MEANING:

Deflation is a phenomenon of persistent and continuous falling prices. In its initial and later stages it may be respectively referred to asrecession and depression. In the case of a deflation , however, prices cannot cannot fall below certain limit. This is partly because theoretically prices cannot become negative. They also cannot fall to zero. And partly, the downward slide of prices comes to an end because demand refuses to go below an certain level.The consumers , For example cannot reduce their consumption to zero if they are to live. Similarly , the component of autonomous investment keeps taking place even when due to poor market demand induced investment comes to an end.

CAUSES OF DEFLATION:

Capitalism characterized by sufficient existence of competition, is regarded as one of the factors responsible for the emergence of Deflation. In this case, with the improvement in the capital stocks, competition increases million fold. Escalation in the total number of competitors boosts up the supply of goods, indicating that the prices must decrease in order to stabilize the demand, thereby bringing in Deflation. Capitalism also brings in innovation and efficiency, which also contributes towards the initiation of Deflation.

In an economy based on credit, a decrease in money supply results in remarkably less lending trend, followed by a sharp decline in the money supply. As a result, there occurs a sharp reduction in the demand for goods. A decline in the demand is followed by a decline in the prices, owing to the development of a condition called the supply glut. Gradually, this assumes the form of a deflationary spiral, where the prices go down below the costs of financing production.

With the advent of deflationary spiral in an economy, the commercial sector of the country stops incurring profits, despite lowering the prices of their finished products. Ultimately, a situation arises where this commercial sector is forced to become liquidated. In order to prevent or slacken down the deflationary spiral, it is necessary for the banks to avoid the collection of non-performing loans.

According to the monetarist viewpoint, Deflation occurs when there is a decrease in the velocity of money, and/or in the amount of monetary supply per person. Deflation helps the economy grow and develop at a rapid pace, even faster than the creation of hard money.

To sum up, deflation arises due to the following conditions stated below:

*Decrease in the money supply

*Increase in the supply of goods

*Fall in the demand for goods

*Escalation in the demand for money

CHARACTERISTICS:

EQUITIES:

Deflation is probably the worst possible environment for equity investing. The 1929-32 crash saw almost nine-tenths wiped off the average US share price, for example. Falling prices lead to a contraction in demand, falling company earnings and dividend cuts. We’ve already seen a small-scale rerun of the 1930s in terms of the cuts in dividends that have already occurred, a topic we covered in a recent article.

Any company or sector that can maintain its pricing in a deflationary environment will be worth its weight in gold as an investment. Food retailing, consumer staples and utilities stand out as obvious defensive sectors. Conversely, companies or sectors with high leverage, or where client demand is discretionary, are particularly vulnerable. The financials and automobile industry equity sectors are examples of both.

However, in an extended period of deflation, companies that can avoid the effects of price cutting may be very hard to find. Even utilities, the ultimate defensive sector, may suffer, as profit margins would get squeezed and dividend cuts might ensue. Furthermore, investors need to avoid companies with excessive debt, and other unexpected liabilities—such as those deriving from pension plans—need to be factored in.

All this suggests that deflation may be, above all, a stock-picker’s environment, and that investing via ETFs may not offer the precision that an investor needs. If one uses sector-based equity ETFs, close attention needs to be paid to the composition of the index, since some sectors show much greater stock concentrations than others.

COMMODITIES:

A deflationary environment should by definition include raw materials prices, but there may be an exception—precious metals. Many commentators have pointed out that gold, in particular, has risen in price during previous deflationary periods. However, there are many analysts who dispute this, and who expect both gold and silver to follow other prices downwards during a deflation.

There is an excellent study, compiled more than 10 years ago, of gold’s behaviour during deflationary periods, available here. To summarise, in the opinion of Sam Hewitt, the study’s author, the likely performance of gold (and silver) during a deflation should be seen in the context of the general trend towards the maintenance of higher cash balances. Gold’s attractiveness would then depend on the credit quality of the many competing vehicles available for cash hoarding.

The relatively poor performance of gold against the yen during Japan’s recent deflation, for example, should be seen as a reflection of investors’ trust in Japanese savings accounts and government bonds. Conversely, the ultra-bullish case for gold seems to depend on a generalised loss of faith in both the banking system and government finances.

For those who wish to invest in precious metals via an exchange-traded product, there is an ever-increasing choice of vehicles available.

A POSSIBLE GAME - CHANGING EVENT FOR INVESTORS:

If deflation really is a possibility—and it still appears far from the mainstream view—then asset allocation during that prevailing time frame will present challenges that none of us will have experienced in our lifetimes as investors.
Cash would be king, and the emphasis would shift firmly from capital appreciation to capital preservation. Accepted portfolio weightings would risk being turned upside down, and each asset class and individual stock or bond would need checking for its vulnerability to the deleveraging trend.
Whether a deflationary outcome is likely or not, every investor should be prepared for the challenges that such an environment would pose.