Economy staring at deflation. Is it a good news?
While a fall in prices may sound like good news to most laymen, economists see this as an ominous sign of a collapse in demand in the economy.
The country is facing a negative inflation or deflation scenario with inflation touching near-zero level of 0.44% and expected to go down further in coming weeks. If negative inflation sustains for longer period of time, it will affect economic activities and in turn performance of most of the companies.
Let's understand what is deflation:
In economics, deflation is a sustained decrease in the general price level of goods and services. Deflation occurs when the inflation rate falls below zero percent, resulting in an increase in the real value of money — a negative inflation rate. This should not be confused with disinflation, a slow-down in the inflation rate (i.e. when the inflation decreases, but still remains positive). Inflation reduces the real value of money over time, conversely, deflation increases the real value of money.Most economists believe that deflation is a problem in a modern economy because of the danger of a deflationary spiral. Deflation is also linked with recessions and with the Great Depression.
In the current scenario, prices are falling not because of improved productivity but because of fall in demand. If deflation sustains for longer period of time, it will have a more adverse impact on demand. "Deflation results in less demand, lower production and weak economic growth," said Citibank in a report "India Macroscope''.A negative inflation discourages investments in the economy. The real interest rate difference between nominal interest rate and inflation becomes very high, making funds costlier. As demand goes down, capacity utilization of manufacturing units declines. This discourages investment in capacity expansion.
As performances of companies will be hit, the Citibank report said investors should be selective while buying stocks in deflationary environment. It said invest in those companies whose products or services are not much affected by fall in demand. So, companies operating in health care, telecommunication and utilities like electricity distribution could be good bet to invest. Services of these companies will remain in demand even if the economy slows down.
Investors also need to identify those companies where decline in prices lead to increase demand for their products, prompting them to produce more value-added products with greater economies of scale. In this category, companies operating in sectors like FMCG, snacks and beverages, health care, utilities and telecommunications can be included.
Checkout: Best FMCG Companies - Stocks to Invest in 2009
Companies with strong balance sheets, which do not have much debt on their books, can also be considered for investment. As debt servicing would become difficult in the deflationary time, one should stick to companies (mainly in IT, health care and energy sectors), which are less leveraged, the report added.
The report pointed out that total investment in the economy may decline by 2 percentage points of GDP by 2010 to 35.7% from 37.1% in the current financial year.
At the same time, companies operating in capital goods sector should be avoided. Capital goods are required when companies are investing in either new projects or expanding existing facilities. But, as companies are avoiding both, the performance of capital goods companies may further dip.
The real estate companies should also be avoided. In deflation, the general perception is that the prices will further fall. So, home buyers will further postpone their purchasing decisions, which will further increase the suffering of the cash-starved real estate sector. Read: Real Estate Sector Still In Downtrend
Checkout: Stock Market in 2009 - Stocks to Buy
Source & Reference: Times Of India
