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Forget Inflation — DEFLATION Is the Real Risk

Inflation has been on the minds of bears for quite some time. And while the logic isn’t that bad — that big federal deficits in the U.S. coupled with loose monetary policy will weaken the dollar and spark inflation — the actual rate of inflation hasn’t been anything to worry about for quite some time.

In fact, the latest data on prices shows that prices actually decreased 0.4% in April after decreasing 0.2% in March, as measured by the Consumer Price Index.

But while you might think lower prices are good, the ugly truth is that this CPI data hints at a much darker issue: the specter of deflation and a downward spiral in prices and spending.

The inflation trade hasn’t been kind to investors lately. Commodities have collapsed and gutted major materials stocks, including Southern Copper (SCCO), Vale (VALE) and BHP Billiton (BHP) to name a few. Gold prices have taken it on the chin, too, and while there are many reasons behind the collapse in precious metals, lack of inflation risk is a big one.

Also, investors who were buying Treasury Inflation-Protected Securities, or TIPS, have been underperforming by a wide margin. These securities are tied to CPI data and move up in kind with inflation … but since consumer prices haven’t budged, neither has the rather meager rate of return on TIPS.

The yield on 10-year TIPS was negative for a while, hinting that investors were afraid of red-hot inflation, but has turned positive this week for the first time since 2012.

On the surface this all looks peachy, since inflation is under wraps — and after all, overtures of tightening at the Federal Reserve will ensure that any modest uptick in prices will be tamped down.

But deflation is in many ways much more painful than inflation and can pose a lasting threat to any economic recovery. As prices fall, consumers spend less because what they buy isn’t worth what it was a month or two ago … so what’s the rush? That results in slow growth and businesses slashing margins (and jobs) in aggressive pursuit of the few buyers that are out there.

Spending, wages, jobs and growth all stall. It isn’t good — and anyone who has studied Japan’s economy during the past few decades knows this.

Throw in the risk of commodity prices crashing further on a lack of demand from emerging markets — not just in China, but also smaller nations that are seeing significant growth struggles — and there’s the very real risk of deflation hamstringing the recovery at home and abroad.

This is not to say there’s no way out, or that falling prices are categorically bad. Consider the “crash” in technology prices — where you can now by a blazing-fast laptop for a few hundred bucks, when a much slower desktop cost twice that 10 or 20 years ago even without adjusting for inflation.

Innovation and efficiency can naturally reduce the cost of things, and that can unlock growth.

But it remains to be seen whether the price pressure we are seeing right now is driven by a lack of demand as growth cools in China and elsewhere, or a virtuous cycle of 21st century progress.

Either way, investors should take note.

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Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at editor@investorplace.com or follow him on Twitter via @JeffReevesIP. As of this writing, he did not own a position in any of the stocks named here.

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