Investing for Deflation

							Can deflation be exploited as an investment?

At a conference recently where an investment service provider was selling inflation guaranteed
investment products, an elderly gentleman raised his hand and politely asked the question, “So, what
happens when there is deflation?”

Gerhard Hametner at m Cubed Alternative Investment Strategies looks at some of the issues and
alternative investment strategies.

This was quite disconcerting to the investment professional selling his wares – the possibility of deflation
had not crossed his, or anyone else’s minds, for that matter.

The reason is simple: The gentlemen asking the question was around before the last Great War (World
War II), when rampant deflation was a major problem. Whereas the people designing the inflation
products have only really been around during the hyper-inflationary environment of the Eighties and
Nineties.

This led me to think about a deflationary scenario in South Africa, and the rest of the world. A scenario
is generally used by companies, governments and investment managers to test for, and later prepare
for, events that might occur at the outer edges of probability, and the more remote reaches of
imagination.

The kind of planning that the designers of the Titanic should have engaged in, before that vessel’s
maiden voyage.

    –    “What happens if the ship hits a iceberg?” –
    –    “You’re crazy – that will never happen.”
    –    “Yes, but what if it does?”
    –    “We’ll probably need more life-boats”
    –    “Ok”

How real a possibility is deflation?
It has been more than a century since we have experienced a sustained period of worldwide deflation. It
seems now that the world economy might again be sucked into a deflationary spiral.

In Asia, a sustained deflationary trend has become apparent in Japan, and more recently in South
Korea, Taiwan, Singapore, Hong Kong and China's urban sector.

Several economic analysts claim there is a serious risk the United States may slip into deflation - a
situation where most prices keep falling. Stephen Roach, chief economist at Morgan Stanley, writes:
"America is already on the brink of deflation."

Deflation anxiety is nothing new, however. In one of its editions in 1997, the Business Week cover was
"The threat of deflation."

So deflation exists in the developed and developing world, and it may be only a matter of time before
South Africa feels the effects, and perhaps is infected by the scourge as a fledgling member of the
global economy.

Where does deflation come from?
Deflation is normally felt after a sustained period of global growth, high rates of investment, rapid
productivity increase and globalisation. The result is global excess capacity, which results in downward
pressure on prices.
China – a gargantuan producer of goods and services, has recently entered the World T rade
Organisation’s global pool bringing even more capacity onto the world markets.

Another cause of deflation is a depressed demand for goods – which happens during and after a
recession, and during periods of rising unemployment and financial stress. T he related drop in spending
may be so severe that producers must cut prices on an ongoing basis in order to find buyers.

A combination of excess supply and low consumer spending, coupled with many central banks’ inability
to stimulate economies through further cutting interest rates, may result in protracted, global price
deflation.

So, the seeds of deflation exist, and in some parts of the world have already taken root, but how can a
period of decreasing prices be bad?

Effects of deflation

Winners – Consumers – they are able to buy goods for less. The big winners here are the pensioners
who have saved enough for their retirement, and now have a consistently increasing purchasing power,
even if they hide their money under the mattress.

Losers – almost everybody else.

Companies – start reducing prices on goods to entice consumers to buy. High production costs and low
sales prices lead to low margins and losses for companies. Earnings prospects plunge, dividends
dissipate and share prices tumble. This kind of deflationary environment exacerbates any weakness in
firms, with the vulnerable ones defaulting on debt and declaring bankruptcy.

Workers – this category probably includes most people we know – anyone who is working in order to
provide for themselves and their families. In a deflationary environment, the cost of production must be
reduced for companies to survive.

A major part of that cost is salaries. Who could take a salary cut at the next employee review? If one
must be completely dispassionate about it, in an inflationary environment, the cost of living increases
and we demand higher salaries to compensate us for our decreased purchasing power – it seems only
fair that when our purchasing power increases, that we should accept a related decrease in salary –
doesn’t it?

Companies downsizing, or worse - going bankrupt – will promote unemployment.

Government – one of the main charters of central banks is that of price stability. A deflationary
environment will be unacceptable to the central bank. The cost of allowing the economy to stray too far
from price stability will be tremendous.

Any ruling government will feel the political pressure from the likes of trade unions to ensure that
deflation does not erode earning potential of their members. A huge amount of resources will need to be
expended to rectify the situation.

How do hedge funds fit into all of this?

In a deflationary environment, traditional investments should suffer. Businesses will make lower
margins, or losses, reducing company earnings and negatively affecting share prices. Weaker
companies will become insolvent, reducing share prices significantly. Traditional equity investments will
be rapidly decimated.
In order to combat deflation and stimulate the economy, the central bank will be forced to cut interest
rates, reducing the yield on fixed income investments.

This economic scenario is bad news for traditional investments, but many alternative investment
managers, or hedge fund managers, have developed techniques to exploit this kind of market disorder
for the benefit of their investors.

Short selling
In contrast to traditional investments where fund managers only profit when the price of shares
increases, hedge funds have the ability to profit from negative equity performance. These funds are not
constrained by the long-only buying mandate, and are allowed the freedom to “short” shares that are
expected to have poor earnings and a related decrease in share price.

“Shorting” is when investors are able to sell an asset expensively in anticipation of the price of that asset
decreasing and profiting from the decrease in price.

Distressed securities
In an environment where investors are afraid of corporate failures and debt default, many shares and
bonds will be oversold as investors flee to the safety of larger companies or better quality bonds.

Hedge fund managers will purchase the distressed security at a price cheaper than the underlying Net
Asset Value of the shares or collateral for the debt and unlock value for their investors by either selling
the underlying assets for a profit or engineering a turnaround for the firm, and disinvesting when the
security is no longer in distress.

Merger arbitrage
Consolidation through mergers is symptomatic of international distress, and many firms join forces with
others in their industry. Hedge fund strategies have been specifically created to extract value from
merger activity.

Yield Curve – fixed income
Similar to the equity universe, hedge fund styles are available to profit from any positive or negative
activity in the fixed income market.

I must admit that the threat of deflation may be rather distant for South Africans. We are, however,
global investors and should be cognisant of threats to our international portfolios - anyone had any
investments in Japan in the last 10 years? - and the potential threat of deflation in South Africa in the
future.

Hedge funds are typically less constrained than traditional investments, and are able to more easily
exploit even adverse economic environments for the benefit of their investors. This is why they were
developed in the first place, and why they have gained so much popularity recently.

A word of advice though: hedge funds are successful alternative investments, and should not be seen
as the answer to all investments. Hedge funds assume a different kind of risk, and investors are
rewarded for assuming that risk. These rewards appear at different times and in different quantums that
the rewards of traditional markets.

If only we were able to invest in Hedge Funds in South Africa… sigh

Ends/

Note to the editor:

Contact Gerhard Hametner on 011-340-2300
Issued for m Cubed Marketing Communications by Channel Communications.
Contact Marie Hitzeroth for further information
mhitzeroth@mcubed.co.za
011-340-2300

About m Cubed Holdings
m Cubed Holdings Limited (m Cubed) is an independent, niche financial solutions provider. It is listed on
the JSE Securities Exchange in the Financials sector.

It specialises in multi-manager asset management, and wealth management. m Cubed has assets
under management of over R43bn. It administers more than 200,000 client records with in excess of
R53bn in third party assets.

The group has offices in Johannesburg, Pretoria, Cape Town, Durban, Port Elizabeth, Bloemfontein and
the UK. The group’s key shareholders include PSG Group, Royal London Scottish Life, management
and staff.

m Cubed’s core business components include:
• Asset management
• Wealth management
• Specialised investments, lending and treasury.