In the previous article we have explained why deflation is bad for the economy. Now we will look at it from a more personal perspective and suggest a few ways to put your finances in the best possible position.
Asset protection should always be your first priority. Deflation is often accompanied by recession and higher volatility of asset prices, making the potential costs of bad decisions higher than usual. For protecting and growing your wealth in deflation, it is essential to enter this turbulent period with your personal finances in order. If you haven’t spent time thinking about your financial goals, expenses, potential risks or liquidity needs, you may want to do so as soon as possible.
Don’t Get into Debt
Getting into excessive debt for the wrong reasons is never a good idea, but the risks and negative consequences become even greater under deflation. While the prices of most goods and services decline and your salary may also decrease (or at the very best stagnate), the amount you owe is fixed and therefore growing in relation to everything else. While inflation favours debtors, because it makes their debt automatically smaller in real terms, deflation favours creditors for the same reason. Think twice before borrowing and try to repay any existing loans if possible.
Cash Is King
If the worst case deflationary scenario materializes and prices fall, then inevitably some bargains will start to appear, such as cheaper real estate or stocks for your retirement portfolio. It is therefore good idea to put some cash aside and wait for the right opportunities. The more buying power you have ready in a market crash, the greater fortune you can make. A cash reserve will also act as a safety net if you happen to lose your job.
Defensive and High Dividend Stocks
Continuing in our defense checklist, when preparing your existing stock portfolio for harder times you may want to increase the share of defensive sectors such as utilities, telecommunications or (some) healthcare – generally companies providing the things which people will still need to buy and pay for even with less money to spend. Focus on those with attractive valuations and high dividend yield – because dividends bring cash and cash is king.
Conversely, deflation might not be the best time for highly speculative and expensive growth stocks and cyclical sectors such as consumer discretionary or financials. The latter are always a gamble and the potential return (if things don’t get as wrong this time) might not be worth the high risk.
Fixed income always has its place in a retirement portfolio, particularly at higher age when your investment horizon shortens. Moreover, when central banks are dealing with deflation, interest rates tend to decline or stay low, making bond prices high – with two caveats.
Firstly, like stocks, all bonds are not equal. In deflation, as credit tightens and some particular companies and countries get in trouble, those who have invested in their bonds may face substantial losses. In general, government bonds of economically stable countries like the US, UK or Germany are the safest, although they also have lowest yields. Which brings us to the second caveat…
In the current situation interest rates have already been extremely low for a long time, which means that (low risk) bonds are already quite expensive and their yields very low. They may still be good investments if the economy slows down and interest rates remain low for longer than expected, but if central banks start to increase rates bond prices may plummet.
Watch Out for Opportunities
In a period of deflation or crisis, the people who eventually make the most money are those who not only have solid defense in place to start with, but also have their eyes open, constantly looking for the bargains and for the opportunities. If you have the time and skills for that, follow the news, try to read between the lines and connect the dots. If you have a financial adviser or retirement planner, it may be useful to talk to them more often when the markets are volatile. Having both the cash and the information ready at the right time is how wealth is made in difficult times.