Vanguard: "Inflation Risk for Global Economy"

[Retire Soon]

Vanguard executives have just issued a statement saying that deflation is a real risk for the global economy, but didn't seem to be concerned with the U.S. economy. If global deflation should become a problem, how will this impact our investments?

Quote from CNBC:

"Executives at Vanguard Group, the No. 1 U.S. mutual fund company, said on Thursday deflation is a real risk for the global economy while downplaying inflation concerns for the United States.
"Most people say, 'Hey, deflation, falling prices, isn't that great!"' Vanguard Chief Investment Officer Tim Buckley said during a live webcast. But as he explained, falling prices are not something to be celebrated, especially in a developed economy that relies on consumption to fuel gross domestic product growth.

Read MoreRichard Parsons: Yes, bubbles could be forming

As consumers hold off buying things, GDP shrinks.

"Once you're in the cycle, it very difficult to get out," Vanguard Chairman William McNabb added.

McNabb said there are no data that support the presence of a lot of inflationary pressure, especially in the U.S. economy.

"When you look at what drives inflation, wages are the largest component. Most people focus on commodity prices, but wages actually are far more important," McNabb said. "And we have not seen much inflation there."

 

[gcgang]

Vanguard has executives? And they have opinions on the economy? Wow. Better move my $ to iShares.


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[Senator]

"When you look at what drives inflation, wages are the largest component. Most people focus on commodity prices, but wages actually are far more important," McNabb said. "And we have not seen much inflation there."

We (i.e. the world) are in the [-]middle[/-] beginning of a global wage equalization cycle. Japan has been in it for 20+ years. We have another 25 - 50+ years to go.

When a company can make a widget, at most any developed country for the same price, only then wages will head up in any significant way. Until then, wages will continue to equalize.

 

[GrayHare]

"Deflation... causes a transfer of wealth from borrowers and holders of illiquid assets, to the benefit of savers and of holders of liquid assets and currency..." - Wikipedia

When the food supply is adequate to foster population growth, the supply of labor goes up, thus labor wages go down.

 

[daylatedollarshort]

Deflation news usually means TIPS yields will go up, even though historically have we ever had any 10 - 30 years of deflation? I hope TIPS yields will go to 3% real and I'll be taking that bet against long term, sustained deflation.

 

[rbmrtn]

There was a period 1870 -1890 where deflation was predominant

The Great Deflation - Wikipedia, the free encyclopedia


John Mauldin referred to this as period of "good deflation" in this article

The Last Argument of Central Banks - Forbes

Japan has been in deflation for 25 years and Europe seems to be following them.

 

[Looking4Ward]

So in a nutshell..... does a period of deflation have a negative or positive effect on a 60/40 investment portfolio?

 

[REWahoo]

So in a nutshell..... does a period of deflation have a negative or positive effect on a 60/40 investment portfolio?

You can find nutshells on aisle 4 here: What does deflation mean to investors?

 

[daylatedollarshort]

There was a period 1870 -1890 where deflation was predominant

The Great Deflation - Wikipedia, the free encyclopedia


John Mauldin referred to this as period of "good deflation" in this article

The Last Argument of Central Banks - Forbes

Japan has been in deflation for 25 years and Europe seems to be following them.

Thanks for the links. I think I would still up the TIPS ante if they go to 3%+. I'll be getting 3% real worst case and I'd get my full principal back at maturity regardless.

 

[MichaelB]

The US economy suffered deflation from 1920-1940 and the 1920 price level was not reached again until 1946. See here Historical Inflation Rates: 1914-2014 | US Inflation Calculator

In a deflationary environment TIPs are particularly dangerous, especially if they are not purchased new and held to maturity. Same with junk bonds.

In a heavily leveraged economy, such as some EU and OECD countries are facing, deflation increases the value of debt, meaning it becomes even more difficult to service. The ability of a nation to meet its obligations is called into question and sovereign default is a possibility. It is not a good scenario for anyone.

 

[friar1610]

Correct me if I'm wrong on TIPs. (I'm an I-Bond guy and don't own any TIPS so haven't looked into the particulars in a long time. I'm going here from a failing memory when I looked at TIPS years ago.)

I thought that TIPS could be hurt during deflation because although the coupon rate stays the same, the underlying amount to which that rate is applied is adjusted upward or downward to take into account inflation or deflation, respectively. So just as the the interest rate is applied to an increasing base when that amount is adjusted upward during periods of inflation, it would be applied to a decreasing base during periods of deflation.

