The dreaded D word is back in circulation, and I don’t mean “depression.” Having skirted that potential calamity, the worry for policy makers and investors now is deflation.
On the face of it, deflation — falling prices — doesn’t seem like it would be so bad. Who wouldn’t welcome discounts that just keep getting better, like those sales at Filene’s Basement where prices get lower the longer merchandise stays on the racks?
Of course, who knows what it really feels like? We’ve never experienced prolonged deflation in my lifetime.
Maybe deflation would be a nice thing for people with secure, steady incomes. But deflation erodes profits and asset values. People wait to buy, expecting lower prices, which reduces demand. Lower profits cause companies to slash expenses, including employees. It’s a downward spiral that, if Japan’s experience is any indication, is difficult to arrest.
Is deflation really a risk? The last deflation scare, after the Internet bubble burst in 2000, turned out to be a false alarm. What we got instead were soaring asset prices, from real estate to commodities to art. The Federal Reserve and other policy makers say they’re determined to avoid it, and with the federal deficit having soared, deflation is the last thing they should want. (Inflation is the time-honored cure for big deficits.) Although short-term interest rates can’t really go any lower, the Fed can still revive other measures it stopped in the past year, like buying Treasuries and mortgage-backed securities. If I had to bet, I’d say we’ll avoid deflation.
But the truth is, I don’t know. I don’t think anyone does. On Sunday, The Wall Street Journal reported that some major investors, including Pimco’s Bill Gross, are taking the risk of deflation seriously and shifting their portfolios accordingly. Like many investors, Gross and his colleagues were focused on the rising risks of inflation just three months ago. They’ve spent their entire careers studying these issues, and I have a healthy respect for their opinions.
Recent price data support them. The headline consumer price index slipped 0.1% in June after falling 0.2% in May.
So how should individual investors protect themselves from even a small risk of deflation? If you’ve been reading and acting on this column, you’re already well on your way. Back in February, when inflation fears were widespread, I wrote a column with a strategy for lower inflation and rising interest rates. I thought the Fed would be raising rates by now, which would lower inflation expectations.
Inflation worries have all but disappeared, which means that advice proved sound. But not for the reason I expected. Interest rates haven’t gone up — they’re even lower — and they don’t seem likely to rise any time soon. That environment requires some further adjustments.
In February, I urged investors to reduce exposure to traditional inflation hedges, such as gold, commodities, energy and TIPS. Gold, precious metals and oil prices are off their peaks, but investors should continue to avoid them.
Deflation is an ideal environment for high-quality fixed-income assets because the value of the income stream rises as prices drop. In February, I urged fixed-income investors to shorten maturities. That meant moving into higher quality bonds like investment-grade corporate bonds and Treasuries, as well as federally guaranteed bank certificates of deposit. To protect against deflation, investors should maintain the focus on high quality but lengthen maturities. This is easily implemented as short-term bonds and CDs mature. There’s also nothing wrong with holding cash or cash equivalents, even with money-fund rates close to zero. Cash gains in value as prices fall.
As a rule, deflation is bad for stocks because it erodes profits. Some investors are hedging against stock declines with exchange-traded funds that rise as stock prices fall (a strategy I tried without much success earlier this year).
Pimco’s Gross said he’s focusing on solid, high-dividend-paying companies, which offer many of the same benefits as bonds.
One advantage of deflation strategies is that they tend to be very low-risk (and low-return). As I said in February, changes in inflation and monetary policy tend to be gradual. I don’t think investors need to radically realign their portfolios just because deflations fears are again on the rise. Lately, stocks have been rallying, suggesting that many investors are less concerned with the likelihood of deflation than Pimco’s Gross. But some modest steps seem in order, starting with a higher allocation to high-quality fixed-income assets with longer maturities.
In this environment, we all need to pay close attention to pronouncements from the Fed. With a few policy shifts, the Fed could probably banish deflation fears — and we’ll all be talking about inflation again.
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