Protect Your Portfolio

During the 1980's, it was considered the “cruelest tax of all,” robbing consumers of purchasing power.

I’m talking about inflation.

Right after the global financial crisis, a financial publisher asked me to prepare a report on the “coming inflation.” After thinking it over, I told them that inflation would be muted for many years. They weren’t happy, but I was right.

Today, you can turn on any business news channel and, before long, several economists will appear to debate whether we’ll have inflation, deflation, or their evil twin stagflation, which we struggled with in the 1970's.

You might be tempted to leave this inflation-deflation debate to the egghead economists. But that would be a mistake. The direction of prices will have an impact not just on your wallet, but also your portfolio, and you’ll need to protect both.

With commodities such as oil, copper, and iron ore plunging, I’d say the deflation hawks have the upper hand, as global inflation is at a 59-year low.

Inflation Versus Deflation

Inflation is “a persistent increase in the level of consumer prices or a persistent decline in the purchasing power of money.” In other words, it’s an upward movement in the average level of prices.

Deflation is the opposite, a downward movement in the average level of prices.

While inflation is the expansion of money and credit, deflation is the contraction of money and credit.

Inflation squeezes your purchasing power and nest egg while deflation pulls an economy’s growth rate and stock markets down to Earth.

In a healthy economy, there will always be modest inflation – it keeps commerce and economic momentum moving forward. Price stability enables everyone in an economy to make sound economic decisions and fosters a virtuous cycle of growth and progress.

High inflation, and expectations that it will get higher, discourages investment and savings – the fuel for growth and productivity.

In my view, deflation, or falling prices, is much more dangerous to an economy than rising inflation. It’s also more difficult to combat.

It’s important to note that price levels reflect, to a large degree, psychological leanings. For example, if most people expect prices to rise sharply, producers will raise prices to protect themselves, workers will negotiate higher pay increases, and the cycle continues and accelerates.

The same is true with deflation. If consumers believe that overall prices will fall, they’ll delay large purchases, companies will reduce costs to maintain margins, and economic growth will suffer. This is exactly why the Japanese economy has gone nowhere for so long.

I put the probability of America following the Japanese deflation model at about 30%, based on the following:

• The Fed is pumping a lot of money into the system, but can’t force consumers or businesses to grow or banks to lend. Small and medium-sized businesses are still starved for capital.
• State and local governments are raising taxes and cutting expenditures.
• Taxes as a share of GDP are rising rapidly and will slow growth – federal, state, and local tax revenue are now at an astounding 38% of GDP. Taxes are likely to expand from this high base given America’s entitlement obligations.
• Core inflation won’t move up until wages do, and with 7% unemployment and the real number based on normal labor participation rates higher than 15%, this isn’t likely to happen anytime soon.
• In addition, the downward pressure on U.S. wages from emerging markets isn’t likely to let up, either. The trend towards temporary and part-time employment in America follows trends in Japan. (According to some estimates, America has about 40 million freelancers.)
• Household spending is expanding at a moderate rate, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit.

Investment Strategies for a Deflationary Environment

A great place to be during a deflationary environment is in long-term bonds or cash. The worst place is probably in the stock market or real estate. The most liquid ETF following long-term Treasury bonds is the iShares 20+ Year Treasury Bond ETF (TLT).

You should avoid most financial companies, especially mortgage-oriented lenders that see collateral coverage plummet as housing prices fall and borrowers drop a notch or two in credit quality.

While being short equity markets is preferable during deflationary times, if you want to hedge, go with dividend-paying stocks, such as regional banks.

For the most part, they’re better managed and prime takeover candidates. Take a look at the SPDR KBW Regional Banking ETF (KRE). It has outperformed the larger bank baskets in part due to healthier balance sheets.

My advice is to take a portion of your nest egg and put it in a deflation protection portfolio – just in case the Japanese disease spreads to America.

Good investing,

Carl Delfeld