I notice something strange is occurring silently in the background without much fanfare.
The Fed may have already started tapering of bond purchases since Q1 2021. What do i mean ?
Below is the M2 graph as of 1st August 2021. The M2 graph denotes the level of money supply in the US economy.
The higher the M2, the higher the supply and in turn, inflationary forces kick in.
The lower the M2, the lower the supply and hence deflationary forces kick in.
What this means is that the Federal Reserve had been slowly reducing the bond purchase programme (Quantitative Easing) from Q1 2021.
During times of deflation, goods and assets decrease in value, meaning that cash and other liquid assets become more valuable. The very nature of deflation discourages investment in the stock market, and decreased demand for stocks can have a negative effect on the value of stocks.
When deflation is a threat, investors go defensive by favoring bonds. High-quality bonds tend to fare better than stocks during periods of deflation, which bodes well for the popularity of government-issued debt and AAA-rated corporate bonds.
On the equity side, companies that produce consumer goods that people must buy no matter what (think toilet paper, food, drugs) tend to hold up better than other companies. These are often referred to as defensive stocks. Dividend-paying stocks are another consideration in the equity space.
Wait But there’s also inflation?
The effects of COVID-19 are what truly caused inflation to rear its head. The closing of retail and global travel resulted in the cutting off of supply chains which in turn increases the price of goods and assets (e.g. the lack of lumber is causing housing prices to increase due to lack of supply )
In the current climate, it seems that both deflationary and inflationary forces are in play right now . The inflationary forces are due to the lingering effects of the many variants of COVID-19 (e.g. the Delta Variant)
Planning for Both Inflation and Deflation
Sometimes it’s hard to tell whether inflation or deflation is the bigger threat. When you can’t tell what to do, plan for both. A diversified portfolio that includes investments that thrive during inflationary periods and investments that flourish during deflationary periods can provide a measure of protection, regardless of what happens in the economy.
Diversification is the key when you don’t have the desire to attempt to properly time the inflation/deflation cycle. Blue-chip companies tend to have the strength to weather deflation and also pay dividends, which helps when inflation rises to the point where valuations stagnate.
Diversifying abroad is another strategy, as emerging markets are often exporters of in-demand commodities (a hedge against inflation) and not perfectly linked with the domestic economy (protection against deflation). However it is also unfortunate and coincidental that China chose to implement its regulatory cleansing during this period. This may result in the portfolio needing to seek other pastures other than China for overseas diversification.
To summarize, the market correction news and fears that you may have seen in MSM (Main Stream Media) recently may have already started when the deflationary forces kicked in !