Things that are deflating are rarely good: deflating balloons and tires, Deflategate (for us here in New England), and especially deflation as an economic term. In school, we may learn a little bit about deflation, but since it’s so uncommon, it’s something we generally forget about. The lingering memory is that deflation is a bad thing. That’s why it’s concerning seeing news of China — the second-largest global economy — potentially entering an era of deflation.
But what is deflation exactly, what’s happening in China, and how might this impact your investments? These are all questions we plan to answer in this post.
What Is Deflation?
As financial advisors, we are constantly warning our clients of the pernicious long-term effects of inflation. Your dollar today won’t buy nearly as many goods as it will five, 10, 15, and especially 30 years into the future. That’s why we advocate so strongly for investing for the long term, so your money grows faster than the rate of inflation, which is the usual state of an economy.
However, in a deflationary environment, instead of the prices of goods and services increasing over time, they decrease. This means, assuming deflation sticks around, your future dollar will be able to purchase more goods and services than it can today. In simple terms, deflation is the opposite of inflation.
Deflation is tracked the same way inflation is, except instead of calculating an overall price increase, a price decrease is calculated. The usual metric used to track inflation is the Consumer Price Index (CPI), which tracks a basket of goods and services. Think eggs, milk, housing costs, gasoline, and the like. Each good or service in the basket is given a weight in the overall calculation of the CPI, with typically larger household expenses, like housing, being given more weight than smaller household expenses, like eggs. After calculating the weighted average of the basket of goods, if the overall prices are higher than when they were last measured — per month is the usual time frame — the CPI has increased, meaning we are in an inflationary environment. If the change in the CPI is negative, this means things are less expensive than when they were last measured, showing a sign of deflation. Of course, the magnitude of the percentage change, either higher or lower, signifies how severe the inflation or deflation is.
While the CPI is tracking a basket of goods and taking its weighted average, some goods increase or decrease faster than others. This is why it’s not uncommon to see the overall CPI increasing while the prices of certain goods and services in the basket are decreasing. This shows overall inflation increasing but specific goods and services decreasing from when last measured, which is considered normal.
Why Is Deflation Concerning?
While most people may not know much about deflation itself, they do remember it being a negative thing. But if the prices of goods are decreasing and your dollar is going further, isn’t that beneficial? Like many things, the concept of deflation is complicated.
While consumers may be happy about prices decreasing, when an economy is in deflation it is generally a warning sign. Like we all learned in economics, the price of a good or service is determined by supply and demand. If the price of a good or service is falling, it either means supply has increased or demand has decreased. Economies run on governments and their citizens spending money. If demand is low, causing prices to drop, there are economic issues in the country. On the flip side, if supply is high, producers were likely expecting higher demand that didn’t materialize and are now selling goods for a lower price to get rid of the inventory hurting their bottom line. In either case, deflation is typically a negative sign for an economy.
Beyond the warning signs of deflation, the behavioral considerations in a deflationary environment can exasperate economic woes. If consumers are seeing prices decline and are expecting them to decline further in the future, they may postpone purchases they otherwise would have made. This means that businesses are not earning revenue from their wares and may plan to cut prices even more. And as prices are cut further — as consumers expected — it hurts businesses’ bottom lines and may lead to layoffs or even the closing of a business. This can quickly spiral out of control. The expectation of increasingly lower prices leads to a longer delay in consumer purchasing that can grind an economy to a halt.
Deflation can also discourage investments in business. If consumers aren’t buying because they expect prices to go lower, then businesses aren’t selling. And if they’re not selling, it doesn’t make sense to expand the business. Many businesses grow by borrowing money and deploying it throughout the company. If tomorrow’s dollars are going to be worth more than today’s, businesses will be encouraged to keep more money on hand and deploy cash later when prices have decreased. Not only are consumers incentivized to delay spending, but businesses as well.
In summary, deflation can definitely be a bad thing. While the concept of lower prices may be appealing to consumers, the tradeoff is rarely worth it when it comes at the expense of potential economic growth stagnation.
