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As deflationary concerns continue to make headlines among investors, dividend paying investments, interest-bearing investments and cash become more appealing.

Weak economic figures, a decline in money supply and fiscal tightening around the world are a few reasons why falling prices could be in the near future. Other factors that could lead to a drop in prices include tight credit markets, declines in consumer spending and high unemployment – all of which lead to a reduction in the demand for goods. Declines in the demand for goods eventually result in excess supply, which further leads to a decline in prices to bring supply and demand in equilibrium.

A fall in prices can be detrimental to an economic recovery if businesses and consumers become reluctant to spend and decide to hold on to any disposable cash. This decrease in money supply is most devastating to economies that are highly dependent on consumer spending, such as the United States. Other results of deflation include erosion of consumer confidence and amplification of the burden of both household and public-sector debt.

Signs of deflation in the US appear to be prevailing. According to the Bureau of Labor Statistics, the consumer price index (CPI) increased a mere 0.3%, which translates to nearly 3.6% annually. However, when stripping out the volatile food and energy sectors inflation was zero in August. Furthermore, consumer confidence continues to remain weak. Although a slight increase in the consumer confidence was seen in August, overall consumers remain pessimistic.

Consumer confidence has been dropping over the last three months. In June, CPI dropped by 0.1%, in May by 0.2% and in April by 0.1%, pushing the price index below its January 2010 levels. In general, as CPI declines, deflation looms. Additionally, the Federal Reserve recently reported that consumer credit decreased at an annual rate of 4.5% in May 2010 and revolving credit decreased at an annual rate of 10.5% during the same time period. These declines in credit utilization contributed to a 1.2% decrease in consumer spending, a trend prevalent in times of deflation because consumers believe that dollars will be worth more in the future and are postponing purchases.

Generally, cash is the best investment in times of deflation; however, one could also consider investments with a steady cash flow stream that shoot off generous dividends and interest payments or precious metals like silver and gold.

Some deflationary plays, which give diversified access to the dividend-paying stocks, include:

  • PowerShares HighYield Dividend Achievers (NYSEARCA:PEY), which boasts a yield of 4.64%
  • WisdomTree Dividend ex-Financials (NYSEARCA:DTN), which has a yield of 4.01%
  • iShares Dow Jones Select Dividend Index (NYSEARCA:DVY), which has a yield of 3.79%
  • SPDR S&P Dividend (NYSEARCA:SDY), which has a yield of 3.59%

As for interest-paying ETFs, one could consider the following:

  • iShares Barclays 1-3 Yr Treasury Bond (NYSEARCA:SHY), which yields 1.18% and primarily holds bonds with a AAA rating.
  • Vanguard Short-Term Bond ETF (NYSEARCA:BSV), which yields 2.34% and allocates nearly 76% of its assets to bonds with a AAA rating, giving investors a little more return for risk.
  • iShares Barclays 20+ Year Treas Bond (NYSEARCA:TLT), which boasts a yield of 3.48% and primarily holds bonds with a AAA rating. This is more of a long-term play on deflation, but generates a healthy stream of income.

When it comes to precious metals, it seems like the historical relationship between precious metals and the US dollar has been broken primarily because many are using precious metals as a global currency and the inherent safe haven characteristics that precious metals entail are likely to prevail in the near future. Some ways to play precious metals include:

  • SPDR Gold Shares ETF (NYSEARCA:GLD)
  • iShares Silver Trust (NYSEARCA:SLV)
  • PowerShares DB Precious Metals (NYSEARCA:DBP), which gives exposure to both gold and silver through futures contracts.

To further preserve capital, it is important to consider the risks that are involved with investing in these ETFs. To help protect against these risks, the use of an exit strategy which identifies specific price points at which downward price pressure could be seen is important.

Disclosure: Long SLV

Source: 10 ETFs to Play Deflation