Deflation is a fairly rare economic phenomenon in which the price of goods and services decreases over time. It is often associated with a contracting or stagnating economy in which investment is curtailed and economic expansion becomes very difficult. Deflationary trends can have a variety of effects on stocks and bonds, which should be carefully noted by investors who wish to be able to make gains during all economic conditions.
Deflation can lead to an economic situation known as the liquidity trap. During times of deflation, goods and assets decrease in value, meaning that cash and other liquid assets become more valuable. Because of this, deflation exerts a disincentive towards investment and spending. In fact, during serious deflation, one of the best investments is a safe filled with cash or a bank account. So 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.
Deflation can also theoretically have a very negative effect on the ability of bonds to generate income for bondholders. First of all, bond prices can rise significantly during times of deflation, since borrowers, who are the bond issuers, can expect that paying back the principal loan down the line will amount to a loss. In other words, borrowers are wary of borrowing because, if deflation continues, the money they pay back is worth significantly more than what they borrowed. Interest rates also decline during deflation to incentivize borrowing, meaning that bond yields will fall. There is also a greater risk of defaults by borrowers during deflationary times.
In actuality, periods of deflation have not necessarily equated to devastation in the stock and bond markets. Mild deflation, below 2.5 percent, seems to have little effect on the performance of the stock market or the bond market. When deflation goes above 2.5 percent, the stock market begins to deteriorate, as measured by a falling price/earnings ratio. This means that in times of deflation, each share begins to lose value relative to the earnings of the company, a situation that can quickly escalate into a vicious cycle, as seen during the Great Depression. When deflation rises above 2 percent, bond yields tend to decline due to falling interest rates. However, bonds issued by highly secure entities tend to remain fairly consistent.
The occurrence of deflation is normally met with a variety of attempts to reverse course, and investment decisions made by investors on the assumption of continued deflation. The Federal Reserve will print money and decrease interest rates in an attempt to encourage borrowing and movement of money. High-quality bonds can actually be positively affected by mild deflation, as investors pull out of riskier investments and move their money to higher rated bonds. There also are companies that can take advantage of low interest rates, expand and do well in the stock market.
Linda Ray is an award-winning journalist with more than 20 years reporting experience. She's covered business for newspapers and magazines, including the "Greenville News," "Success Magazine" and "American City Business Journals." Ray holds a journalism degree and teaches writing, career development and an FDIC course called "Money Smart."