AUGUST 7, 2010
How to Beat Deflation
Strategies to protect your portfolio from—and take advantage of—the dreaded 'D' word
By JANE J. KIM And ELEANOR LAISE
The markets are signaling that a bout of deflation may be coming. Many economists still dismiss the threat. But if they are wrong, and deflation does set in, what would it mean for stocks, bonds, gold and other investments?
The last time deflation fears gripped the markets was in 2003, when the economy was recovering slowly from the dot-com recession. The worries of a sustained fall in prices across the economy turned out to be overblown as growth snapped back, prices for oil and other commodities jumped, and inflation rose enough for the Federal Reserve to begin tapping on the monetary brakes in 2004.
But the signs seem more ominous this time around. The core inflation rate rose just 0.9% in June from a year earlier—among the lowest levels seen since 1966.
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Deflating balloon.
Gold $7.4 billion
Net inflows into the SPDR Gold Shares ETF in the first six months of this year, according to Morningstar.
Stocks -28.3%
Decline in the S&P 500 stock index from its all- time high on Oct. 9, 2007, through Aug. 6, 2010.
Homes -29.1%
Decline in U.S. single family home prices, from mid-2006 peak through May 2010, according to S&P/Case-Shiller Home Price Indices' 20-City Composite.
Bonds +15.5%
Year-to-date returns through July for long-term government bond funds, according to Morningstar.
And on Tuesday, the Commerce Department reported that the core price index for personal-consumption expenditures—a key inflation gauge watched closely by the Fed—was up only 1.4% in June from a year earlier, below the 1.5% to 2% rate the Fed likes to see.
In the bond market, meanwhile, investors have been flocking to all manner of fixed-income investments recently, from Treasurys to "junk" bonds. The attraction: steady interest payments, which would become increasingly valuable if deflation were to take hold.
How striking has the rally been? Investors have bid up high-grade corporate bonds so much that their yields, which move in the opposite direction to price, now are close to the yields on ultrasafe U.S. Treasury bonds. The yield of the Barclays' U.S. Corporate Investment-Grade Index is barely a percentage point above the current 10-year Treasury yield of 2.83%. The spread was about 1.6 points last October.
Some prominent economists are beginning to sound alarms as well. St. Louis Fed President James Bullard, for example, said recently that the risk of deflation has risen, and warned of a period of falling prices and slow growth in the U.S similar to that of Japan in recent years.
Deflation doesn't mean prices for goods and services will plunge—that rarely happens. But the longer prices edge lower, the bigger the changes in behavior for consumers and businesses. As corporate profits drop, managers tend to lay off more workers and cut spending, while consumers, expecting lower prices in the future, pull back on buying, weighing on profits even more.
You will know you are in period of true deflation when there is a sustained decline in prices over a couple of years, not just a negative core CPI reading for a few months, economists say.
The problem is that deflation is much more difficult to stop than its cousin, inflation. Central bankers can raise interest rates sharply to stop rising prices, but they can cut interest rates only as far as zero; after that they have to get creative to put more money into circulation. It can be like pushing on a string.
Plenty of economists doubt a long period of deflation will unfold in the U.S. Unlike Japan, which saw steady declines in wages and productivity during the 1990s, the U.S. has had relatively stable growth in both recently, says Tom Porcelli, U.S. market economist at RBC Capital Markets. "Structurally, we are a different animal from what Japan went through," he says.
Fed Chairman Ben Bernanke has said the central bank would do whatever it can to prevent significant deflation in the U.S. In a now-famous 2002 speech, while he was a Fed governor, he said, "The U.S. government has a technology, called a printing press that allows it to produce as many U.S. dollars as it wishes at essentially no cost," and thus fight deflation.
Of course, if the Fed were to turn on its money machine full blast, that could spark inflationary pressures over the longer term, bringing a whole new set of investing challenges.
Some money managers are playing both scenarios, investing with an eye on deflation in the short-term and inflation later on. "We're not sure which side the bubble is on," says David Scott, chief investment officer at Sunrise Advisors Inc. of Leawood, Kan., who is buying inflation hedges—such as a silver exchange-traded fund and commodity funds—and deflation hedges like cash and short-term bonds.
If deflation does kick in over the next several months, here is how it might affect your portfolio, from stocks and bonds to cash and real estate:
Stocks
Deflation is generally bad news for stocks, since a period of falling prices and weak demand tends to weigh down corporate earnings and, therefore, share prices.
But that doesn't mean investors concerned about deflation should avoid stocks entirely. Companies with plenty of cash, low debt, steady dividends and products that people will buy even in tough economic times should fare relatively well, analysts say.
