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In the Current Deflation Spiral, Flat Is the New Up

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Commodity prices exerting deflationary pressures

As deflationary pressures continue to rise, most developed markets (EFA) (VEA) are feeling the pressure. Europe (VGK) has been trying to abate deflationary pressures for some time now, and while many nations in the region have put quantitative easing measures in place, the measures have done little to raise the general price level in the economy so far.

To make matters worse, the situation has become even more grave since mid-2014, when commodity prices took a hit. All major commodities including fuel, metals, agricultural raw materials, and food have been witnessing price down-slides since then.

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Countries are exporting deflation

Meanwhile, there’s a currency war going on, which is only adding fuel to the deflation situation, and currency warfare is often a way that deflation gets exported. When one country weakens its exchange rate, another country’s exchange rate gets stronger. This makes imports cheaper for the country with the strengthening currency, and the increased availability of cheap imports, of course, is detrimental to domestic producers.

Why? What happens is that domestic producers are then forced to reduce their prices in order to maintain their market share, and lower prices, in turn, weigh down inflation. This persistent reduction in the general price level, also known as deflation, creeps into the economy. As can be seen below, in a deflationary spiral, flat becomes the new up.

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As deflationary pressures rise, your returns feel it

We’ve heard billionaire investor George Soros shed light on the enormity of the situation. George Soros thinks we’re repeating 2008. According to Soros, global markets are currently facing a crisis reminiscent of the 2008 market collapse, and he has identified the key issue currently facing the global economy as none other than deflation.

Lower commodity prices, the currency war, and the slowdown in industrial production in major world economies are leading the world economy into a state where deflationary pressures are getting worse. China’s economic slowdown is impacting all of its major trading partners (United States [SPY], Hong Kong, and Japan [EWJ]) along with its domestic economy.

Many evils

Deflation gives birth to many evils. Along with a drop in the general price level, employment, and wages, deflation leads to the strengthening of the value of currency, such that people start holding onto cash as they expect prices to drop further. This is highly counterproductive for spending in across economies.

In his economic principles template, “How the Economic Machine Works in 30 Minutes,” Ray Dalio has mentioned that spending is the driving force behind any economy. But deflation also anchors investment returns. How specifically? Keep reading this series to find out.

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