While we’ve heard a great deal about inflation over the last several years, its counterpart—deflation—has been less discussed and is less well understood.

But with the potential for deflation becoming a growing concern for the global economy, it’s time to better understand the causes and risks of deflation and how you can protect your investments from its negative impacts.

Deflation 101

So, what is deflation?

‘Deflation’ refers to a general decrease in the prices of goods and services, usually resulting from a reduction in the money supply and the availability of credit within an economy.

Central banks, such as the Bank of Canada or the US Federal Reserve, play a crucial role in regulating the monetary supply and work to control the possibility of deflation, just as they do the possibility of inflation.

Though monetary issues are usually the chief cause of deflation, declining prices can also result from an overall drop in the demand for goods and services, reductions in government spending, stock market downturns, increased consumer saving, and higher interest rates. Likewise, deflation can also be caused by technological advances, especially those that increase productivity faster than the supply of circulating money and credit.1

While the declining price of goods and services might sound attractive (Who wouldn’t want increasing buying power with the same income?), the downsides of deflation can be even more severe than those of inflation.

Deflation can drive waves of unemployment, as with price drops come lower profits, forcing companies to lay off workers to cut costs. Deflation also makes debt more expensive, as interest rates trend upwards, causing businesses to curb spending. And as deflation generally occurs as part of an economic contraction or recession, in the very worst cases, a ‘deflationary spiral’—a domino effect of lower prices leading to decreased production, leading to lower pay, leading to further lowered prices, and on and on—can turn a recession into a full-blown depression.2

Deflation has happened before

When deflation hits, it tends to hit hard, as history shows us.

Canada has had nine periods of deflation since 1914. But when they happened, they were devastating. Prices dropped 20% in the early 1920s, and during the depths of the Great Depression from 1930 to 1933, prices fell an additional 25%. Falling prices meant lower profits, lower incomes, and rising unemployment, with the deflationary cycle becoming self-reinforcing.3

Similarly, the wholesale price index fell 33% in the United States during the Great Depression, while unemployment climbed above 20% between 1929 and 1933. The US economy wouldn’t get back on its previous long-term trend until well into 1942.4

Globally, numerous other countries have been mired in periods of deflation, with Japan perhaps the most famous (or infamous) example.

Between 1991 and 2001, Japan experienced its so-called ‘Lost Decade’ of stagflation—a vicious combination of economic stagnation and price deflation that sapped Japan’s once booming economy as the country struggled with both tight credit and a liquidity trap. While Japan eventually pulled itself out of this period, its recovery was notably slower than other major economies, and the effects of this period still reverberate in the Japanese economy today.5

What is the current deflation risk to the global economy?

Deflation commonly follows periods of prolonged artificial monetary expansion—such as most economies experienced during the pandemic. So, what is the current risk of deflation to the global economy?

One theory is that the rapid price rises seen in 2022 could turn to deflation in 2023 as global growth slows, energy and food prices fall, and unemployment begins to rise. And there are some signs that this is beginning to happen.

In Canada, once-in-a-generation high CPI inflation has dropped to 5.9% in January 2023 from a high of 8.1% in June 2022,6 with projections that it could go as low as 3% by the end of 2023.7 In the United States, the CPI fell even more dramatically, from 10.57% in the first half of the year to 1.88% in the second.8

These US numbers were driven by price drops in 59% of CPI components, including oil (down 38% from 2022 highs), lumber (down 67%), and housing (down 10% from peak values), as well as the biggest decline in annual M2 money supply growth since World War II.9

Similar evidence is available all over the world. In Turkey, inflation declined at its fastest rate in a quarter century in December. The UK saw price declines in December for the first time in over a year. And in France and Germany, inflation slowed more than expected at the end of 2022.10

While there are too many metrics at play right now to say definitively that a period of deflation is around the corner, with signs that point to the possibility, investors would be wise to take steps to protect themselves and their portfolios from the chance.

Investment ideas for deflationary times

While it might be hard to forecast deflation in advance, it can happen quickly. Remember how fast 9% inflation snuck up on us?

So how can investors position themselves to weather a potential period of deflation? Here are a few ideas:

  • High-Interest Savings Accounts (HISA). An option that provides both earning potential and security. By having funds in a HISA investment, you gain access to high interest deposit accounts with major banks that offer higher rates of return than any savings vehicle besides government bonds and Treasury bills.11 Depending on the make-up of your HISA investment, interest accrued each month can be paid out either as additional units of the fund or as cash distributions.
  • Defensive sectors. While some investments can be riskier in deflationary periods, investing in defensive sectors of the economy can be a safer haven during economic uncertainty. Defensive sectors tend to have more stable demand regardless of market conditions.12 These sectors—such as healthcare, REITs, and materials & mining—usually have strong cash flows, lower volatility, and more promising returns.13
  • Dividend-paying stocks. These companies regularly pay shareholders a percentage of their net earnings, either in cash or additional stock. Such payments tend to be made quarterly but can be made semi-annually or annually. As with defensive stocks, dividend-paying stocks tend to be established companies with predictable profits, such as in the finance or healthcare sectors. Several Canadian banks, for example, have recently raised their dividends. National Bank of Canada raised their dividend 23% late last year,14 and Royal Bank of Canada, the Bank of Nova Scotia, and the Bank of Montreal have all raised their dividends since February 28.15 This marks the second such increase for BMO in recent months, following a 25% dividend hike in late 2022.
  • Investment-grade (IG) bonds. Also called high-grade bonds, IG bonds are highly rated by rating agencies (rated at least Baa by Moody’s or BBB by S&P and Fitch) because they are believed to have a lower risk of default. These bonds tend to have lower yields than lower rated bonds, making them a stable, low-volatility vehicle to weather uncertain times and deflationary periods.16

