke doctrine'.
It seems that many central banks around the world today have adopted the “Bernanke Doctrine.” That is, believing that deflation is caused by inadequate demand, their policies are geared toward lowering interest rates through asset purchases (Quantitative Easing), devaluing their currencies, discouraging savings (negative interest rates) and supporting asset prices in an attempt to increase aggregate demand (via the "wealth effect").

Especially in Japan and the Eurozone today, there appears to be a massive experiment underway by the central banks to avoid persistent and crippling deflation. Their success or failure in the coming years will likely tell us a great deal about the future of economic growth and asset returns in an aging world, where workforces and populations are shrinking or just growing more slowly. These are two real-world petri dishes, if you will.
Post Reply