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The impact of deflation on the stock market

by , 28 April 2015

South Africa has battled with high inflation for a number of years. Only recently has inflation fallen back within the Reserve Bank's target range thanks to the lower oil price.

But what happens when deflation hits? What effect does this have on the stock market?

Read on to find out…

Deflation isn’t something to be scared of

The word deflation can make investors start worrying about what’s to come.

The UK is currently on the verge of deflation, while the Eurozone is in deflation territory.

So what does deflation mean for the stock markets? Is it bad news?

The fact is, deflation isn’t always bad news for the stock market. It all comes down to how quickly prices are falling and why, Cris Sholto Heaton in Money Week explains.

Extreme deflation is bad news

Times of extreme deflation can affect the returns from stocks in two ways:

  1. It can impact the profits of a company.
  2. It can change how much investors are prepared to pay for these profits.

Both of these scenarios can impact companies’ margins.

In times of severe deflation, there are usually economic problems such as a high number out of work, consumers spending less and cuts in investment. This weak demand means companies are under pressure to reduce their prices.

But these companies still have to cover their fixed costs, which aren’t falling. These include long-term rental agreements and servicing debt.

This leads companies to cut their margins to survive, which impacts profits. And this increases the number of firms that go out of business.

In times like this, it’s more common for investors to keep out of stocks and stay in bonds and cash.

What type of deflation is good for the stock market?

The best scenario is steady changes in prices. For example, the S&P 500 showed some of its best returns during periods of mild deflation.

This is down to companies being able to maintain their profit margins. When this happens along with economic stability, investors are confident to stay in the market and will pay higher prices for shares. This helps valuations to rise.

So there you have it, the impact of deflation on the stock market.

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The impact of deflation on the stock market
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