Investing in a deflationary world

Friday, Sep 11 2015 by

Inflation has been such an ingrained element of most major economies for so long it is assumed to be the normal state of affairs. Certainly, central banks and governments would like that to be the case and most of them are making vigorous efforts to get back to a situation where inflation is running at 1% to 2%.

This is mainly being done through Quantitative Easing (QE) in which governments simply invent money by printing more of it. The scale of this is truly staggering, albeit hard to quantify but seems to be about $4.5 trillion in the US, £375 billion the UK, €360 billion Europe and ¥240 trillion in Japan.

Despite this QE hasn’t worked. Growth is low in these major economies, even after six years of this stimulus, and inflation is either zero or barely positive. The only bright spot had been China which had been growing at double or high single digits for over a decade.

However, even here recent events suggest that its own, hard to measure stimulus from large scale borrowing is having less effect and it has now resorted to devaluing its currency to stimulate growth to make exports cheaper. Lower prices from cheaper white goods and other manufactured products will, effectively, export deflation to the West by undercutting competitors. Good news perhaps for commodity producers if not for washing machine repair men and economic growth in those countries.

This new development is happening when the economic recovery in the UK is already six years old (which is longer than normal) and interest rates are still at rock bottom. That means central banks can’t cut rates to tackle this new threat and governments may be reluctant to restart QE.

Outright deflation may now occur despite all the efforts to prevent it.

If deflation does happen should investors adopt different strategies? An obvious answer is to buy fixed income which will at least preserve capital values, as cash becomes more valuable, even if the return is miniscule. Investors need to commit a lot of capital to get a reasonable income. Conversely, low interest rates might mean debt is superficially cheap for borrowers, in nominal terms, but in real terms, when the value of money is rising, deflation makes debt repayment harder. This is the opposite of what has been the norm for so long when inflation gradually reduced the burden of mortgages and loans.

Fixed income might be attractive asset class for capital preservation but the returns are low. An alternative is to invest in equities but, in an environment of low growth and an inability to raise prices, this asset class will struggle to generate capital growth. It is hard to think of any goods or services that are actually suffering from shortages and where prices might rise. Worse, the ever expanding utility of the Internet has not only made price discovery easier it has increased the number of potential suppliers from a handful in the local area to, potentially, the whole world courtesy of UPS and the Royal Mail. A repair to a broken down washing machine is no longer dependant on the cost and availability of local providers if the alternative is to buy a new Chinese made one (now even cheaper after the devaluation) on the Internet that will probably arrive before the repair man.

And it is not just blue-collar workers in manufacturing and services who are threatened. The ability to ping a spreadsheet or a drawing to India at 5pm and have a completed version back at 9am the next day is putting cost pressure on white collar technology workers too.

So if returns don’t come from capital growth they have to come from cash flow.

While it may be easy to get depressed about these threats to incomes there is an analogy with railways in the nineteenth century. That technology also widened markets and competition but it created some of the fastest growth ever seen, without much inflation, in a period of fixed exchange rates.

Businesses that prospered then were the ones that should do well now. Companies that do not rely on external finance but generate enough cash internally to fund their own growth and have a surplus to return it to shareholders for them to reinvest as they think fit.
The dramatic cuts in interest rates, both real and nominal, at the start of the financial crash had the logical result of increasing capital values of assets; tangible and intangible. But that was a one-off effect.

Now, capital appreciation of fixed, or even intellectual, assets will become harder because interest rates cannot go any lower. It is the cash flow those assets can generate that will become more important. In a rational world that ought to focus attention, and value measurements, away from assets to operating cash flow, retained income and dividends. But that may not happen quickly.


Past performance is not a guide to future returns. The value of investments and the income from them may go down as well as up and is not guaranteed. An investor may not get back the amount originally invested. For risks relating to specific products, please refer to the relevant documentation for that product.

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21 Posts on this Thread show/hide all

Rob Davies 11th Sep '15 2 of 21

The BoE website says:

Quantitative easing (QE) is an unconventional form of monetary policy where a Central Bank creates new money electronically to buy financial assets, like government bonds.

