💼 Deflation Station

briefcase | invest smarter | Issue #141

In a sign of what’s to come for the U.S., Canada’s central bank held its key benchmark rate this week. Central banks be all like…

Don’t the central bank interest rate decisions feel like watching your grandpa adjust the thermostat?

If that made you chuckle, please forward this to your closest pal, we’d really appreciate it!

Now on with this show…

🪙 The Discount You Never Asked For

Over the past 18 months, we’ve been collectively terrified by inflationary pressures. We’re told that it’s actually inflation that stopped the coronavirus from traveling…high gas prices and all.

We’ve also heard about disinflation, stagflation, deflation, tourflation, and all other types of flation.

At the moment, we are stuck with sticky inflation that keeps prices and interest rates high, causing problems for those overly exposed to debt.

It’s kind of like the poet Jay-Z once said: “I’ve got 99 problems, and inflation makes it 100.”

We’re pretty sure that’s the quote anyway. So, how did we get to turbo inflation? We’ll let Anakin Skywalker and Padmé Amidala explain…

Not so much. But the latest CPI data shows a marked deceleration of inflation, a welcome development for grocery shoppers everywhere. According to CNBC:

But now, we have another potential death star approaching: Deflation.

Sorry to scare you kiddo, but you know when you let go of a helium balloon, and it shoots up into the sky? Inflation is kind of like that—prices go up, and your money's worth goes down. But what happens if, instead, the balloon deflates, shrivels up, and sadly sags to the ground?

Welcome to the world of deflation!

Normally, inflation tends to real estate assets well because it increases asset values, erodes the value of historical debt, and puts upward pressure on rents.

But deflation is a whole different batch of problems for real estate watchers. So what could a deflationary environment look like and how should we prepare?

Let’s take a look at the ongoing economic concerns in China, which offers us a lens into what deflation looks like.

💥China's Prices Drop Faster Than Bad Karaoke

Deflation is the decline in prices due to reduced demand. This can lead to a cycle of businesses lowering prices to attract customers. Consumers may see this as a benefit, especially after a period of inflation or when wages are not increasing.

In a deflationary environment, borrowers may struggle to repay their loans, and assets like stocks, bonds, and real estate typically lose value along with consumer goods.

Not great, and the world’s second-largest economy—China—is facing the real threat of deflation. In China, the word "deflation" is so taboo it's like Voldemort in the wizarding world. Party officials are zipped up tight, but new reports give us a little flavor of what is going on.

China’s inflation figures fell into the negative territory in July, dropping to -0.3% over the last year. That's after months of staying as stagnant as your uncle's dance moves.

China’s exports are also down 14.5%, imports dropped 12.4%, and oil demand has peaked in the country. Couple that with real estate development decreasing 33% year-over-year, and it’s safe to say China is already facing a recession.

While consumer prices are slipping, unemployment is also climbing, especially for youngsters. A whopping 21% of 16- to 24-year-olds were jobless in June. And the trend line for this is going in the wrong direction.

How bad could it get? Let's take a look at a similar situation that happened in Japan, a rising economic power in Asia that caused quite a bit of worry in Washington and Europe. Back in the 1970s and 1980s, Japan was booming, but unfortunately, their bubble burst in the 1990s.

This led to a long period of economic stagnation and deflation, which had a significant impact on the country. It made the citizens poorer and burdened the national debt even more.

For Japan’s real estate sector, we saw a dramatic drop in asset values for over a decade. There’s a reason they call it the ‘Lost Decade.‘ Further, Japanese banks had heavily financed the real estate bubble, and when property values plummeted, they were left with a mountain of bad loans.

This led to the bankruptcy of several financial institutions and necessitated large-scale government bailouts. Sound familiar?

In China, a third of the country’s GDP is real estate, and the cracks are already being seen in the bankruptcy troubles of the first and second-largest developers in the country: Country Garden and Evergrande.

So, what lessons does a deflationary environment in China hold for us here in North America?

• 💥Significant economic disruptions in China, especially in sectors as large as real estate, can send shockwaves through global financial markets.

• 💥If China's real estate market faces a prolonged downturn, it might lead to reduced foreign investment in North American property markets or even a sell-off of assets by Chinese investors seeking liquidity.

• 💥A slowdown in its real estate and construction sectors can reduce demand for commodities like steel, iron ore, and copper. This can impact commodity prices globally and affect North American producers and exporters.

• 💥If the global economy faces headwinds due to issues in China, central banks in North America might respond by maintaining or even lowering interest rates to stimulate economic activity.

While the immediate impact of China's real estate woes might seem localized to that country, the global interconnectedness of today's economy means that significant shifts in one major economy can have far-reaching implications globally. Including in North America.

So What? While real estate can be a hedge against inflation, it becomes a liability during deflation if purchased with debt. While deflation in isolation isn't dangerous, it becomes problematic in highly leveraged, credit-based economies, like the US and Canada.