Deflation: What is it and should you be worried?

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19/05/2015
UK Consumer Prices Index (CPI) inflation has turned negative for the first time on record. This is the first instance of deflation in the UK for 55 years. But is deflation here to stay and what does it mean for your savings and investments?

What is deflation?

Deflation is a decrease in the general price of goods and services. Deflation occurs when the inflation rate falls below 0 per cent.

Is deflation a bad thing?

While falls in prices are generally welcomed, sustained deflation can be hazardous. The longer deflation lasts, the further prices fall. Consumers become accustomed to costs constantly reducing, and decide to postpone the purchase of goods in the belief prices will fall further. This naturally dents company profits, meaning a reduction in wages, and potentially the sacking of workers and the scaling down of production.

Equity prices can correspondingly decline as people sell off investments that no longer offer decent returns. Governments usually respond to deflation by lowering interest rates – however, as the Bank of England base rate has been stuck at 0.5 per cent since March 2009, interest rates cannot be reduced much further.

Is deflation here to stay?

Experts believe the current period of deflation is likely to be short-lived.

Mainstream media reporting on UK deflation will likely invoke the case of Japan; the country suffered a prolonged economic downturn throughout the 90s, exacerbated by severe deflation. However, it’s unlikely that the UK’s deflationary experience will be same.

Japan’s deflationary period was driven by the collapse of asset prices, and falling wages. In the UK, deflation is being driven by falls in food, energy and other import prices. The Bank of England’s Quarterly inflation report issued in May 2015 forecasts that these prices will “rise notably around the turn of the year” – and UK wages are also on the rise.

Azad Zangana, senior European economist at Schroders, says: “We expect the UK to see higher inflation as we progress through the year and the impact from lower energy prices falls out of the annual comparison.”

Jeremy Cook, chief economist  of World First, believes that a brief spell of deflation, coupled with average wages rising by 2 per cent in real terms, make for “great conditions for UK consumers to continue spending through the summer months.”

Rain Newton-Smith director of economics at the Confederation of British Industry (CBI), says that short-term deflation would be “good news” for the UK, “boosting household incomes and lowering costs for businesses.”

What does deflation mean for investors and savers?

Investors…

If consumers stop buying, then company profits can be negatively impacted – leading to a fall in investor returns, and share prices.

This might cause a domino effect as investors sell off shares of companies they no longer consider profitable. Investors not quick off the mark may then experience real losses from their investments.

However, Tom Stevenson, investment director at Fidelity Personal Investing, believes that the current economic milieu is a strong argument for investing in the stock market. “The rebound in oil prices and stability of global food prices means we can expect the dis-inflationary period to be short lived,” he says.

“Companies that have pricing power through their brand names are safe havens in a disinflationary environment. Funds such as Nick Train’s Lindsell Train UK Equity and Terry Smith’s Fundsmith Equity are good ways to play this theme. Alternatively, equity income provides yield with the prospect of growth as well via funds like Michael Clark’s Fidelity Moneybuilder Dividend.”

Chris Williams, CEO of Wealth Horizon, believes that investors should prepare for the return of inflation. With interest rates still at record lows, it will become even more important to invest in assets which deliver a return well above the official inflation target of 2 per cent, Williams says.

Shaun Port, CIO of Nutmeg, says that investors can protect their portfolios through balance, suggesting “an underweight exposure to bonds and an associated overweight to equities.”

Savers…

Falling prices mean that every pound has more purchasing power and also means that the virtually non-existent savings rates offered by banks and building societies will be worth more.

By way of example, it is better to have a 2 per cent interest rate with prices declining by 1 per cent a year – meaning you’re actually netting 3 per cent for your savings pot, than a 5 per cent interest rate when inflation is 4 per cent.

Calum Bennie, savings expert at Scottish Friendly, says that UK consumers should “make hay while the sun shines”, by putting any extra cash away now into savings or stocks and shares ISA before the “inevitable return” to inflation.

Deflation is good news for those on fixed incomes, as falling prices means their money goes further. Retirees likewise stand to benefit, as they are often hit hardest by inflation due to rising energy costs.

However, retirees also depend on the interest paid on their savings to boost their retirement savings. Vanessa Owen, head of retirement products at LV=, says that “the prolonged period of low interest rates means many retirees will struggle to make ends meet.”

 

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