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First, the good news: all those fears about runaway inflation following from the massive injections of capital into financial markets appear to have been overblown. Now for the bad news: the alternative may be much worse.

For months wary investors have been eagerly watching CPI reports, fearful of the release indicating that price increases are beginning to accelerate, presumably spiraling out of control in the not-so-distant future. But instead of racing towards the double digits, CPI figures have slipped closer and closer to negative territory. That has sparked fears of deflation, a rare but serious economic condition that has some of the world’s most prominent investors legitimately concerned.

PIMCO chief Mohammed El-Erian recently told Bloomberg that the US faces a 25% chance of deflation and a double-dip recession. El-Erian said:

I do not think the deflation and double-dip is the baseline scenario, but I think it’s the risk scenario.

Jan Hatzium of Goldman Sachs, another in a growing group of “deflationistas,” sees CPI increases near zero in the near future and views a decline in prices as a very real possibility. Hatzius contends that the deleveraging process is still in the early stages, and notes that the tremendous amount of spare capacity in the US economy will make it difficult for companies to raise prices (thereby increasing the risk of deflation).

What’s So Bad About Deflation?

With all the talk about deflation, there is some confusion among investors as to why such a scenario would be a negative economic development. In periods of rising prices consumers see their discretionary income decline; as a greater percentage of income is spent on food, gas, and other staples, there is less room available in the budget for electronics, vacations, and other luxuries. So some view deflation as a positive; when prices are falling, their dollars will go further.

From a higher level macroeconomic perspective, however, deflation can be devastating. When prices are falling, consumers are likely to delay purchases, waiting for costs to slide further before making a cash outlay. In a deflationary environment, sitting on a pile of cash becomes an attractive investment option with a positive real yield; the prospect of investing that money becomes rather unappealing. Moreover, borrowing money becomes undesirable because any loan will have to be repaid in dollars that are worth more than the dollars borrowed.

There are other reasons why deflation is generally an unwanted development. Falling prices increase the burden of debtors. Finally, when prices are falling wages often decline too – either in the form of nominal cuts or upticks in unemployment. James Stewart summed up the risk of deflation nicely in a recent WSJ column:

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, reducing demand. Lower profits cause companies to cut expenses, including employees. It is a downward spiral that, if Japan’s experience is any indication, is difficult to arrest.

ETF Ideas for Combating Deflation

For investors looking to add some “deflation defense” to their portfolios, there isn’t necessarily a silver bullet that will thrive as prices slide. But there are a number of options that tend to perform relatively well:

  1. Long-Term Bonds

Deflationary environments are generally bad for stocks, since profits tend to decline as prices fall. But deflation can be good news for fixed income investors. That’s because of the implications of the “fixed” part of the asset class name; as prices slide the real value of fixed coupon payments rises. In general, longer duration securities will perform better in deflationary environments, since the coupon payment is locked in for an extended period of time. Using the ETF Screener to identify long-term bond ETFs yields a number of results:

  • iShares Barclays 20+ Year Treasury Index Fund (NYSEARCA:TLT)
  • Vanguard Long Term Corporate Bond ETF (NASDAQ:VCLT)
  • Market Vectors Long Municipal Bond ETF (NYSEARCA:MLN)

Zero coupon bonds, known as “strips,” can provide solid returns if deflation kicks in; these securities allow investors to lock in fixed rates and reinvest at those rates. PIMCO’s 25+ Year Zero Coupon US Treasury Index Fund (NYSEARCA:ZROZ) is the best option for establishing exposure to this corner of the government bond market.

  1. Dividend-Paying Equities

Some investors embrace equities of companies that make significant dividend payments as an alternative means of protecting against deflation; the dividend payments made by these securities are similar to the coupon payments made by bonds. Because most companies seek to avoid reducing dividend at all costs, dividend streams are unlikely to dry up unless equity markets enter into a severe depression. There are a number of ETFs that focus exclusively on companies that offer the most attractive dividend yields; some of the most popular include:

  • Claymore/Zacks Dividend Rotation ETF (IRO)
  • PowerShares Dividend Achievers Portfolio (NYSEARCA:PFM)
  • First Trust Dow Jones Global Select Dividend Index Fund (NYSEARCA:FGD)
  • iShares Dow Jones Select Dividend Index Fund (NYSEARCA:DVY)
  • SPDR S&P Dividend ETF (NYSEARCA:DWX)
  • WisdomTree’s suite of dividend-weighted ETFs
  1. Cash

In deflationary environments, cash is king. Even when the yield is close to zero, the purchasing power of a dollar increases as prices slide. For investors looking to part assets in a low risk security that essentially strives to achieve capital presentation, there are some interesting ETF options. Currently, there are six ETFs in the Money Market ETF Category, including:

  • PIMCO Enhanced Short Maturity Fund (NYSEARCA:MINT)
  • Barclays Short Treasury Bond Fund (NYSEARCA:SHV)
  • SPDR Barclays Capital 1-3 Month T-Bill ETF (NYSEARCA:BIL)
  1. Inverse ETFs

Because deflationary environments are bad for equities, some more risk tolerant investors may be intrigued by the idea of establishing short exposure to stock markets. The funds in the Inverse Equities ETF Category offer a way to short most major indexes, including both domestic and international benchmarks:

  • ProShares Short S&P 500 (NYSEARCA:SH)
  • ProShares Short Russell 2000 (NYSEARCA:RWM)
  • ProShares Short MSCI EAFE (NYSEARCA:EFZ)

Another interesting idea is short exposure to commodities; natural resources are always vulnerable to falling prices. There are a number of funds in the Inverse Commodities ETF Category, including

  • PowerShares DB Agriculture Short ETN (NYSEARCA:ADZ)
  • PowerShares DB Base Metals Short ETN (NYSEARCA:BOS)
  • PowerShares DB Commodity Short ETN (NYSEARCA:DDP)
  1. Other Ideas

In addition to the general ideas outlined above, there are some other intriguing ETF ideas for deflation protection. Most investors view IndexIQ’s CPI Inflation Hedged ETF (NYSEARCA:CPI) as an inflation hedge, but because this ETF seeks to generate a “real return” above the CPI, it can be a valuable tool in deflationary environments. There’s also the volatility ETNs from iPath; the S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX) generally exhibits a strong negative correlation with equity markets. Because deflation is bad news for stocks, it may give VXX a boost.

Again, none of the funds profiled above are surefire solutions to deflation; the economic conditions that often accompany falling prices can be complex, and can have unpredictable impacts on financial markets. But for investors looking to protect against deflation, they may be worth a closer look.

Disclosure: No positions

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Source: ETF Ideas for Deflation Defense