As I understand it, that is one reason why, in this scenario, an I-Bond is preferable because the base does not vary, the guaranteed rate does not vary and the semi-annual inflation adjustment does not go below zero.

But, I might have this wrong.

 

[jim584672]

Best investment in a deflation - zero coupon 30 year Treasury bonds.

 

[Looking4Ward]

You can find nutshells on aisle 4 here: What does deflation mean to investors?

Thanks. Looks like the short answer is: Negative.

 

[daylatedollarshort]

Correct me if I'm wrong on TIPs. (I'm an I-Bond guy and don't own any TIPS so haven't looked into the particulars in a long time. I'm going here from a failing memory when I looked at TIPS years ago.)

I thought that TIPS could be hurt during deflation because although the coupon rate stays the same, the underlying amount to which that rate is applied is adjusted upward or downward to take into account inflation or deflation, respectively. So just as the the interest rate is applied to an increasing base when that amount is adjusted upward during periods of inflation, it would be applied to a decreasing base during periods of deflation.

As I understand it, that is one reason why, in this scenario, an I-Bond is preferable because the base does not vary, the guaranteed rate does not vary and the semi-annual inflation adjustment does not go below zero.

But, I might have this wrong.

I-bonds have limits as to how much you can buy in a given year. With TIPS the base would be adjusted downward during deflation. But you would still get the 3% real or whatever you buy them at plus the full principal back at maturity if you don't buy on the secondary market.

I was sorry the last time there were deflation fears and the yield shot up I did not buy more TIPS. If the yields shoot up again I am going to bet that we won't have prolonged deflation and even if we do, worst case I'd still be getting 3% real when I am planning on 1% real now.

If there is no deflation, then I'm getting 3% real + normal or high inflation adjustments on the principal. I think if I made a decision tree with all the probabilities and outcomes, TIPS would be a good bet, for me at least. I have low return expectations for our portfolio so I would be ecstatic with a 3% real return.

 

[Mulligan]

I'm not going to hold my breath waiting for deflation in my cable, electrical, healthcare, insurance, or food bills.


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[meierlde]

Actually if deflation occurs ordinary FDIC insured bank accounts work well as long as negative interest rates are not imposed (otherwise cash in the safe deposit box or travelers checks work well). Even with low interest rates as today a bank account or CD will gain in value if deflation occurs, assuming also no wealth tax.

 

[Chuckanut]

I have a secret plan to keep my investments doing well if we have a long term deflation, say a year or more.

I plan to re-balance my AA every year. Shhh.... don't tell anybody.

 

[audreyh1]

The U.S. imports deflation - meaning that as we are an importing country, costs of such goods and services will drop for the U.S. consumer. This means domestic producers can't raise their prices either.

High quality bonds appreciate in a deflationary environment, and CDs are more valuable in real terms. And cash is very, very good.

But deflationary economic periods have caused great hardship in the past, so the Fed stays accommodative to counter it.

 

[friar1610]

I-bonds have limits as to how much you can buy in a given year. With TIPS the base would be adjusted downward during deflation. But you would still get the 3% real or whatever you buy them at plus the full principal back at maturity if you don't buy on the secondary market.

I was sorry the last time there were deflation fears and the yield shot up I did not buy more TIPS. If the yields shoot up again I am going to bet that we won't have prolonged deflation and even if we do, worst case I'd still be getting 3% real when I am planning on 1% real now.

If there is no deflation, then I'm getting 3% real + normal or high inflation adjustments on the principal. I think if I made a decision tree with all the probabilities and outcomes, TIPS would be a good bet, for me at least. I have low return expectations for our portfolio so I would be ecstatic with a 3% real return.

Points taken. To split a hair here, all other things being equal (interest rate, time period, face value etc.) there would be a slight advantage to the I-Bond during deflation. The interest rate would be applied to the I-Bond on the face amount until maturity. With a TIPS, during the period of deflation, the interest rate would be applied to a decreased face amount, resulting in slightly less interest for that period. Therefore, it seems to me, the total amount of interest at the end would be a wee bit more for the I-Bond.

I realize this is a "how many angels can dance on the head of a pin" argument, but - hey- what's this forum for?

