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Inflation or Deflation: Back to the Future?

Fourteen years ago, in November, 2003, I wrote an article titled "Inflation or Deflation? It makes all the difference in the world".  This was written five years before the financial crisis and the massive monetary stimulus that followed. This is as the article appeared with no edits:


Inflation or Deflation? It makes all the difference in the world.

The biggest question in the world economy and the financial markets is whether the central banks of the world will be successful in halting the forces of deflation. Following any huge buildup of credit like we have seen over the last couple of decades the natural forces at work are those of credit contraction, economic recession, and price deflation. Add on the competitive forces of the internet and lower wage costs in Asia and it is not a surprise that after more than a dozen interest rate cuts we still do not have the inflation and “disinflation” is still a major concern (in the Fed’s own words last week).  

The goal of a low interest rate environment was to spark economic activity and to make it easier for corporations and individuals to refinance their large amounts of existing debt. Lower interest costs would make it easier for debt holders to get their affairs in order and to heal their extended balance sheets. While this has been somewhat successful in certain parts of the corporate sector, individuals have instead used a lower interest rate environment to take on even more debt in the form of larger real estate mortgages and additional credit card debt. The monetary policy has indeed been successful in supporting retail spending and the real estate markets but the probability of major credit contraction in the future has not gone away and has perhaps become even more of a problem than it was before.

Another goal of easy monetary policy is to inflate out of the debt problems by making money worth less. Individuals and corporations would theoretically be able to pay back a fixed amount of debt with dollars that are worth less. The real question is whether the current monetary policy will be successful in raising the wages of the average worker. As more jobs are moving overseas or threatening to do so (see Bombardier 11/07/03) this may be very difficult. The worst case scenario would be if the central banks were successful in raising consumer prices but employment wages stayed the same. Higher inflation would also eventually result in much higher interest rates that would make borrowing costs and mortgage costs higher.

To summarize, the natural force of boom/bust project deflation over the coming years but the U.S. is doing everything that it can do to counteract this from happening. The reason that I am bringing this up is that the outcome is very difficult to predict here and the ramifications to the financial markets and to different asset classes are profound. The investments that will do well in an deflationary environment are very different than those that will do well in an inflationary environment. My approach an strategy over much of this year has been to wait until one force prevails over the other. One thing that is quite certain is that the market will let us know which way this is going to go in the very near future. It is unlikely that we will see a scenario that is middle of the road here. Either deflation or inflation should win in the coming months.

If deflation prevails then the assets that should perform the best are cash (T-Bills), higher quality government bonds, GICs, and maybe gold. The assets that would probably perform the most poorly would be real estate, commodities (especially base metals), and most certainly equities. Both energy and gold are the real uncertainties here. It will be interesting to see if they can perform well if deflation prevails.

If inflation prevails then the assets that should perform the best are commodities (most certainly gold) and perhaps real estate and equities (see Argentina). Holders of cash will not lose capital but they would lose purchasing power as their dollars would not buy the same amount of goods. Holders of individual bonds will not lose capital if held to maturity but they will see paper loses for the duration of the bond. Holders of bond mutual funds would most certainly see the largest losses.

Even if deflation prevails and commodity prices fall sharply for a few years it has historically been the case that hyperinflation would eventually occur within a few years. Investors that realize this would certainly have one of the best opportunities ever presented if this scenario materializes.


Jon Batchelor (November 2003)


What Happened?

The article was written on the heels of the internet/technology collapse of 2000-2002, the tragedy of 911, and the wars in Afghanistan and Iraq.  The interest rate cuts cited in the first paragraph were in response to these challenges and helped fuel the equity bull market of 2003-2007.

The most prescient part of the article was the following:         

The monetary policy has indeed been successful in supporting retail spending and the real estate markets but the probability of major credit contraction in the future has not gone away and has perhaps become even more of a problem than it was before.

Interest rate cuts fueled the growth and speculation in U.S. housing which led to the credit crisis of 2008-2009.  In response to the crash, monetary policy became even more experimental and aggressive with the introduction of negative interest rate policies (Quantitative Easing) by all of the Central Banks (U.S., ECB, Japan). This fueled the bull market especially in U.S. equities from 2009 until the present.      


What Now?

Despite a strong equity market, one can clearly see from the current news headlines that there are challenges ahead. Low interest rates have once again been successful in increasing the price of assets but debt levels have risen to much higher levels. The estimated sovereign idebt of the U.S. has almost tripled since the article was written in 2003 to over $20 Trillion, not including benefits (source usdebtclock.org). The household debt of the average Canadian is at record highs relative to income. Some corporations have very good balance sheets while others have taken on high levels of debt at low interest rates. The risk and probability is that the interest costs on debt may increase substantially when rates move higher as it appears unlikely if not impossible that these debt levels will be reduced through repayment.  



We have seen a lot since 2003 but ironically the global economy may now be in a similar position but with a lot more debt. The next 15 years will potentially be even more dynamic with periods of very good markets interrupted by sharp corrections. We intend to approach the future with a steady hand and an open mind.  Here is a review of our core strategy:  



A Balanced portfolio

Laddered GICs

High quality large important companies with good balance sheets

Exposure to $U.S. assets

Precious Metals



Personal Debt

Having all assets in Canadian Dollars

Bond Funds and Fixed Income Exchange Traded Funds (ETFs)/Long duration Bonds

Companies with too much debt relative to market capitalization

Excessive exposure to Exchange Traded Funds (ETFs)


This publication is solely the work of Jon Batchelor for the private information of his clients. Although the author is a Manulife Securities Advisor, he is not a financial analyst at Manulife Securities Incorporated and Manulife Securities Insurance Inc. This is not an official publication of Manulife Securities. The views, opinions and recommendations are those of the author alone and they may not necessarily be those of Manulife Securities. This publication is not an offer to sell or a solicitation of an offer to buy any securities. This publication is not meant to provide legal, accounting or account advice. As each situation is different, you should seek advice based on your specific circumstances. Please call to arrange for an appointment. The information contained herein was obtained from sources believed to be reliable; however, no representation or warranty, express or implied, is made by the writer, Manulife Securities or any other person as to its accuracy, completeness or correctness.