DIAL D FOR DEFLATION?

(Cartoonist: Harley Schwadron;Cartoonstock.com)

Has the media been scaring investors into thinking that we are in a deflationary spiral and that deflation spells disaster?  Should we factor this while taking investing decisions?

 

Deflation v/s Disinflation

There is a fair bit of confusion on the terms ‘disinflation’ and ‘deflation’. Deflation is a sustained fall in prices, just as inflation is a sustained increase in prices. We are all used to inflation. Disinflation is a period of falling inflation. Most of the world was facing disinflation till the third quarter of 2014. Then suddenly oil prices collapsed. The media started swinging the deflation theme. As happens so often, once the media starts swinging, most all of us swing with the media.

 

Deflation: The new definition

The Bank for International Settlements (BIS) has on 18th March 2015 released a report titled ‘The costs of deflations: a historical perspective’. Click here to read the report in full.  The BIS operates like a Central Bankers Bank and also as a think tank. The report claims to have tested the historical link between output growth and deflation. The sample size covers 140 years across 38 economies.  In the normal course, I would have expected the BIS report cited to follow the script and echo the consensus view, that D stands for Deflation and Disaster. However, the BIS research cited above is subversive. The following are the important takeaways from the survey:

• The BIS is pointing to the fact that there is a difference between a general fall in prices accompanied by a fall in asset prices and one which is not accompanied by a fall in asset prices. It seems the former is bad; the latter is good.

• It ends up arguing that a fall in prices can be positive. The BIS research does show that there had been numerous periods since 1870 when deflation occurred amid growth.

• Historically deflation signals a fall in demand resulting in a fall in prices and incomes. However deflation may also result from increased supply. It seems supply driven deflation is what we are currently experiencing. This, the report says, depresses prices while raising incomes and output.

• The BIS argues that during the period of the Great Depression of the 1930’s, there was a fall in prices of all assets. That period (1930) is an exception. In the current scenario, this is not true. Hence, it seems, the current bout of deflation is of the ‘good’ variety.

Yashodhan here. If for the sake of argument one does assume that the BIS is correct, then the raison d’être of the current easing experiment seems less compelling than it is being made out to be. The risk in the current scenario is a bit different. The way in which the money printing has been going on, it has a likelihood of creating asset bubbles. When these bubbles burst, it can result in ‘bad’ deflation. That is the only risk for us as investors. However, I wouldn’t want to let that thought affect my decision-making when it comes to buying the dip.

 

Is the current deflation temporary?

Inflation readings and oil prices are positively correlated. There is an important observation regarding oil prices which is worth sharing. The image below shows the price of oil on a yearly basis:

From the above image, one can draw the following conclusions:

1. It is clear that oil prices are off by about 50 per cent year on year (YOY).

2. This has had its toll on the inflation figures that have been reported for the last couple of months. The higher base effect of oil has been giving abysmally low inflation readings.

3. Everything else remaining the same, the inflation figures for the next few months will likely show a downtrend or sideways direction (depending on the price of oil). However, once the higher oil prices of the earlier period fall out of the base comparison yardstick, the spectre of falling inflation (disinflation) will cease.

4. In other words, as we progress further into 2015, the higher oil prices of yesteryear’s disappear from the denominator.  We then start reading inflation from a lower base. If oil prices do stabilise, the effect on inflation readings will not be as devastating as it has been thus far. The media on its part will start swinging in a different direction altogether, be prepared for that.

5. Please note that this assumption is on the basis of ‘relatively’ stable oil prices. Any upward or downward movement in oil prices needs to be factored in separately.

 

Deflation and current stock valuations

Markets have shown time and again that  ‘what everyone knows isn’t worth knowing’. If we are in a deflationary spiral, it is already embedded in stock prices. In a nutshell the answer to the valuation question is:

• The crux of the argument is whether the current valuations are justified. My take is simple. In the past corrections have not occurred because of high stock valuations. There has always been an ‘additional reason’. This ‘additional reason’ in conjunction with high stock valuations, has resulted in corrections.
• Stocks are forward-looking and are pricing in future growth. The current earnings season is critical. If earnings do not support high valuations, then stocks will correct.
• In other words, stocks will tend to look even more highly valued in case earnings are way below expectations. Whether or not earnings surprise on the downside, we will have to wait and watch.
• The current debate over FII taxation (MAT, etc.) is not even worth discussing. It is buying opportunity.

Have a look at the image below:

It shows the Nifty from 01st November, 2014 till date, almost six months. It also shows the CNX 500 for the same period. Both show little movement in this period. The following are the key takeaways:

• Most investors are afraid that the markets are going to fall off a cliff. Markets will correct, they always do and they should. The word ‘crash’ is a bit of heightened pessimism, to which I do not subscribe. Markets fall off the cliff by exception and not by rule.
• Investors need to focus on valuations of individual companies. That should not be confused with overall market valuations. If you see the index in absolute terms, it has gone nowhere for the past six months. Individual stocks have. Someone called John Lennon famously said: ‘Life is what happens while you are busy making other plans’. This is very true when it comes to investing. We are brought upon words like ‘risk appetite’, ‘headwinds’ and ‘tailwinds’, etc. These mean little and are  mostly irrelevant to our investing decisions. 
• In short valuations along with downbeat earnings should be considered a ‘buying opportunity’. This depends on what you are buying and at what price you are buying.

 

Deflation: Good, Bad or Ugly?

The debate is now shifting from deflation to ‘secular stagnation’. The honest answer is that nobody knows. The best thing to do is to not hold views too firmly on either side. Deflation or Secular Stagnation, does it really matter? I don’t think so. The sketch below says it better than words:

 

 

(Sketch Credit: Carl Richards – Reproduced under a Creative Commons License).