The current bull market has been the longest in history.
While some market commentators are warning of a potential recession signalled by an inverted yield curve, we argue that this type of inverted yield curve, caused by decreasing interest rates in the long-term portion of the yield curve may signal further deflation around the world rather than recession. Further deflation would signal slow, low growth for much longer.
This blog considers the difference between a recession and deflation, and how it impacts our investing.
Recession
Recessions are an economic contraction where indicators like employment and production decline. Recessions usually arise after a period where economic expansion drives inflation. Central banks raise interest rates to reduce inflation. Increased interest rates increase borrowing costs forcing people to reduce spending. These increasing interest rates in the short-term cause an inverted yield curve.
Our 2018 blog described how the oil price rises during an economic upturn as a result of demand and how the US federal reserve increases interest rates to control inflation by decreasing demand.
But interest rates are currently low, and employment remains high. Consumers have jobs, can manage their debt and therefore, can keep spending. The oil price has remained under control because of increased production from the US. It is difficult to have a recession with low-interest rates, high employment and low oil prices.
Deflation
In markets where there is no inflation, interest rates are low and negative in some countries like Germany, Switzerland and Japan. In countries where the rate of inflation is decreasing from a high rate of inflation to a low rate of inflation, interest rates move from high to low, South Africa is an example of this inflation rate movement. Both these scenarios point to a deflationary environment.
In a deflationary environment, products get cheaper or stay the same price for many years. That’s deflation. You can buy more in the future with your money than you can buy today with the same money, so it pays you not to spend. Under these conditions, it pays people to save more and spend less. People will get wealthier by not spending as their buying power will continue to increase over time. This realisation changes people’s behaviour.
Increased saving results in decreased spending and decreased spending is deflationary not recessionary. The difference being, that quantity goes down and quality goes up when it comes to consumer spending. Growth stays low but lasts longer. The economic cycle becomes a marathon and not a sprint.
Spending tends to focus on quality products, experiences and brands. Purchases are done with savings rather than borrowings. People do not have to rush to buy anything, because the products will be available at current prices in the future.
But why are the interest rates so low?
Interest rates go down because there is less demand for loans. The less need there is to borrow money, the lower the interest rate goes, just like any other product where supply and demand dictate pricing. That is a further sign of deflation.
Deflationary environments and investing
It is essential to invest during inflationary periods as your purchasing power diminishes over time. During deflationary periods, it is essential to invest as the growth in quality companies is ensured by brand power. As people save, they also spend more on quality products.
Where to invest in a deflationary world?
Warren Buffett has commented that if interest rates remain low, then stocks are “ridiculously cheap”. Buffett reminds us that any investment is worth all the cash you will get out between now and judgement day, discounted back to today. However, he also reminds us to remain prudent during a low interest rate cycle as the threat of higher interest rates is always around the corner when demand picks up.
Good news for AXIAM clients
If interest rates remain low, then we have bought our stocks at a bargain price, and the value of the companies is higher than estimated! Also, we invest in companies that have strong brands sought after by the top 1% wealthiest people in the world who will seek quality.
If there is a recession, then share prices will decline, creating the opportunity for us to buy more shares.
Like Warren Buffett, whether there is a recession or deflation, we will continue to invest in companies that have great brands, good cash flow and provide us with increasing dividend returns.
At AXIAM, we have spent many years growing wealth with an investment strategy inspired by the wisdom of great investors like Warren Buffett. We buy shares in companies that pay regular, increasing dividends, because they own great brands that are known, loved and used around the world daily, and we keep them for a long time. Sign up for our newsletter, or contact our fund management team to invest.