Useful and timely piece from the FT. Not really an analysis of deflation, but full of timely advice. Of particular note is the suggestion that "he best way to ride out a deflationary meltdown involves liquidating an investment portfolio and burying the cash in the garden".
Forget inflation. A greater risk to the US economy and investors' portfolios, Federal Reserve policymakers declare, is "the probability of an unwelcome substantial fall in inflation". The Fed did not even mention deflation, but investors translated the "Fed speak" with ease. Now some, at least, are pondering how best to position their portfolios for an economy where prices and asset values spiral lower.
That is not an easy task. It is unfamiliar terrain: Americans have not experienced deflation since the Depression of the 1930s, and only a few years ago inflation was the big threat. But 12 interest rate cuts since 2001 have failed to jumpstart the US economy. Factoring out the impact of the war in Iraq on energy costs, consumer prices in March rose only 1.7 per cent from year-earlier levels, putting inflation at a 37-year low. Until recently, John Forelli, a portfolio manager at Independence Investment, calculated there was, at most, a 5 per cent chance the US economy would spiral into deflation. The Fed's decision to put deflation front and centre in its statement on interest rate policy last week has prompted Mr Forelli to raise that to 10 to 15 per cent.
When true deflation takes hold, the value of assets, ranging from stocks and commodities to a new car, deflates along with the economy. The only havens are cash and Treasury bonds, whose value is backed by the US government. "Cash becomes king," says Cliff Gladson, senior vice-president of fixed income investments at USAA, a mutual funds company. Mr Gladson grew up listening to his grandfather's story of buying a house built for $35,000 for only $8,000 in cash in the depths of the 1930s Depression. The best way to ride out a deflationary meltdown involves liquidating an investment portfolio and burying the cash in the garden. But that melodramatic solution is far too drastic even if it were clear that inflation is inevitable. Paul O'Brien, fixed income economist at Morgan Stanley, notes that in Japan it took two years for the economic growth rate to fall to zero from 1.5 per cent - and another four years before deflation took hold. "Deflation is not something that will happen tomorrow," he says.
Investors who believe there is a high probability of deflation should build a portfolio full of Treasury bonds and income-yielding securities - high-grade bonds or stocks - issued by companies that can maintain pricing power in a sluggish economy. "Until you get to where interest rates are zero, Treasuries would reward you richly in that initial deflationary period," says Stephen Peterson, vice-president at Sand Hill Road Advisors. The US economy retains pockets of pricing power and strong demand that stock market investors can tap into. A starting point might be the insurance industry. As most consumers who have received bills for car or health insurance premiums know, these sectors appear to have plenty of pricing power. Regional banks with strong loan portfolios are attractive, since the dollars earned through those loans become more valuable in a deflationary environment.
The allure of cash in deflationary times makes dividends more attractive, especially when they are paid by companies whose products remain in demand. "You'd look at a company like ConAgra, a food-processing company, which yields about 4.5 per cent," says Neil Hokanson, a financial adviser. Pharmaceuticals company Bristol-Myers, and even Altria (formerly Phillip Morris), might be other candidates, he suggests. Investors with a higher risk tolerance could look at companies such as Starbucks, which Mr Hokanson says might defy deflation because consumers will still be willing to pay a few dollars for a latte. As college tuition fees surge, companies specialising in adult education such as Apollo Group might also be a good bet, he notes.
The biggest problem with these strategies is that most of these assets, including Treasury bonds, are already priced at a premium as investors have flocked to havens over the past two years. "It's like buying flood insurance after it's started raining," Mr O'Brien says. "The market is already very pessimistic about growth prospects, so for investors to profit things have to turn out even worse." Treasury prices, for instance, reflect investors' conviction that economic growth will average 1.5 per cent a year over the next five years. Then there is the risk of being in the wrong place if or when the economy comes roaring back to life. Treasury investors could face big losses, and those without exposure to commodities or companies that benefit from a growing economy could forfeit big gains. There are ways for investors to hedge their deflationary bets. They could buy inflation-protected bonds, or TIPs. "If inflation falls, (an ordinary Treasury) will do better than a TIP, but a TIP will still benefit," Mr O'Brien says. "If inflation rises, you'll get the yield plus the increase in the price level."
Putting more money into overseas markets, particularly emerging ones, is another strategy. These economies are at a different stage in their development and in their growth cycle, notes Mr Peterson, who urges his clients to keep as much as a third of their stock allocation overseas. Those fearing deflation can also take smaller steps to protect themselves. Cutting debt is a good idea, Mr Peterson says, since future payments on that debt would be made with increasingly valuable dollars. "But the best approach these days is to hope for the best and plan for the worst," Mr Peterson says. "That way you won't be caught off-guard by either deflation or inflation."
Source: Financial Times
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