Deflation: How Should You Invest?

The word deflation generally carries a positive connotation for consumers. Prices fall and your money buys more. But heavy deflation normally brings a recession with it, during which building wealth becomes more difficult.

Does that mean that you should hide your money under your mattress till deflation reverses? This moneyland.ch guide explains which investments benefit in times of deflation and which do not.

Savings accounts

Many residents of Switzerland cannot imagine that parking money in savings accounts can be a profitable investment in times of low interest. But in reality, when prices fall, the value of currency can climb high enough to even balance out negative interest losses.

Example: You hold 100,000 Swiss francs in a savings account over five years, all the while paying negative interest at a rate of 0.75 percent per annum. The nominal value of your account balance would shrink by 3700 francs to 96,300 francs over that period. But if annual deflation rates average 2 percent over the full term, your money’s actual purchasing power would increase by over ten percent. You would achieve a real return of around 6500 francs in spite of negative interest charges.

Of course, that return would be higher if you could use banks which did not charge negative interest, or even paid you interest. The savings account comparison on moneyland.ch shows you which accounts are worth using.

If your only option is using accounts with negative interest rates, then holding your money in cash at home would be more profitable from a pure investment perspective. However, you bear the risk of loss (through theft or fire, for example) yourself. Note that theft coverage from household insurance typically only insures up to several thousand francs of cash and equivalents.

Bonds

Bonds are considered to be a safeguard against deflation. A Credit Suisse study on the returns of various asset classes over around 100 years has confirmed this: In years when deflation rates in Switzerland reached 3.5 percent or more, bonds delivered a real return of around 20 percent. That makes them one of the most profitable investments during deflationary periods. Even holding cash would achieve a return of nearly 15 percent according to the study. That value exceeds 3.5 percent because the study also accounts for countries where annual deflation rates were as high as 26 percent.

Bonds are loans – and being a lender is profitable in times of deflation because the real value of interest and debt principal increases. Because bonds generally have fixed interest rates, you continue to receive the same amount of money as interest even when the real value of money increases. The borrower must repay the loan at full face value at the end of the bond term, and the real value of that money may be much higher if deflation has occurred over that period.

However, during recessions it is important to exercise caution when choosing bonds. If the borrower which issues a bond becomes insolvent and cannot repay their debts, that bond will become worthless. Deflation – with the economic effects it brings – normally increases the risk of companies becoming insolvent. You can reduce your investment risk by sticking to bonds from companies and governments with very high creditworthiness ratings.

Historically, gains in the value of money during periods of deflation in Switzerland have been less notable, and the returns on Swiss bonds have likewise also been lower. Between the start of 2014 and the end of 2015, the Swiss Bond Index (Domestic AAA-BBB) showed a real return of 10.5 percent. The annual deflation rate during that period sat at 0.82 percent. So even investing in Swiss bonds was more profitable than pure saving.

When deflation is moderate, though, stocks normally achieve higher returns than bonds. Between 2014 and 2015, Swiss stocks delivered a real return of nearly 18 percent, as the historical return calculator on moneyland.ch shows.

Stocks

Stock trading can also be a lucrative investment during deflation. The real returns of stocks over long deflation periods ranged between 3.5 and 26 percent, or an average of around 11 percent per year. That is significantly less than the 20 percent returns on bonds, but it is still a substantial profit. However, according to the CS study, holding cash delivers a real return of 15 percent, making it a more profitable investment than holding stocks.

The nominal values of stocks tend to decline in periods of deflation, but stocks tend to be less affected by changes to consumer prices than bonds. That is why returns are not as high as those of bonds and cash, which are directly linked to the value of currency. The advantage of this lesser correlation is that stocks provide better protection against fluctuation between deflation and inflation. The returns of bonds can radically shrink if inflation sets in, while stocks can still deliver returns in periods of moderate to high inflation.

Important: If deflation results in a recession, the economic impact can have negative effects on many companies and even entire industries. A worst-case scenario would be investing in the stock of a company which ends up going bankrupt during an economic crisis. Companies which carry large amounts of debt are likely to suffer the most from deflation.

