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Although inflation is a major concern for long-term investors, the global economy is still shaky at best and central banks are starting to worry about deflation instead. While inflation can make your money worth less and help reduce the real value of debt, deflationary cycles can destroy any chance of sustainable economic growth, devalue real assets and increase the value of debt (exactly what the government does not want).

Since the credit crunch, central banks have collectively been printing huge sums of money and many investors have feared this extra liquidity will lead to rampant inflation. Despite nearly $10 trillion being printed to date inflation has remained subdued and it is actually falling with latest US CPI at 1.5%.

In 2008, many people lost houses, businesses and a lot of money in investments. This forced consumers and companies to take action, strengthening balance sheets and paying off debts. This process of deleveraging was a necessity to ensure if we were put in the same position again, we would have a level of protection. While many businesses are now seeing the positives of this action and using this extra cash to grow and repay shareholders, a majority of the population is continuing to deleverage. This psychological state is hard to change and once you have started repaying debts instead of spending (promoting growth), you may be inclined to save. Not only is this a slippery slope to deflation, it sounds familiar to a nation which has been overrun by deflation for over 10 years - Japan.

Another major problem with this "deleveraging" frame of mind is that incentives become less effective. Tax breaks can result in increased saving rather than increased spending which is the desired outcome. If the government were to provide tax breaks and put extra money in your pocket, would you think to go out and spend it or rather save this extra money? This a core issue we are facing and it is a difficult one to overcome. Once in a deflationary cycle consumers are incentivized to hold off spending today, knowing the real value of their money will be more in the future, as prices fall.

One main driver of inflation is economic growth and how this increases demand for products, raising prices. Global economic growth remains anemic, and although we have seen signs of recovery from the US, top end estimates of 3% GDP growth may not be enough. It also may create another issue. If the USD strengthens, as it has against many major currencies, it devalues exporting countries' currencies. This has the effect of making US imports cheaper, thus importing deflation. Last week we saw commodities such as gold (NYSEARCA:GLD), copper and oil all fall in value as the USD strengthened. These commodities are heavy drivers for global product prices as they make up a core cost in a majority of production and manufacturing of goods. A 10% rise or fall in the price of oil generally equates to a 1% equivalent movement in inflation.

Drivers of Deflation

As discussed the psychology of deleveraging is a problem. However there are more apparent tangible direct impacts on falling prices. Japan has seen its currency fall by over 30% in five months, and this has been positive news for the heavily exporting nation. However, the lower currency value effectively lowers the prices of goods around the world and exports deflation.

Commodities have had a torrid time in 2013, demand has fallen dramatically for hard metals as fears escalate over a Chinese hard landing. Crude oil has fallen about 15%, due to different reasons but it will have a significant effect on inflation going forward. Lower commodity prices are generally not seen on a consumer level for a number of months and these lower prices may cause deflationary pressure later this year.

How to Prevent Deflation?

Lowering interest rates to stimulate economic growth and demand is generally the main tool for preventing deflation. However central banks have implemented aggressive monetary easing globally, and with interest rates at rock bottom this tool for stimulating growth is no longer viable. Quantitative easing (QE) is yet to have the desired effect on stimulating economic growth, and it remains to be seen that it will. Japan has been one step ahead in the process, having undertaken QE a number of years ago with no success. Their more aggressive 3 arrows approach may work, however it is a desperate measure to save them from deflation.

Once deflation starts, it is very difficult to get out of it. Debts increase and like Japan, with debt to GDP at 230%, it is understandable why other central banks are getting concerned.

While inflation remains high in a number of emerging markets, such as Brazil, developed economies are facing a different problem, and although we are not there yet, it can catch you off guard quickly.

Inflation (NYSEARCA:CPI) for the current major economic players remains above 1% (except Japan) and it is important it stays that way. The chart below shows how consumer prices have been gradually falling over the past year, and more so in the longer term.

(click to enlarge)

This chart, rather than telling us that we are headed for deflation (although this could be the case) implies inflation is not rising to the extent many had forecasted. We recently wrote about the drivers of inflation, and QE being one major factor. But we are now 5 years down the line from the first QE tranche and still nothing has appeared. Will it ever?

How do you protect yourself from deflation?

Cash naturally appreciates during deflationary cycles as the value of your money increases as prices fall. We are yet to see deflation, so it would not be wise switching investments to cash, especially when interest rates are minimal. Therefore high yielding equities would provide the best of both worlds: cash flow (through dividends) and hopefully capital value appreciation. Companies that have pricing power will adequately deal with deflation as they will be able to maintain prices to a large degree and therefore maintain revenue and profits. Such sectors are those that we have talked about for their strength during inflationary periods. Tobacco, utilities and telecoms are all those having pricing power as these are treated as staples. Even if demand falls for consumer goods, it should remain relatively stable for these companies and therefore sustain revenue as costs fall. An example of a tobacco company which has dealt with rising prices and taxation very well is British American Tobacco (NYSEMKT:BTI), and as demand is relatively consistent through all economic climates it should be a defensive performer through deflationary cycles. With prices rising they have managed to consistently grow revenue and profits. Attributes such as its strong free cash flow and dividend yield, coupled with a resilient customer base, are those that would serve well if deflation would appear.

Summary

Although we are yet to see deflation, pressure is mounting and it remains a worry for many. Deleveraging and exporting deflation may continue to counteract the inflationary pressures. While I am not implying action should be taken now, forward thinking never hurts and high yielding equities should provide a level of protection. It is one area I will be watching closely and with US CPI data to be released on Thursday it may provide a further indication of which way prices are moving.

Source: Deflation: What Can You Do About It?