We have lived through 60 years of inflation, far longer than most of us can remember, so it is hard to imagine deflation, or falling prices.
From the Napoleonic wars’ inflationary high in 1812, however, prices fell by half in the UK – and even more in the US – during the deflationary era to 1896. And in this country, prices fell by an average of 3% a year between 1921 and 1932.
Deflation is far more difficult to control than inflation, unfolds at a faster rate and leaves more havoc in its wake. In a deflation-prone economy, wealth is actually destroyed.
Why should deflation come about? After the crippling high inflation and unemployment of the 1970s the current financial orthodoxy in the developed world is for low inflation, which is backed by governments, central banks and public opinion. Meanwhile, the increasing power of international financial markets imposes a further discipline on governments. Then there are the consequences of a cycle marked by global over-investment and excess supply, which has left the entire world economy vulnerable to deflation.
A stock-market decline or crash could be the event that sparks off deflation.
Alternatively, deflation, or the fear of deflation, could cause a stock-market crash. The London, New York and many European stock markets are currently near their all-time highs and look very vulnerable.
The London Stock Market has not seen a serious decline for 11 years, or a full-scale secular – long-term – bear market since 1975. US stocks have never been as highly valued as they are today, not even at the peak of the 1929 boom. By contrast, Japan has been in recession for eight years, suffered a 60% collapse in stock market values, and seen her economy gripped tightly by deflationary forces.
Some financial pundits are talking about a full-scale crash on the New York and London stock exchanges similar to the 1929 Wall Street cataclysm, followed by a period of deflation and depression most resembling the early 1930s. We should also remember that in a rampant bear market shares can lose up to 90% of their value (during the bear market of 1972-75, the Financial Times 30 Share Index shed some 70% of its value).
What will happen to bonds in a deflationary situation? As at present, there will be a flight to quality – in other words, triple A-rated government bonds, particularly those issued by the US, Germany and UK. They will continue to increase in value, and for the individual British investor any capital gains realised on UK government bonds are, of course, tax free.
Index-linked UK government bonds will not be popular in deflationary times as, while they are safe, their income falls as inflation falls and when inflation reaches zero only the coupon stated will be paid out.
With corporate bonds, again only those with a triple-A rating should be considered. Those with a lower rating may have their underlying security called into question.
With deflation comes a contracting economy; badly run businesses will fail as will those that use old methods and technology. Business activity will decline, resulting in lower sales and profits, and many companies will declare losses.
Commercial property will fall in price due to lack of demand and lack of credit. Housing prices will fall and housing turnover will continue to remain low compared to the 1980s. This will be due to people seeing houses as a place to live, rather than an inflation hedge or investment.
Rising unemployment and the possibility of lower pay levels will further impact on house prices.
Some people will buy gold in a crisis, but most respected financial commentators feel that the metal is not the store of value it once was and is becoming more of a commodity. Commodities will fall in price, particularly base metals, as the production of goods that contain them decreases.
The price of antiques and works of art could slump dramatically as the contraction in the economy and the difficulty in obtaining credit would drag this market to a virtual standstill. Life assurance companies’ bonus payments will continue to fall, but policyholders will see a ‘real’ return when with-profits endowments mature.
How will deflation affect accountants? In a prolonged spell of deflation and depression many accountants will lose their jobs. Some of the accountancy jobs most at risk could be those dealing with hedge funds and at investment banks which speculate in the derivatives market. Accountants employed in the housing industry and financial-services sector will also be vulnerable.
Employers will seek cost reductions, including rates of pay, and accountants already employed will not be immune from this trend either. Wage rises will be limited to merit and promotion awards.
Accountants seeking to borrow money, to start a business for example, will find it very hard in a deflationary era as banks and other financial institutions will only want to lend where there is adequate security.
Practices will come under severe financial pressure and some will fail or be forced to merge. Yet accountants engaged in insolvency work will prosper with the rise in receiverships and liquidations.
Retired accountants on a pension will gain as the purchasing power of their pension will increase. They will gain even more if they have a pension with a fixed increase every year. Accountants coming up for retirement and not in a final salary pension scheme could be doubly affected as the assets of their pension fund decrease in value, and they find when they purchase an annuity that annuity rates are very low. There will also be the very real possibility of short-paid – or even unpaid – pensions as employers and financial institutions go under.
Accountants still employed should try to make sure their jobs are relatively safe. Easier said than done, when one looks back over the job losses of the last few years, but it would be a good policy to avoid the vulnerable job sectors already mentioned.
Accountants should recognise early on that deflation requires a different strategy from inflation and should convince firms to opt for a low-margin, high-value strategy plus the higher value of investment necessary. This strategy would recognise increasing price awareness by consumers.
Firms that do not recognise the changed business environment will perish.
Accountants will have to build deflation into their budgets and business plans, and adjust selling prices accordingly. They will also need to take into account that there will be no annual pay awards for wages, interest rates will be low and prices for plant, machinery, vehicles etc. are unlikely to rise and could even fall. Accountants will have to recognise that, in a deflationary era, the rate of return on capital investment does not need to be as high as that in an inflationary environment.
All bad things, as well as good, must come to an end. If a full-scale secular bear market does occur in the near future, it will end sometime, and that is the time to sell bonds and buy shares at low prices but high yields, and offering strong prospects of substantial capital gains in the years ahead.
Some readers may think this forecast stretches the limits of credibility.
Financial commentators in the Financial Times and Sunday Telegraph among others however, have recently been warning about a future deflationary nightmare. Several texts have been written over the last few years on the phenomenon of deflation, including Roger Bootle’s ‘The Death of Inflation’ and ‘Into The Upwave’ by Robert Beckman. Readers are also invited to turn to books on stock market crashes, two of which are ‘The Great Crash 1929’ by J.K. Galbraith and ‘Crashes’ by Robert Beckman.
Will we fall into the abyss of deflation and depression? We can’t tell for certain. Maybe we can look forward to the ‘soft landing’ some economists predict, and the world economy will muddle through. But after 60 years of inflation, economic history tells us that there is normally a deflationary correction, and the longer it is put off the worse it will be.
The fact remains: we are being warned that deflation and its attendant dangers may transpire in the near future. Accountants who perceive some truth in these warnings should arrange their affairs accordingly.
Michael R Goddard FCA is a chartered accountant who was, until recently, FD of Concorde Express Transport plc
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