Most people see inflation as a big risk.
There’s an assumption that the growth in consumer prices has devastating effects on people’s purchasing power and that’s true, to some extent.
Nevertheless, a certain degree of inflation is healthy for most economies (low single digits) as it increases corporate revenues and promotes employment.
But what happens when the opposite occurs and instead of going up, prices start to go down.
Deflation is an undesired scenario for most countries, as creates unemployment and slows down economic growth.
Some analysts appear to be thinking that deflation is a risk that investors should be prepared to hedge against during 2020 and here are some of the facts that back these predictions.
The Aftermath of Quantitative Easing (QE)
There’s a delicate balance between monetary supply and inflation (or deflation). Most people assume that an expansionary policy can only fuel inflation but the fact is that it can also have a deflationary effect over the long term.
When too much money is poured into the economy, corporate profits soar and companies tend to feel optimistic about the future. As a result, investment programs are green-lighted and the volume of goods supplied to the economy increases.
This situation can lead to excess supply, as more goods are being produced but the demand is not necessarily keeping up the pace.
Additionally, corporations are hoardings trillions of dollars in cash (approximately $1.9 trillion), which means that this QE money is no longer going into the productive cycle. Instead, it is just sitting in bank accounts earning an insignificant interest income.
This is the long-term aftermath of QE and it is one of the reasons why some economists are warning that unproductive cash reserves held by corporations, excess supply, and unprofitable investments might lead to deflation.
The Downside of Technology
Furthermore, the rise of artificial intelligence (AI) and automated industrial processes has considerably increased the efficiency of businesses and manufacturers, who can now produce the same goods, but faster.
The incorporation of technology further increases the risk of deflation, as companies are rushing their production processes to deliver goods to an already flooded market that is not ready to buy them.
As a result, markdowns, discounts, and liquidations may be needed to encourage consumers to spend money, which creates a deflationary scenario.
Central banks are already noticing the long-term effect that QE may have on their economies. Deflationary pressures seem to be appearing and investors should be careful if negative inflation reports start showing up. Even though it may not be a scenario that has a high probability of occurrence, there are enough facts to at least consider the possibility.
Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.