Surely it is semantic to argue that "creating" is diferent to "printing"? 

Fund Management: VT Smart Dividend UK Fund
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underscored 11th Sep '15 3 of 21

Well considering all modern money is "created" by private banks making loans, rather than printing... and the BoE say "!The central bank can also affect the amount of money directly through purchasing assets or ‘quantitative easing’."

Then I think it is fair to say that QE is money printing.

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Blissgull 11th Sep '15 4 of 21

The point is that money is not being created and pumped into the economy. The BoE is trying to nudge financial institutions into doing something more constructive with their money than passively holding gilts. No money has been created outside the reserves of the BoE.

Here is a nice explanation.

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dmjram 11th Sep '15 5 of 21

QE as carried out by the BoE swaps one asset - gilts - for another asset - central bank reserves on the balance sheets of institutions such as banks. It is intended to act by lowering the rate of interest across the economy, not by directly pumping up the money supply. That needs something like Friedman's helicopter money.

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tournesol 12th Sep '15 6 of 21

So coming back to the topic announced by the thread title…..

I regard preference shares as useful components of my investment strategy in the difficult times described by the original poster. Many of them offer a real rate of return significantly higher than inflation / interest rates and if bought in a timely manner can deliver capital gains to boot.

My portfolio contains

I used to hold RUSP but sold it when Russia invaded Ukraine.

These yield between 6 and 9% and some have delivered very repectable capital growth.

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herbie47 15th Sep '15 8 of 21

Talking about preference shares what is the tax situation, I understand tax has already been deducted before payment? Therefore this will not be included in your dividend tax from next April when the new £5,000 allowance comes into being. Also less incentive to hold in a ISA.

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Graham Neary 15th Sep '15 9 of 21

Central bank reserves are base money - the money from which all the other forms of money are a derivative.

"QE as carried out by the BoE swaps one asset - gilts - for another asset - central bank reserves"

And where do the central bank reserves come from? Yes, the BoE just creates them out of thin air. That's why it's fair to call it money creation. We can colloquially call it money printing too, although of course there is a very complicated relationship between the relative supply of central bank reserves and actual paper notes.

"One asset for another asset" makes it sound as if maybe the assets aren't so very different. But actually one of them is money, whereas a gilt is the promise to pay money. These are different things.

Gilts were issued by governments in exchange for money, and the money was used to buy real goods and services (and votes). Issuing gilts meant that taxes did not need to be so high, and the burden of payment could be transferred to future electorates.

Now that the pile of gilts is so incredibly large, it turns out that the government found it useful to have the Bank of England create the money to buy back a large quantity of them and to manipulate interest rates to be as low as possible, making it easier to issue more gilts. This is akin to a counterfeiter paying their debts with money they printed in their basement. It would be recognised as criminal (theft or fraud) if anybody except for the government were to do it. It steals from productive elements of society, especially those who save in cash, degrades the currency, and distorts the allocation of capital throughout the entire economy. It's a bailout primarily for the government itself but also for the large number of voters who don't want normal or natural interest rates.

As for deflation - normally a sign of increasing prosperity, it is today a barometer of weak credit creation. We should all be thankful that exploding central bank balance sheets have not yet resulted in soaring consumer prices. But we do have very high asset prices, and even if these asset bubbles don't burst, we will still have to deal with the fallout of the capital misallocation they represent.

There are still opportunities in the stock market and I would still be invested, but there are also some clear bubble phenomena and when interest rates eventually go back to normal levels, then sanity is likely to prevail. Those businesses which are marginal and need refinancing may find that conditions become much tougher in the years ahead - this is already starting to play out in the energy sector.

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mpat89 15th Sep '15 10 of 21

In reply to post #106476

I don't believe this is true.

Dividends paid by companies (to both ordinary and preference shareholders) are not a tax deductible expense under corporation tax. The dividends are paid to shareholders without any tax deduction. The individual investor will therefore receive the dividend gross of any tax and would need to include it in their tax return as dividend income.

