Afraid of Deflation?

Try Some Medicine
By PAUL J. LIM
Published: August 7, 2010

AS chatter has grown about the possibility of a double-dip recession, so, too, have fears about another “D” word: deflation.

Late last month, Jeremy Grantham, the chief investment strategist at GMO, an investment firm based in Boston, issued a warning about deflation after worrying for months that inflationary pressures were brewing. Mr. Grantham told GMO clients recently that as the recovery has slowed, “downward pressure on prices from weak wages and weak demand seems to me now to be much the larger factor.”

In doing so, he joined a growing list of prominent analysts — including William H. Gross, the co-chief investment officer of Pimco — who’ve raised concerns that consumption may be postponed and growth thwarted if price declines occur throughout the economy.

Long periods of deflation are quite rare. In fact, before Japan’s on-again, off-again experience with deflation starting in the 1990s, you have to go all the way back to the Great Depression to find another sustained bout of this trend in the developed world.

As a result, if deflation were actually to strike in the United States — and that is a big “if” — investors might not be able to draw from their own experience to determine how best to position their portfolios.

So what are investors to do?

One textbook strategy is to buy long-term Treasury bonds, which many people already appear to be doing as a hedge against general economic troubles. Yields on 10-year Treasury securities have plunged to 2.8 percent from about 3.8 percent in late April.

In the 1930s, this strategy proved successful in combating deflation, as long-term government bonds generated nominal total returns of nearly 5 percent a year, versus annualized losses of 0.1 percent for equities during that decade, according to Ibbotson Associates.

Strategists who’ve expressed concerns about deflation aren’t necessarily predicting a return to protracted, Depression-era downward price spirals. “We’re certainly not positioning for a Japan-like scenario,” said Ben Inker, a colleague of Mr. Grantham’s who is GMO’s head of asset allocation.

Robert D. Arnott, chairman of the asset management firm Research Affiliates in Newport Beach, Calif., said that while a brief bout of modest deflation was a threat in the short run, inflation — or rising prices that eat away at consumers’ purchasing power — remained the bigger long-term menace.

He said that growing fears over deflation made it more likely that policy makers would overreact in their attempts to stimulate growth in the economy. And that, in turn, means that “inflation is still what you have to worry about down the road,” he said.

As a result, Mr. Arnott isn’t focusing entirely on near-term deflation. Rather than buying long-term Treasuries, he suggests an investment in Treasury inflation-protected securities, or TIPS.

Mr. Arnott argues that if inflation begins to become a threat two or three years down the road, having the inflationary hedge of a TIPS bond will protect an investor against rising prices — which is something that a regular Treasury bond won’t do.

In the meantime, individual TIPS are still government bonds backed by the full faith and credit of Uncle Sam. And even if Mr. Arnott is wrong and deflation persists for years, investors who buy individual TIPS will at least have the security of being able to recoup the face value of their bond at maturity, while still earning a yield of around 1.2 percent a year.

Now that’s 1.6 percentage points less than what regular Treasuries of equivalent maturities are paying. But, Mr. Arnott asks, “What are the chances of inflation being less” than that for a decade?

If you truly fear deflation, fixed-income securities — because of their relative safety and the income they throw off — will most likely be better than equities, money managers say. But they note that investors need to be choosy about the types of bonds they buy.

Among corporate securities, investors should pay attention to companies’ balance sheets. “You want to avoid highly leveraged companies,” said Carl P. Kaufman, manager of the Osterweis Strategic Income fund. In a deflationary environment, a debt-ridden company would have to pay back obligations with increasingly valuable dollars. “In inflation, you’re cheapening the value of dollars over time,” Mr. Kaufman said. “In deflation, it’s the opposite: dollars become dearer over time.”

Fixed-income investors may want to focus on high-quality companies that routinely generate tons of cash. The same argument goes for equity investors as well.

Sam Stovall, chief investment strategist at Standard & Poor’s, says that in deflationary times, some stocks could actually post gains. Throughout the 1990s, when the Japanese stock market began to crater under the weight of deflationary forces, technology, telecommunications and health care shares rose on local markets.

INVESTORS who want to maintain their stock weightings should consider “high-quality, large, blue-chip companies that have balance-sheet strength,” said Brian McMahon, chief investment officer at Thornburg Investment Management in Santa Fe, N.M. He said companies like Google and Microsoft often have an added advantage: dominance over their industries, enabling them to maintain their prices even if others in the industry start to lower theirs.

Stocks that pay dividends would also make sense, because the cash thrown off by these shares would be quite valuable in a deflationary environment.

In fact, said Mr. Inker of GMO, if investors really fear deflation, they might consider increasing the cash in their portfolios. “There’s a strong case for building up dry powder,” he said. “If something bad happens economically — whether it’s deflation or inflation — that’s generally provides a good buying opportunity for investors who have some cash to put to work.”