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Inflation or Deflation
‘Inflation or Deflation’ was a hotly debated topic in the popular Aussie Stock Forum last week so I thought I would write a few posts with my thoughts on this topic. There are many economists who are convinced that due to government action in the recent financial crisis, there will be high inflation in the future and there are just as many who are convinced that the opposite will happen i.e. deflation is what we can expect in the future. Before we discuss the case for either inflation or deflation, we need to firstly define:
- what these terms mean and
- why it is important to investors like us
What do we mean by inflation or deflation?
We generally associate inflation with prices going up and the Consumer Price Index (CPI) is a common gauge we use to measure inflation. If we use CPI as our gauge, then inflation would mean a positive CPI and deflation would mean a negative CPI. CPI is derived from a basket of consumer goods so it may not be so relevant for investors. For example, if the price of petrol goes up, CPI will go up but this may not have much impact on the price of assets such as property and shares. I thought it was important to agree on a common definition as some people discussing this topic in the forum were citing things such as ‘prices of computer and electronic items are down’ so we must be having deflation whilst others say ‘prices of rent and food has gone up’ so we must be having inflation. For investors, I think what we really care about the most is the price of investment assets such as property and shares so I would only really worry about inflation or deflation in terms of these assets. The prices of these assets are also determined locally (by this I mean at least on a national level) rather than globally so what we see happen in another country may or may not be applicable in Australia. For the rest of our discussion, I would like to limit our definition of inflation or deflation to increase or decrease in prices of assets like property and shares.
Why is inflation or deflation important to investors?
The answer is quite obvious. When we buy assets, we want prices to go up so we can make money on our investments. If there is high inflation, it is good to own a lot of assets as you will make a lot of money. However, if asset prices go down, we will lose money if we own assets. For most investors in Australia, inflation is a basic assumption which has held true for the past few decades, or in the entire lifetime of present day investors. Prices of these assets have always gone up over time. Even though there were periods where prices were flat or even dipped, they eventually came back and went even higher. This is the basic assumption of ‘buy and hold’ investors. If you hold it long enough, prices will go up and you will make money. In fact many experienced investors say ‘time in the market’ is more important than ‘timing the market’. If we believe this, we should buy during the dips as prices will eventually recover and you would have purchased the asset at a bargain.
Correctly forecasting inflation or deflation is crucial for investors especially if leverage is used to acquire these assets. If we are expecting high inflation, we should leverage up and borrow as much as we can to buy more assets and leverage will increase our rate of return. A simple example used in property investment books is say you buy a property for $100,000 with $10,000 of your own money and you borrow $90,000 from the bank. For simplicity, we will not worry about interest on the loan and assume that this is covered by the rental you receive from the property. If the property price goes up 10% i.e. by $10,000, you would have doubled your money or have a rate of return of 100%. The more leverage you use, the higher would be your returns. If you only need to put $1000 down and can borrow $99,000, then the same 10% increase in the price of property would give you a 1000% return. Using debt to buy appreciating assets was the smart thing to do and this was how many property investors made a lot of money.
However, leverage is a two edged sword. If the same property goes down in price by 10%, you would have lost 100% of your money if your investment was $10,000. If your investment was only $1000, you will be in big trouble as not only have you lost they money you put in, you will have negative equity of $9000. You will need to find an extra $9000 to be able to fully repay your loan if you (or the bank) decide to sell the property. In the real world, the problem can be even worse as there is usually an additional 10% cost involved in buying and selling property from having to pay stamp duty and commissions. So even if you buy and sell at the same price, you would have lost 10% so you really need the price to go up at least 10% just to break even. Rental returns generally are not enough to cover expenses like interest and management fees so you will also be losing money even if you do not sell the property. This was the scary lesson I personally learned when we wanted to sell some of our highly leveraged investment properties last year. If you are forecasting a deflation in asset prices, you would want to sell your assets, or at least reduce your level of leverage as soon as possible.
I will discuss the case for inflation and deflation in separate posts over the next few days.
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Inflation does mean prices go up, but I’m not sure it is correct to then assume the price of all assets will go up with inflation. Look at the US during the ‘66 – ‘81 secular bear market. Inflation was high for most of that period.
Deflation seems to always be bad.
Completely agree with you that inflation (as measured with CPI) does not always mean asset prices will go up, which was why I was trying to narrow the definition of inflation/deflation in our discussion to inflation/deflation of assets like property and shares which is what concerns investors most.
Thanks for pointing this out and I will be sure to re-iterate this in the following posts in this series. I plan to write two more posts “Case for inflation” and “Case for deflation”. Blogging has been a little slow since Kingsley started his one month vacation a week ago as it is hard to find quiet time to write. Kids will be will be on holidays from 19 Sept which will not help either.
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