I am aware of some interest bearing ETFs (i.e. bonds) that are taxable as interest income (i.e. income tax rates) rather than dividend income, so it would be worth checking how an interest bearing share such as a preference share is affected by this rule, though as far as I know I don't think preference shares are affected.

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herbie47 15th Sep '15 11 of 21

In reply to post #106498

Thanks but I have seen several articles state otherwise: "Dividends on preference shares are paid out of taxed company profits and thus treated as 'franked investment income' so are paid 'net', meaning the basic-rate UK income tax has already been deducted, as with dividend income"

That was from Citywire article in 2012. Can anyone else clarify the situation.

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mpat89 15th Sep '15 12 of 21

In reply to post #106502

Citywire is wrong here as is often the case with these sites.

Dividends are treated as franked investment income for companies receiving dividends from other companies. Basic rate tax is not deducted from a preference share. Usually basic rate tax is only deducted from certain types of bonds, loan stocks and bank interest.

The best thing to do is to see what the dividend tax certificate says for anyone receiving dividends from these shares as this will show exactly how the dividends are paid with respect to tax deductions. Presumably they will currently be treated as paid net of the notional 10% tax credit until the tax credit goes out of use after which they will be treated as paid gross.

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herbie47 15th Sep '15 13 of 21

In reply to post #106508

OK thanks. I'm not sure I will see any certificate. If it is gross then I will have to put in my ISA. This dividend tax is a real nuisance.

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dmjram 15th Sep '15 14 of 21

In reply to post #106479

"That's why it's fair to call it money creation."

It's the creation of central bank reserves, that most definitely is not money as defined by the monetary aggregates which are relevant (for some people) for inflation and economic activity. Hence the doomsayers perdicting hyper inflation several years ago were proved totally wrong - they mixed up central bank reserves and the money supply. To call central bank reserves "money" leads to this confusion.

"One asset for another asset" makes it sound as if maybe the assets aren't so very different."

They are indeed different, the primary difference is that gilts pay greater interest. Swapping them for reserves reduces the net income of the private sector. Hence one aspect of QE can actually be defined as deflationary.

"It steals from productive elements of society, especially those who save in cash, degrades the currency, and distorts the allocation of capital throughout the entire economy"

Re cash savers, only if it leads to inflation. It doesnt and hasnt.

Re degrading the currency, sterling's external value increased while QE was being undertaken. In general, no one knows what determines forex movements nor can they predict them.

Re allocation of capital, yes to a degree. Though it needs to be remembered that QE was a response to the failure of the economy to allocate much capital at all as investment and credit dried up following the financial crunch.

"We should all be thankful that exploding central bank balance sheets have not yet resulted in soaring consumer prices"

That's the crux of it - there is no detmerministic mechanism whereby central bank base money turns into higher prices for goods in the CPI basket. As Viktor Constancio noted several years ago, central bank reserves are not an inflationary form of liquidity.

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Graham Neary 15th Sep '15 15 of 21

In reply to post #106520

If anybody is confused by dmjram, they need only remember that the government's actions - issuing bonds which are then bought by the Bank of England - is a device used to pay for real things under the illusion that they are "free". Voters wouldn't stand for the taxes necessary to pay for them honestly, and so they settle for this sleight of hand which is actually just the debasement of their currency.

While the central bank-manipulated credit system remains under pressure since the last time it created an economic disaster in 2007/8, the inflationists can enjoy the illusion that their policies don't ruin their currencies and the economic system as a whole. But all fiat currencies eventually die by their hand. Jeremy Corbyn's plan for a "people's QE" shows the UK the way forward to becoming the next Venezuela.

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Graham Neary 15th Sep '15 16 of 21

In reply to post #106520

Also worth pointing out that savers are stolen from not just by the absence of greater deflation (which should and would have occurred without the BoE's creation of £375 billion out of thin air) but also by the reprehensible elimination of interest rates on their savings and the confiscation of a host of other attractive investment opportunities in the equity and real estate markets thanks to the central bank's deliberate blowing of asset bubbles.

