What does it mean for investors when prices are falling?
09 February, 2015
Over the final three months of last year the price of petrol notably fell and miscellaneous items like shampoo, men's socks and cling food wrap also declined in price. These are just some of the selected items that make up the Consumer Price Index (CPI) which saw a 0.2% decline over the quarter and is likely to also show a decline over the early part of 2015.
Falling consumer prices are termed "deflation" and this has become a global trend with many countries showing falling CPI numbers (especially in Europe). On the face of it, lower prices should be a good thing but many experts are concerned that it is potentially a greater evil for the broader economy than rising prices.
The fear is that genuine, broad-based deflation would cause consumers to delay all kinds of spending. As demand slows, businesses would strike difficulties and some may default on their loans, lay off staff or postpone capital spending.
However, it seems that consumers are not that keen to delay spending even when faced with a high likelihood of lower prices in future. The queues to buy new digital devices are testament to the consumer desire to have things now even if future prices are almost certain to be lower.
For share market investors, selecting the right companies becomes more important. Deflation affects companies differently and those with the strongest pricing power are able to grow their businesses even when prices are declining. In share portfolios we consider the long-term trends in an industry and look for companies with growing businesses and resilient prices.
For fixed interest investors, falling consumer prices can cause dramatic changes in the investing landscape. When we look at the yields on government bonds we can find at least ten countries whose bonds are trading on negative yields. That is to say, those who buy these bonds and hold them to maturity will get back less than they paid for them, even after taking into consideration the interest they receive. It seems strange that investors would be lining up to get less money back than they put in, but this is what negative yields mean. One possible reason is that investors are so cautious that they are prepared to pay have the government safeguard their savings. However, the gradual improvements we are seeing in confidence about the economy suggest that pessimism is not the reason for negative yields.
Instead it looks as though deflation concerns may very well be driving investors' decisions. In the world where the price of goods and services are getting cheaper day by day the purchasing power of your money is improving even for those investors buying bonds on negative yields. After all, in an environment where prices are falling, you are able to buy more with each dollar tomorrow than you could have today.