What’s Happening in China?
Now that we know why deflation is concerning, we can see why investors are worried about headlines reporting that deflation is emerging in the Chinese economy. In July, China’s Producer Price Index (PPI) fell for the tenth straight month. The PPI is different from the CPI because it tracks the prices producers (manufacturers) are charging. And while dropping prices does not necessarily mean that lower prices will be seen at the store, it does make it more likely. When the PPI declines, it is a sign that the economy may be slowing, and if it becomes a trend, as it has in China, it brings about concerns that deflation may be rearing its head.
While the PPI has been declining in China for the past ten months, the CPI had its first monthly decline since 2021. While it is clearly not trending the same as the PPI at this time, a decline in the CPI is triggering concerns that deflation may be impacting the broader economy, with more to come in the near future.
As mentioned above, just because the PPI is falling does not necessarily mean the CPI will continue to fall with it. Sellers of manufactured goods have other expenses that go into the prices they charge (e.g., overhead, shipping). A decline in the PPI can also signify poor projections by manufacturers that produced more goods than are in demand, forcing them to sell at a discount. However, since there have been numerous PPI declines in a row and now the CPI has shown a decline as well, it’s certainly cause for concern in China.
What Might This Mean for the Global Economy?
With China being the second-largest economy, what happens there certainly has an impact on the rest of the world. However, some economists do not anticipate deflation in China having an overwhelmingly negative impact on the global economy, especially in developed nations. In fact, according to the Business Insider article linked above, deflation in China may benefit the global economy at large.
While China is contending with deflationary pressures, much of the rest of the world, like the US and Europe, is struggling with inflation. While the rate of inflation has trended down in recent months, it is still higher than the Federal Reserve’s target of 2%. With continual PPI declines in China, and China being a large global exporter, other countries can purchase goods at lower prices. These lower-priced imports may, in conjunction with higher interest rates, be a significant factor in bringing down overall inflation.
However, any time a large global economy struggles, there is likely to be some impact on the global economy at large. Many large companies do not just sell in their home country, but around the world. If demand in China is lower, as seen by the reduction in PPI and CPI, this may have an impact on the profits of many global businesses, even if deflation in China does help lower overall inflation in the rest of the world.
What Should You Do?
As with most things with investing, we do not recommend making drastic changes to your portfolio because of what’s happening in the news. We continue to advocate staying the course, since no one can predict exactly how all these economic factors will play out. The world is too complex. While deflation in China is certainly concerning, there may also be beneficial ripple effects for the rest of the world.
Since no one truly knows what will happen, the best course of action is to maintain a well- diversified investment portfolio that consists of many different industries and countries.
Despite the concerns we’re seeing in China, we still strongly believe in investing globally, as we wrote about in a recent post, because no country, including the US, is immune to short-term economic woes. While past performance does not guarantee future results, despite near-term troubles, we firmly believe that over the long term the global economy will continue to expand, and the best way to participate in this growth is by owning a little bit of a lot of things. Although the global economy continues to become more and more connected that does not mean that all countries will necessarily move together economically. That’s why it’s so important to be diversified among many different countries as well, so when one country is struggling that does not necessarily have an outsized negative impact on the rest of your portfolio.
Although we here in the US are experiencing the pains of inflation, other countries, like China, are struggling with deflation. As difficult as moderately high inflation is, trying to handle deflation can be even harder.
Just because some countries are experiencing deflation, it does not mean it will catch on globally, even if one of the countries in question is the second-largest economy in the world. In fact, because much of the globe is dealing with inflation, deflation in China may be globally beneficial in helping reduce it.
We’ve said this many times before: Despite the fears and worries that result from today’s news headlines, we strongly believe the best path continues to be to stay the course. While past performance does not guarantee future results, the global economy has continued to grow, and we don’t see a reason that it would be different this time. Of course, if something has changed with your personal situation, it may make sense to speak with a financial advisor to review your investments as they relate to your goals. If you need assistance with your financial plan or investment strategy, please reach out to our team.