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dmjram 15th Sep '15 17 of 21

In reply to post #106522

QE was not set up to fund government borrowing. It's purpose was to increase liquidity and drive down the risk free interest rate across the economy with the hope it would lead to credit/loans flowing again and stimulate economic activity and also asset prices so that a wealth effect would benefit activity as well. That was the theory anyway.

Now, several years on from enormous QE, there is no inflation in the economy, literally. Inflation results when the demands are made of the real economy it cannot make. If anyone is in any doubt as to whether QE is inflationary look at Japan for empirical evidence (as well as the UK, the US and now the ezone).

Corbyn's variant is more likely to generate inflationary pressure as it will lead directly for competition for resources in the economy. It will lead to inflation if the cumulative demands made of the economy exceed its productive capacity. Maybe it will, but it isnt a deterministic outcome.

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dmjram 15th Sep '15 18 of 21

In reply to post #106525

Savers (and companies with defined benefit pension schemes) were indeed the biggest losers from QE. Financial repression was deemed the better course than financial collapse.

Again, you are assuming QE necessarily causes inflation. It doesn't.

"Central bank reserves are held by banks and are not part of money held by the non-financial sector, hence not, per se, an inflationary type of liquidity. There is no acceptable theory linking in a necessary way the monetary base created by central banks to inflation."

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Graham Neary 15th Sep '15 19 of 21

In reply to post #106528

Excuse my conspiratorial nature, but if I was creating money out of thin air, then I would also say that I was doing it to benefit everybody and not just myself.

Readers should recall that the government is not even paying any interest on that £375 billion debt pile, as to do so would be "economically inefficient" (so the BoE just sends interest coupons back to the Treasury).

We have a society which is sick on credit and sick on debt, but with the deflationary forces of prior credit binges being unwound, and with the diversion of easy money to asset prices instead of consumer prices, there are sufficient headwinds (for now) for the inflationists to pretend that their plans haven't wrecked the economy. With key interest rates still at absolute all-time record lows and with central bank balance sheets bulging with vast quantities of assets which they are unable and unwilling to sell, however, things are very far from normal and very, very far from ok. It's sad that the inflationists will be proven so wrong, but I suppose this lesson has to be learned every couple of generations in a fiat money system.

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dmjram 15th Sep '15 20 of 21

In reply to post #106532

The BoE did it to benefit the economy as a whole (they thought), they acted to stabilise the financial system and ease the crunch. They believed they were benefitting everybody overall as it was in no ones interest - especially savers - to see the financial system collapse and banks fail as the US had experienced in the 1930's when the Fed stood aside and let events run their course.

It would be economically stupid to pay interest, it would all wash out in the consol as the BoE is 100% owned by the government. A pointless exercise in admin creating book keeping.

Actually, the UK isnt in too bad a place re credit/debt in the international league table per the latest BIS report.

Finally, quite why its sad that inflationists were wrong and QE has eased the adjustment I'm not really sure. Yes it had distributional issues but standing aside wasnt really an option when the real economy was contracting at a rapid rate and the financial system was imploding even faster.

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Rob Davies 15th Sep '15 21 of 21

What should have happened in 2008 was that bust banks should have failed and their assets acquired by more solvent banks for true market value, maybe a tenth of book value. It would have been painful, very painful, but it would have benefited the prudent.

That was politically unacceptable so QE was launched to pretend we were all richer than we really were.

However, that has not solved the problem that a lot of spending prior to the bust was superfluous and not needed, much of it by the state.

Despite claims to the contrary that spending has continued and is still unaffordable but the state can claim everyone is better off by, for example, higher house prices.

We are not. We just have an enormous amount of debt we will pass on the next generation which cannot earn enough to buy those houses from the current owners. That is why cash flow will become more important than asset prices.

Fund Management: VT Smart Dividend UK Fund
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