And if inflation does come roaring back in the longer term, these companies might still do well because they tend to have significant pricing power. That means they can raise prices to compensate for their own rising costs.
That Sinking Feeling
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Many stocks in the consumer-staples sector will likely hold up well in a deflationary period, money managers and analysts say. Investors should seek out companies that dominate their industries, such as spice maker McCormick & Co., says Josh Peters, editor of Morningstar DividendInvestor.
One sector that warrants caution: financials. As borrowers struggle to pay off debts, lenders could face more defaults. And as loans are paid down, there may be little demand for new borrowing. Both would hurt profits.
Bonds
In a deflationary environment, longer-term government bonds tend to do well. As investors rush to the safety of Treasuries, yields drop and prices jump, resulting in higher total returns. Hence the recent rally.
Bond-fund manager Jeffrey Gundlach—who thinks yields on the 10-year Treasury note could fall to 2%—has about 40% of the DoubleLine Total Return Bond Fund's assets in longer-term government debt, such as Ginnie Mae securities. If yields on 10-year Treasurys fall to 2% within a year, investors could reap total returns of 10% to 12% as the price of the securities jump, he says.
Zero-coupon Treasury bonds, known as strips, can provide the best protection, since the fixed rates are locked in and automatically reinvested at the fixed rate, says Troy Von Haefen, a financial adviser in Nashville, Tenn., who primarily uses Treasury strips as a deflation hedge and holds them to maturity.
Conversely, inflation-linked securities such as TIPS (Treasury inflation-protected securities) and I Bonds (inflation-linked savings bonds) could lose value in a period of sustained deflation. When the consumer price index turned negative in 2009, for example, rates on I Bonds temporarily dropped to 0%. Investors could see the value of their TIPS decline, since any negative change in the CPI would be applied to TIPS' principal, reducing the interest earned. (If investors buy TIPS at auction and hold the bonds until maturity, the Treasury pays the inflation-adjusted principal or the original principal, whichever is greater.)
Last month, Janet Briaud, a financial adviser in Bryan, Texas, sold her clients' holdings in TIPS, parked the proceeds in cash and has been putting as much as 20% of clients' money in long-term government bonds. "If markets come down over the next 18 months, we expect that investors will go to the safe haven of Treasury bonds," she says.
Cash
Cash is king in a deflationary world. While investors may not earn much interest, cash gains in value as prices fall. "If you're concerned about deflation in the short-term, cash gives you the best flexibility," says Greg McBride, senior financial analyst at Bankrate.com.
Amid a flight to safety, yields on money-market mutual funds have fallen to near-record lows, even as banks are more inclined to cut yields on deposit products. Just last week, Bank of America Corp. cut some rates on CDs. Average yields on one- and five-year CDs have fallen from 3.77% and 4.03%, respectively, in August 2007, to 0.66% and 1.93%, according to Bankrate.com.
But consumers can find higher yields at smaller community banks or credit unions and other financial institutions. The banking units of SLM Corp.'s Sallie Mae and Discover Financial Services are offering one-year CDs of 1.5% or more, while NewDominionDirect.com is paying 2% on two-year CDs.
Hard Assets
Deflation generally means falling prices for commodities, real estate and other hard assets. But as with stocks, investors shouldn't write off the category altogether.
Gold, which many investors consider an inflation hedge, also can be a useful deflation-fighting tool, analysts say. The government tends to respond to deflationary concerns by printing money, which in turn can spark fears of inflation and drive up the price of the metal. Gold is a hedge against financial stress, and "the source of stress doesn't matter, whether deflationary or inflationary," says Joe Foster, manager of the Van Eck International Investors Gold Fund.
In a deflationary period, investors should be especially wary of commercial and residential real estate and the real estate investment trusts that invest in such properties, analysts say. Much of the value of real estate is predicated on an ability to raise rents, says Morningstar's Mr. Peters. A lack of inflation, little rent-raising power and low occupancy rates, he says, "could come back to hammer this group a second time."
Debt
Deflation generally isn't kind to debtors. "If you have $1,000 in debt, and if prices are falling, it will cost you more in terms of forgone goods and services," says Kris Mitchener, an economics professor at the Leavey School of Business at Santa Clara University.
To the extent that you have to take on any debt, opt for as short a term as possible, says David Hultstrom, a financial adviser in Woodstock, Ga., who would counsel clients to pay off their mortgages and invest in long-term bonds if they expect a deflationary environment. "You don't want to get locked in."
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