Deflation Scenario

DEFLATION SCENARIO 

The inter-market principles described herein are based on market trends since 1970. The 1970s saw runaway inflation which favored commodity assets. The decades of the 1980s and 1990s have been characterized by falling commodities (disinflation) and strong bull markets in bonds and stocks. During the second half of 1997, a severe downturn in Asian currency and stock markets was especially damaging to markets like copper, gold, and oil. For the first time in decades, some market observers expressed concern that a beneficial disinflation (prices rising at a slower level) might turn into a harmful deflation (falling prices). To add to the concerns, producer prices fell on an annual basis for the first time in more than a decade.

As a result, the bond and stock markets began to decouple. For the first time in four years, investors were switching out of stocks and putting more money into bonds and rate-sensitive stock groups like utilities. The reason for that asset allocation adjustment is that deflation changes the inter-market scenario. The inverse relationship between bond prices and commodities is maintained. Commodities fall while bond prices rise. The difference is that the stock market can react negatively in that environment. We point this out because it's been a long time since the financial markets had to deal with the problem of price deflation. If and when deflation does occur, inter-market relationships will still be present but in a different way. Disinflation is bad for commodities, but good for bonds and stocks. Deflation is good for bonds and bad for commodities, but may also be bad for stocks.

The deflationary trend that started in Asia in mid-1997 spread to Russia and Latin America by mid-1998 and began to hurt all global equity markets. A plunge in commodity prices had an especially damaging impact on commodity exporters like Australia, Canada, Mexico, and Russia. The deflationary impact of falling commodity and stock prices had a positive impact on Treasury bond prices, which hit record highs. Market events of 1998 were a dramatic example of the existence of global inter-market linkages and demonstrated how bonds and stocks can decouple in a deflationary world.