Is the US in danger of Japanese-style deflation – and what does this mean for investors?
- A divided Congress, unable to agree on a stimulus package, could set the US economy down Japan’s path
- Currently popular assets, such as tech stocks, could then underperform cash and long-maturity Treasuries, a lesson Japanese investors have had to learn
In 2000, I sat in a bland grey Prague conference room opposite officials from Japan’s Ministry of Finance. We were attending a G7/International Monetary Fund meeting. I asked if they thought the US and Europe could avoid Japan’s protracted deflation. None of them could suppress a smile. “Unlikely,” said one.
Historically, bipartisan agreement for big fiscal pushes has only come in the midst of obvious national emergencies, like the attack on Pearl Harbour or Covid-19. When Covid-19 fades, as it eventually will, the risk is that a divided Congress will not agree on meaningful fiscal policies. There are signs we are already seeing this, such as its inability to agree on a supplementary stimulus.
Inflation is the change in the average of the prices of what we buy. This mostly boils down to labour, commodities and shelter. If the supply of these items increases, absent a surge in demand, prices will fall. It is not hard to envisage that occurring.
Take labour. The ability of technology to integrate emerging-market workers into the global economy has been deflationary. While this has been available to large corporations for years, it is now increasingly available to small businesses via portals like Indeed or Upwork.
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Equities, which is what most investors hold, do well when inflation is low but positive. For much of the 20th century, investors struggled with unanticipated shifts higher in inflation, particularly in the 1970s. Inflation destroys the value of cash by eroding its real purchasing power and hurts stocks. Bond yields tend to rise as investors demand compensation for higher inflation; rising bond yields depress equity valuations.
For much of the 19th century, however, investors struggled with unexpected downward shifts in inflation. In one of the worst 19th century deflations, US prices fell by almost 2 per cent a year from 1873 to 1896. Falling inflation boosts the relative attractiveness of holding cash, which then makes taking the additional risk of stocks less attractive.
Yet, in Japan, that theoretical possibility never became a practical reality in enough magnitude to drive inflation steadily positive due to bureaucratic infighting, similar to that which is now evident in the US. Japanese equities are in a 30-year bear market. By contrast, Japanese bonds have returned 2.8 per cent a year.
The US bond market is now forecasting sub-2 per cent inflation for a decade, which one can see by comparing the prices of a nominal and inflation-protected security of similar maturity. In other words, the market is predicting the Fed will fail to meet its target. Meanwhile, at present, the US Congress cannot coalesce around meaningful fiscal policy.
Perhaps a Democratic sweep of the US elections will change the odds of meaningful fiscal policy, but the possibility of a Japan-like outcome for the US remains substantial, and the implications for US and global households are significant. The investment returns they earn will be much lower than many investors are expecting.
Paul Podolsky is an investor and the author of Raising a Thief. For 20-plus years, he worked on Wall Street, most of the time with Bridgewater Associates