Deflation – How Should We Invest?

by JDH on July 11, 2020

In the month of May 2020, in Canada, the Consumer Price Index fell 0.4% on a year over year basis.  That’s negative inflation.

That’s deflation.

That’s not a surprise. There is high unemployment, so based on the law of supply and demand, companies need fewer employees, so that pushes wages down.  Companies are selling less stuff, so that pushes prices down.

Look at your own situation.  Even if you are able to leave the house to go to work, you aren’t going to restaurants (unless you live in an area that has outdoor patio dining), you aren’t spending money on airplanes and hotels to go on vacation, and you probably aren’t even buying clothes or anything else.  Who needs a new suit when they are stuck at home, working in their shorts and a T-shirt?

Until the economy fully re-opens, our level of spending will not return to previous levels.  When will that happen?  No time soon.

We all want the kids to go back to school in the fall, because if the kids are at home, and if the daycare centres are closed, the parents can’t go back to work, and if the parents aren’t working, the companies don’t have employees, and no-one is earning any money to spend.  It’s a classic vicious circle.

The best case scenario is that the powers that be, whose every decision has been wrong up to this point (don’t wear a mask, then it’s mandatory to wear a mask) actually figure out a way to have kids back in school, but I don’t see it, until the number of new cases substantially decreases.  The good news is that the number of new cases is dropping, as are deaths here in Ontario, but until we have no new cases, can we send kids to school?

It’s not the kids I worry about.  They appear to be very resilient, but kids are always sick with a cold or the flu or something, and they give it to their teachers, and their family, and that’s how it spreads in the community.  So until we have that problem solved, the economy cannot fully reopen.

And even when it does re-open, it will be very different.  Many businesses will never re-open.  If your restaurant has stayed closed for six months, but your landlord still wants their rent money, you have no way to recover.  How soon will you return to eating in an indoor restaurant?

What about the hair salon that lost three month’s worth of business, never to return?  Are you going to get three haircuts on the day they re-open?  Will you go for 50 workouts when your gym opens up again?  Not likely.

And what about real estate?  If my boss will let me work from home, will I continue to live in a tiny condo in downtown Toronto when I can move outside the city, with a yard, so my kids can actually go outside?  Will anyone ever use Airbnb again?  Commercial real estate in the core is dead.  Residential and commercial real estate outside the city may do well, but overall, that’s deflationary.

And what happens next spring, when the 8 million Canadians who have received the CERB benefit have to pay taxes on that benefit?  That’s a lot of money that will be sucked out of the economy.

It would appear that we will be in a deflationary environment for many months, perhaps a year, perhaps longer.

What’s the implication?

In a world of deflation, you do not want to OWE money.

It is not good to be a debtor during deflation. During a deflationary period, my dollar buys more stuff.

If you have 2% deflation, that means that last year my dollar bought a dollar worth of stuff, but this year that same dollar can buy the equivalent of $1.02 worth of stuff.  Prices go down, so my dollar buys more.

That’s bad if I have debt.

I borrow $1, but next year when I pay back my debt I’m using a dollar worth $1.02 in terms of spending power.  That’s not good for me.  My debt cost went up.

Of course on top of that I’m paying interest, so it’s a double whammy; I pay interest, but I also pay back my debt in more valuable dollars.  That’s a problem.

But does that help the lenders?

Probably, because their loans are being repaid in more valuable dollars.  Being a lender is good in a deflationary period, provided that your borrowers actually have jobs and can service their loans.

So, on that basis, it appears to me that ZEB.TO – BMO Equal Weight Banks Index ETF is a good investment.  It pays a dividend, currently around 5%, which is more than you can earn in a savings account, and if the economy picks up, banks will do fine.

There is obvious support around $21, so if we have another correction, that would be a great buy point.  The 50 day moving average at $23.30 also looks like a good buy point.

The big banks in Canada never cut their dividend.  They pay out about 50% of their profits in dividends now, so even if their profits fall, they still have the cash to maintain the dividend.  You buy ZEB, sit on it for a year or two, collect the dividend, and when the economy recovers you sell it for $30 and make a nice capital gain.

Seems like a good investment in these deflationary times.

(Gold is good to, because it’s a store of value, but that’s a topic for another day).

Enjoy, and see you next week.