There is a case to be made that the potential downside of this round of deflation is worse than catastrophic. There is an estimated $22 trillion worth of global commodities-based derivatives.
Oil is now down over $60 per barrel since last June. The price of iron ore has collapsed 47 percent in the last year. Last month the UK experienced its slowest annual consumer price growth in a decade. Real wages in Japan have been falling for most of the past three years. Last month's official PMI figure from China hit an 18 month low. The Eurozone bloc has officially hit negative inflation. Bloomberg's Commodity Index just hit a 15 year low. There's a word for this: it's called deflation.
For a public that has been primed for inflation over the past seven years, this deflationary cycle may come as a shock, and it comes with the temptation to believe that the opposite of the boogeyman we've feared must be a good thing. Sadly, this is not the case. Like any other changing investment environment, deflation brings with it its own set of potential risks and rewards.
The first thing people will notice is that prices for a range of goods (gasoline first and foremost amongst them) will decline. This is obviously good for the pocketbook, but in a deflationary environment, wages will stop rising, bonuses will dry up, and, if the cycle lasts long enough, wages will even begin declining, thus offsetting the advantages of declining prices.
On a bigger scale, deflation means a slowdown in business and production at the best of times. At the worst of times, it can be catastrophic (think the Great Depression). There is a case to be made that the potential downside of this round of deflation is worse than catastrophic. There is an estimated $22 trillion worth of global commodities-based derivatives. If commodity prices continue declining, those on the wrong end of those trades may find themselves going under, including some of the banks that are playing the oil futures markets. As Ellen Brown recently explained on The Corbett Report, this could be a trigger for the next round of banking panic and, thanks to some newly-minted G20 banking regulations, Cyprus style bank bail-ins.
There's also the firms directly involved with selling, transporting, warehousing and otherwise dealing in these commodities. All of them are hurt by dropping prices, and depending on how much slack there is in any given system it could lead to layoffs in various sectors. Sticking with the oil sector, there are an estimated 20,000 businesses involved in the US shale oil and gas sector that has driven the growth in production in recent years. With oil under $50 a barrel, these businesses are finding it impossible to stay in the black. Many of them will go under if prices remain at these levels.
There are winners in this game, of course. China is taking advantage of dropping prices to stock up on various commodities, including oil, gold, and iron ore. Their own stock market bubble may be about to burst and the country remains on the edge of a shadow banking failure that could topple the country as a whole, but at least they'll have some physical assets to show for their spending spree of central bank funny money. That's more than a lot of countries can say.
As for investing strategies in the face of deflation, investors should be wary of the stock market now more than at any time. If deflationary pressures continue they will pierce the bubble of “record high” stock indexes in short order, and the resulting release of hot air will not be pretty. Long-term loans are also to be avoided during a deflationary cycle, as the loan has to be paid back with scarcer (and stronger) dollars than were loaned in the first place. As long as the deflation persists, fixed income payments (CDs, bonds, treasuries) will all be appreciating in value. Even just keeping your portfolio in cash is a sound strategy when deflation is in full bloom. The catch is that some are warning that the real inflationary cycle is waiting behind this deflationary blip. If that's the case, then the timing of getting out of those trades and back into commodities and hard assets will be paramount.
For the time being, Japan may be a good bellweather for the world to look to. Mired in stagnation and with a deflationary undertow for over two decades, the perennially moribund Japanese economy might be what many in the industrialized world will have to look forward to if the current cycle persists. Prepare yourself accordingly.