Each week Tom Stevenson shares his perspective on the market.  Tom has been a financial journalist for nearly 20 years, writing for the Investors Chronicle, The Independent and more recently the Daily and Sunday Telegraph.  The ideas and conclusions in Tom's weekly column are his own and do not necessarily reflect the views of The FG (IFA) Ltd.  They are for general interest only and should not be taken as investment advice or as an invitation to purchase or sell any specific security.

Turning Japanese?

2nd September 2010.  No-one likes inflation – it eats away at the value of your savings, an insidious tax on the prudent minority who have paid off their debts and built up some personal wealth. But the bigger concern for policy-makers, and those who have borrowings not assets, is deflation. The combination of falling wages and asset prices with fixed levels of borrowings is a killer.

Inflation is also much easier to deal with. If prices rise too fast, the authorities can raise interest rates to choke off demand. Once they start to fall, there is a limit to how far policy-makers can reduce the cost of money – it’s called the zero-bound and in the US and Britain we are close to it.

We have a perfect case study when it comes to deflation. Japan has been mired in it for more than a decade now. Increasingly, as poor economic data piles up in the West (and especially in the US), comparisons are being drawn with the sick man of Asia. Are we turning Japanese? And if we are what does it mean for investors?

The Federal Reserve is busily pouring cold water on the idea that America is heading for a Japanese-style deflationary slump. “While no member saw an appreciable risk of deflation, some judged that the risk of further near-term disinflation had increased somewhat” was as far as the Fed would go in the minutes of its August open market committee meeting.

Others are not so easily convinced. Goldman Sachs economist Jan Hatzius said the Fed’s coolness under fire was surprising given the recent data on wages and prices. Core inflation, as the chart below comparing US and Japanese price changes over the past 20 years shows, stands at only around 1% (around the same incidentally as in the UK where no-one is yet fretting about deflation).

There are good reasons to believe that the US is not following Japan’s lead. Credit Suisse came up with fully nine of them recently. Here are the main ones.

First, it believes that the US authorities have acted much more quickly and decisively to fend off deflation than the Japanese did in the wake of the bursting of their property bubble in 1989. For example, they moved quickly to slash interest rates and use fiscal measures to boost the economy. In Japan, by contrast, they didn’t adopt a loose monetary policy for five years and even then they raised rates prematurely a couple of times when they started worrying wrongly about inflation again.

Second, wages are not falling in the US, despite unemployment hovering around 10%. That’s because America prefers to lay people off rather than cut their wages. In Japan, where the job-for-life culture is still much more in tact, wages are about 10% lower than in 1997.

Third, asset prices have fallen by much more in Japan than in America. House prices are down by three quarters since the peak, while they have fallen by only around a quarter in the US and are already starting to look very affordable.

Fourth, US banks are much better placed to fend off deflation than in Japan, where losses were much bigger relative to the size of the economy, where banks were slow to recognise non-performing loans and where operating losses continued for years.

Finally, the US and Japan are very different countries. Japan has one of the world’s oldest populations with a dwindling workforce and no desire to allow the immigration which continues to keep America relatively young and vibrant.

Because Japan’s population is relatively old and with a high proportion of its wealth in financial assets, it is also argued that there is a built-in bias towards deflation because many more of its people stand to benefit from falling prices. If you have a lot of cash and no debts then falling consumer prices make you feel richer. Indebted Americans, by contrast, can’t stomach the value of their borrowings staying high while the assets backing them dwindle.

But investors need to be prepared for all eventualities. What if all these differences are an illusion and the West does lurch into a Japanese style deflationary slump? What does that mean for investors?

Well, the first point is that government bonds, despite looking very stretched with their record low yields, could yet rise further.

As for equities, a deflationary environment would most likely favour those countries that were most likely to avoid falling prices. Places like India, where inflation is close to double digits and economic growth strong, would be better-placed.

In terms of sectors, investors might look at those with relatively low levels of debts – telecoms, pharmaceuticals, tobacco and technology look comparatively interesting. Some of these – telecoms and technology, for example – have also spent many years getting used to falling prices so they have learned to improve their productivity to counter deflationary trends. Some retailers would fall into this category too.

Finally, high-yielding investments would most likely do well in such an environment because interest rates would stay low and investors would chase income. High-yielders have ourperformed by a wide margin in Japan since 1997.

Deflation remains a long-shot. But forewarned is forearmed.

You can see Tom's previous commentaries here.