By Professor Ricardo “Rick” Ulivi, Ph.D.

When you consider making an investment, you are really betting on its future cash flows, so it’s important to have a mental picture of what might happen to the economy. That’s because if the economy slows down, you can expect the future cash flows from your investment to slow down too, and this will reduce the value of your investment. On the other hand, if the economy grows, you can expect your investment’s cash flows to grow too, and therefore, the value of the investment to go up. So, where’s the economy heading now?

My crystal ball is foggy because there are many indicators that can justify two very different, and opposite scenarios. For that reason, I will review both and give you a recommendation.

Deflation: Again?

The US experienced a deflationary period between 1930 and 1940. An excellent movie which illustrates some of the consequences of deflation is “The Grapes of Wrath.” No, I don’t believe that things will become as bad as they were back then. However, imagine if for the next 10 years your house did not increase in value, your stock portfolio remained stagnant, interest rates continued to be as low as they are now, and you received no increase in salary. How would you adjust yourself to these new circumstances?

Most likely you would begin saving more and spending less, resulting in increased unemployment. Given that prices were not increasing, you might also postpone purchases in the hope that you could buy goods later for less. This type of behavior would reduce demand for goods and services, and therefore, increase unemployment. In sum, a deflationary period for a consumer oriented society like ours is not a sweet dream. It would be the equivalent of tough love for consumers and for investments too.

Is there any evidence to suggest that a deflationary period could be on the horizon? Yes, for example, commodities prices have collapsed over the last year; not just oil, but wheat, corn, soybeans, copper, iron ore, natural gas, and so on. The drop in these prices could be signaling deflation. Also, inflation continues to be very low–below 2%–another potential indicator of deflation. We also have negative interest rates in many countries, including Japan, and this is very strong deflationary indicator. For example, last week Japan sold the equivalent of ten billion dollars with a ten year bond paying a negative rate. If you would have invested in one of these bonds, let’s say $100,000, you would have received NO interest for ten years, and then you would get back LESS than $100,000. That’s negative interest rates, and that’s deflation!

The Japanese have lived in a deflationary environment for nearly 20 years, and it continues to this day. Could we end up like Japan? Yes, we could and so deflation is a real possibility for the USA.

What about Inflation?

Because I grew up in Argentina, I have first-hand experience with the negative impact that inflation can have on the working class. It’s horrible, and I am always fearful of it. In a nutshell, with inflation, your purchasing power deteriorates regularly, so you become poorer. Yes, salaries increase, but not as quickly as prices. Inflation also forces interest rates up, so imagine the consequences of 10% or higher interest rates in the USA. Some of you may remember the period around 1980 when we experienced very high rates and inflation. It was ugly. Could this happen again?

Yes, it could and that’s because we have indicators that suggest we are at the beginning of a new inflationary cycle. For example, the Fed’s super easy monetary policy, and the Federal government’s runaway deficits. Both of these factors can be the fuel needed to start an inflation fire. Furthermore, worker productivity is barely rising, and Americans keep spending all they earn, saving very little. The combination of all these factors can trigger a new round of inflation. If this happens, it won’t be pretty.

What Should You Do Now to Protect Your Investments?

I recommend you keep a very cautious outlook. This means staying conservative with your investments, and increase your cash position until we can have a clear understanding as to where we are heading.

If you need some help with investment or retirement planning, please give me a call at 714-771-6000 or just reply to this email.

Have a wonderful month.