 

[jim584672]

Actually if deflation occurs ordinary FDIC insured bank accounts work well as long as negative interest rates are not imposed (otherwise cash in the safe deposit box or travelers checks work well). Even with low interest rates as today a bank account or CD will gain in value if deflation occurs, assuming also no wealth tax.

I would stay out of the banks, even with FDIC. If we go into a real Deflation the banks are toast. This time they will do a "bail in", everyone account holder takes a x% haircut. Cyprus was only a test run.

They will try negative interest rates, pay the bank to hold your money. Absurd really.

The safest place is cash in the mattress in a real Deflation.

 

[daylatedollarshort]

Points taken. To split a hair here, all other things being equal (interest rate, time period, face value etc.) there would be a slight advantage to the I-Bond during deflation. The interest rate would be applied to the I-Bond on the face amount until maturity. With a TIPS, during the period of deflation, the interest rate would be applied to a decreased face amount, resulting in slightly less interest for that period. Therefore, it seems to me, the total amount of interest at the end would be a wee bit more for the I-Bond.

I realize this is a "how many angels can dance on the head of a pin" argument, but - hey- what's this forum for?

I have I-bonds, too, it is just for my particular situation I have more available cash in retirement accounts where I can buy TIPS and no annual purchase limits.

Check out this article from 2008. There were deflation fears then, too, and check out the TIPS yields. I wish I'd bought more back then.

How Deflation Would Affect TIPS and I-Bonds - The Wallet - WSJ

Based on how accurate economic predictions and financial prognosticators tend to be, their advice is generally irrelevant. So if you like TIPS and I bonds, you might as well buy them when the forecast is for prolonged deflation and yields are high, because the predictions tend to be inaccurate anyway.

 

[GrayHare]

Banks are only as strong as their loans. During deflation banks/lenders/investors do well since their loans are repaid with more valuable dollars. If borrowers default, well, obviously that's not good, but that's true regardless of the economic situation.

Cash is not immune to shock either. If the Fed wants to reduce the cash supply (not wise during deflation) by 10% they can declare all notes with serial numbers ending in digit (pick one) to be worthless.

 

[clifp]

This is a pretty good WSJ article on the impact of deflation on iBonds and Tips Bonds.
iBonds seem like they are the best bet.

 

[Mulligan]

This is a pretty good WSJ article on the impact of deflation on iBonds and Tips Bonds.
iBonds seem like they are the best bet.

I am going the opposite way. After 5 years of maxing out my IBonds since retirement, I am cashing them all out and investing them in higher quality preferred stocks getting 6%, instead of the pitiful 0 fixed and 1% plus inflation adjustment.
My situation is different as I live on my pension easily and do not need a well balanced investment plan. Plus I can pay in the 15% tax bracket instead of the 25% paid on CDs or IBonds. Rates can go up or down the next 20-30 years and I am not going to worry about it too much as I will just buy more of them with the dividends, along with my continued mutual fund purchases.


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[friar1610]

I have I-bonds, too, it is just for my particular situation I have more available cash in retirement accounts where I can buy TIPS and no annual purchase limits.

Check out this article from 2008. There were deflation fears then, too, and check out the TIPS yields. I wish I'd bought more back then.

How Deflation Would Affect TIPS and I-Bonds - The Wallet - WSJ

Based on how accurate economic predictions and financial prognosticators tend to be, their advice is generally irrelevant. So if you like TIPS and I bonds, you might as well buy them when the forecast is for prolonged deflation and yields are high, because the predictions tend to be inaccurate anyway.

Similarly, I used to own a few TIPS but they matured and I haven't bought any more. I am fully retired; I bought my I-Bonds quite a while ago and most of them pay 3.4% fixed, so I am holding onto them. I have a few with lower fixed rates and I look at those more as emergency money than long-term investments.

I read the article you cited and something it said in there made me take a look at the Treasury Direct site. I have been wrong all along in my understanding about what would happen during periods of deflation. I thought that the fixed rate always stayed the same and wouldn't be diminished in deflationary periods. But if the variable rate were to go into negative territory, that negative number would indeed be subtracted from the fixed rate thereby reducing it. The combined rate can never go below zero but it can go below the fixed rate.

Generally speaking, I haven't been buying anything new of any flavor the past few years as I am fully retired. So I'm generally just moving money around to keep my AA where I want it. But this year I will start taking RMDs from my Rollover IRAs. Since I don't expect to need that money for living expenses, I'll have to do something with it, so maybe I-Bonds and TIPS will be on my radar again.