I t’s not only share prices that are falling. This week’s inflation data confirmed that UK consumer prices fell last month at their fastest rate since the adoption of the CPI measure 11 years ago. Economists were quick to predict that October’s drop in headline inflation could be just the first portent of a downward spiral that would give Britain its first dose of deflation for almost half a century.

For investors, who had spent the first part of this year fretting about the impact of rising commodity prices on corporate profits – whether fuel for airlines, energy and raw materials for manufacturers, or foodstuffs for restaurants and caterers – the initial reaction might be relief.

The problem is that it is hard to pinpoint a corner of the stock market that clearly will benefit from a sustained fall in the general level of prices. Retailers, perhaps? Given that wage settlements lag CPI, employees will enjoy a boost to their buying power from a rise in disposable income – even more so for borrowers whose interest costs have been cut by this month’s 1.5 percentage point reduction in UK base rates. But deflation also instils in consumers the discipline of deferring discretionary purchases in the expectation of obtaining the same goods for less later on.

Even supermarkets, the sector’s relative safe haven, should suffer. Just as food price inflation has been a core component of their recent like-for-like sales growth, falling food prices will work in reverse. Other retailers are more accustomed to coping with deflation, whether in clothing or big-ticket electrical goods, but there are already signs of heavy discounting – witness this week’s one-day “20 per cent off” sale at Marks & Spencer – and the likes of Investec Securities expect such promotions to pick up ahead of the Christmas peak season as clothing chains try to shift unsold stock.

The other concern is currency. At a peak $2.10 to the pound, retailers were able to retain an element of dollar-related buying gains in sourcing goods from the Far East to offset cost inflation elsewhere. However, with sterling now at $1.48, they face a severe squeeze on margins through their supply chain.

Nor is the hit confined to the high street. Companies that hold high levels of stocks must contend with falls in the value of their inventory – a problem for oil producers, housebuilders and food producers alike. This month’s profit warning from Dairy Crest was partly pegged on a 25 per cent fall in the price of skimmed milk powder, which it sells to rivals as a food ingredient. The company also holds extensive stocks of cheese for maturation.

Neither are utilities, perhaps the ultimate defensive investment, wholly immune. Lower inflation assumptions feed through into a reduction in the value of their regulated assets, whose revenues are index-linked. That was one of the considerations that this week prompted Merrill Lynch to cut its share price targets for water companies before next year’s half-year results season.

Heavily indebted companies have already been penalised by the stock market for high financial leverage, but deflation should only increase their woes. Just as inflation usefully erodes the real value of fixed-rate corporate borrowings, so deflation makes that burden relatively worse. This phenomenon will be keenly felt among pub companies, where high levels of net debt are commonplace. Similarly, the ability to offset falling volumes with higher food and beer prices is no longer there. Of course, the composition of a company’s borrowings is key: those with a high proportion of floating-rate facilities will benefit the retreat in Libor.

And the stock market’s potential winners? In the short-term, bus and train operators. As yesterday’s rail fare increases demonstrate, regulatory formulas enable them to set next year’s fares based on historic levels of inflation – specifically, the July reading of CPI. This is set at RPI plus 1 per cent across the industry, with the exception of Go-Ahead Group, whose Southeastern franchise is able to raise fares at RPI plus 3 per cent (reflecting an element of catchup from previous regulatory agreements). In the long run, however, falling prices are just as pernicious to transport operators as every other company.

Other relative beneficiaries are sectors that historically have enjoyed strong pricing power: cigarette makers, for example.

Perhaps the only clear winners from deflation are companies with large pension liabilities. As most pensions are linked to RPI, a fall in inflation will affect the annual increase in pensions paid – and also the calculation of future liabilities. As Citigroup points out, when inflation starts to fall, the values of pension scheme liabilities should reduce – which in the short term should bring an improvement in reported pension positions.

There is another effect. The credit crunch means that the fall in inflation has not been accompanied by a fall in corporate bond yields, where default risk remains the key concern. That, in turn, has affected the discount rate, which is used by actuaries to calculate a pension scheme’s liabilities. The table on the left shows those companies that have the biggest pension obligations and deficits relative to their stock market value, led in the FTSE 100 by Invensys, the industrial controls maker. Helpful, certainly, but a narrowing pension scheme deficit has never been enough reason on its own to invest. That suggests it will take further falls in share – if not consumer – prices to tempt buyers back in.

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