Investing in a High Interest Savings ETF

If you’re looking for ways to protect your money against deflation while maximizing your monthly income, consider investing in a high interest savings ETF.

Evolve’s suite of cash solutions include the High Interest Savings Account Fund (HISA ETF) and US High Interest Savings Account Fund (HISU.U ETF). Both ETFs invest primarily in high-interest deposit accounts, exclusively with some of Canada’s ‘big six’ banks.

With cash as an important component of a well-diversified portfolio, the HISA ETF (in Canadian dollars) and HISU.U ETF (in U.S. dollars) help you preserve capital during market downturns until the time is right to invest your money elsewhere.

For more information on Evolve’s High Interest Savings Account Fund (HISA ETF) or US High Interest Savings Account Fund (HISU.U ETF), download the brochure.

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1 “Deflation: Definition, Causes, Changing Views on Its Impact,” Investopedia, April 2, 2022; https://www.investopedia.com/terms/d/deflation.asp
2 Ashford, K. & Reilly-Larke, C., “What Is Deflation?”, Forbes Advisor, July 20, 2022; https://www.forbes.com/advisor/ca/investing/what-is-deflation/

3 “Inflation and deflation in Canada,” Statistics Canada, June 28, 2006; https://www150.statcan.gc.ca/n1/pub/11-402-x/2006/3956/ceb3956_003-eng.htm

4 Ashford, K. & Reilly-Larke, C., “What Is Deflation?”, Forbes Advisor, July 20, 2022; https://www.forbes.com/advisor/ca/investing/what-is-deflation/

5 Nielsen, B., “The Lost Decade: Lessons From Japan’s Real Estate Crisis,” Investopedia, January 14, 2023; https://www.investopedia.com/articles/economics/08/japan-1990s-credit-crunch-liquidity-trap.asp

6 “Consumer Price Index, January 2023,” Statistics Canada, February 2, 2023; https://www150.statcan.gc.ca/n1/daily-quotidien/230221/dq230221a-eng.htm

7 “Inflation will likely drop to three per cent by the end of 2023, new report finds,” RSM Canada, February 22, 2023; https://rsmcanada.com/newsroom/2023/inflation-likely-to-drop-to-three-pc-by-end-of-2023-new-report-finds.html

8 Calhoun, G., “A Deflation Alert Hidden in The Latest Consumer Price Indicators,” Forbes, January 28, 2023; https://www.forbes.com/sites/georgecalhoun/2023/01/28/a-deflation-alert-hidden-in-the-latest-consumer-price-indicators/

9 Fox, M., “Wall Street has turned a blind eye to the potential for deflation over the next year – and it’s the one thing that could surprise investors in 2023,” Markets Insider, January 16, 2023; https://markets.businessinsider.com/news/stocks/stock-market-outlook-deflation-surprise-wall-street-investors-inflation-cpi-2023-1

10 Curran, E., “Inside the Biggest Economic Mystery of 2023,” Bloomberg, January 4, 2023; https://www.bloomberg.com/news/newsletters/2023-01-04/inside-the-biggest-economic-mystery-of-2023

11 Carrick, R., “Rob Carrick: Answers to your questions about the low-risk ETF paying almost 5%,” The Globe & Mail, March 10, 2023; https://www.theglobeandmail.com/investing/personal-finance/carrick-on-money/article-rob-carrick-answers-to-your-questions-about-the-low-risk-etf-paying/

12 Gopalakrishnan, J., “Defensive sectors,” Britannica Money, n.d.; https://www.britannica.com/money/defensive-sectors

13 Chen, J., “Understanding Defensive Stocks, Pros & Cons, Examples,” Investopedia, December 24, 2020; https://www.investopedia.com/terms/d/defensivestock.asp

14 Liew, C., “These 2 Canadian Banks Just Raised Their Dividends,” The Motley Fool, December 19, 2022; https://www.fool.ca/2022/12/19/these-2-canadian-banks-just-raised-their-dividends/

15 Stalter, K., “3 Canadian Banks That Just Increased Their Dividends,” Nasdaq.com, March 6, 2023; https://www.nasdaq.com/articles/3-canadian-banks-that-just-increased-their-dividends

16 “Investment-grade Bond (or High-grade Bond),” Investor.gov, n.d.; https://www.investor.gov/introduction-investing/investing-basics/glossary/investment-grade-bond-or-high-grade-bond

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