There are companies which have historically also been able to make a profit during consumer crises. These include established manufacturers of consumer goods, such as food producers. These products generally continue to be sold, even if demand generally declines. During a recession, consumers are more likely to wait on buying a new car than to cut down on their grocery purchases.

During a deflation, cash is king. Because of this, it can be beneficial to focus on stocks which pay out high dividends. The money you receive as dividends may gain in value faster than your investment portfolio.

Precious metals and other commodities

Precious metals are established commodities which are often bought to hedge against inflation. But when money gains in value, it is important to exercise caution in these investments.

The prices of many metals which are used in manufacturing – such as silver and copper – can drastically fall when deflation results in economic recessions. Resultingly, these metals deliver lower returns to investors during such periods. That is also true of other commodities which are used in the manufacturing of consumer goods.

As in many other cases, gold is an exception to the rule. According to the study, the yellow metal still yielded a real return in years when deflation rates exceeded 3.5 percent. The real return on gold averaged 12 percent per year over these periods. That means the real return on gold in times of deflation is slightly higher than that of stocks. If you are considering investing in gold, you can find useful tips here.

Real estate

Deflation can be problematic for property owners. Real estate is a classic material asset. Its monetary value can dwindle over extended periods of deflation, but its real value generally remains the same. If you have a fixed-rate mortgage, that can put you at a disadvantage, because the real interest you are paying for the same mortgage on the same property becomes higher.

If you expect high deflation to occur, then choosing the right mortgage is particularly important. If your salary is reduced to match deflation, making fixed interest payments for a mortgage may become more difficult.

When deflation only occurs over short periods of several years, property prices may remain stable for a time. In the best-case scenario, prices may not fall at all. When that is the case, selling real estate during deflationary phases can, in some cases, result in a capital gain. However, finding willing buyers can be difficult during these periods.

Demand for real estate always plays a significant role in determining its price, regardless of deflation. Depending on the type of property and its location, losses in value cannot be ruled out.

If you rent out property and the rent you receive remains unchanged, you will achieve higher real returns over periods of deflation. If, on the other hand, you have to lower rents to match deflation, then it is your tenants who will benefit from deflation. But even in this scenario, the real value of the rent you receive normally remains the same. So lower nominal rents do not necessarily result in a real loss.

Cryptocurrencies

Many cryptocurrencies, including bitcoin, have limitations on the generation of new currency units, and how many units can be created in total. In theory at least, bitcoin would could thus provide a shield against inflation. But cryptocurrencies do not benefit when deflation drives up the value of money. So holding fiat currencies will generally be more interesting for investors during deflationary periods than holding cryptocurrencies.

It is not yet clear how the value of cryptocurrencies would develop in times of deflation, because there is still very little historical data for this young asset class. It is often said that cryptocurrencies will play a similar role to gold. Because there is clear data showing the real value of gold during deflation, this theory posits that bitcoin and similar cryptocurrencies could also yield real returns.

The volatility of prominent cryptocurrencies like bitcoin could be a disadvantage. If deflation brings on a recession, big investors may choose to avoid risky alternative investments. Assuming the value of bitcoin does not stabilize, a recession could cause a withdrawal of investment which could in turn cause cryptocurrency prices to fall.

Exotic material assets

The prices of niche material assets like fine art, jewelry, watches, and classic cars, will generally go down as deflation rates increase. But, unlike the most popular investment vehicles, there are no comprehensive indexes which track bids and offers for these assets. Because of this, there is no way to clearly track the impact of deflation on the values of these “exotic” investment vehicles.

Financial experts generally advise that you only invest in niche assets which you have an affinity for. Ideally, you should already have some knowledge of the market for the asset you want to invest in, understand what affects its value, and have a good idea of how prices are likely to develop.

Because markets for niche material assets are much less liquid than other markets (the stock market, for example), converting your exotic investments into money can take some time and effort. If you are forced to sell under pressure and do not have time to find the right buyer, you may not profit from these illiquid investments. In the worst case, you may even have to accept a capital loss. As a general rule, these kinds of assets should never make up the bulk of your investment portfolio, regardless of how prices develop.

More on this topic:
Use the deflation calculator now
How to protect your wealth from inflation
Basic investment strategies you should know about