Reconsidering the Deflation Risk

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 |  Includes: AGG, DJP, TIP
by: James Picerno

The Fed's current monetary policy only looks reckless for those who see inflation bubbling. The same monetary policy looks prudent, even prophetic, for those who see deflation as the dominant risk.

Our bias, for what it's worth, leans toward inflation, as our posts, such as this one, suggest over time - and we're not alone. However, that doesn't make us right, and to the extent that the crowd's on board with this idea gives us pause. Nonetheless, from what we can tell, inflation risk looks to be the bigger threat, although that view is contingent on a future of a fairly orderly downturn in the business cycle followed by a somewhat routine recovery in a timely manner.

As for the belief that the crowd's thinking inflation: one clue is found in the rush into inflation-linked Treasuries. The iShares Lehman TIPS (NYSEARCA:TIP), for example, posts a 12.9% total return for the year through last night's close, according to Morningstar.com. That's far above the 7.6% total return for nominal bonds overall during that span, as per the iShares Lehman Aggregate Bond (NYSEARCA:AGG). Another sign that inflation expectations have deep roots: the bull market in commodities prices. The iPath Dow Jones-AIG Commodity ETN (NYSEARCA:DJP), for instance, boasts a total return of more than 25% for the past year.

One can surmise that inflation fears have the market's attention, but it would be wrong to say that alternative views are absent or even misplaced. Indeed, some believe that deflation risk is relatively high and rising. Leading this charge is the deflation master-in-chief: Fed Chairman Ben Bernanke.

It certainly helps seeing Bernanke's aggressive easing strategy in a prudent light if deflation is a real danger in the foreseeable future. If so, dropping interest rates quickly and dramatically looks like a reasonable strategy for minimizing the potency of the approaching deflationary forces.

Then again, if inflation is the bigger threat, Bernanke's current game plan looks rash if not irresponsible.

Alas, no one knows what's coming and so we're all - central bankers included - reduced to guessing, also known as forecasting, predicting, etc. Some guesses are better than others, perhaps because some guesses are better informed than others. Still, in real time it's hard to tell one from the other absent the passage of time.

It's no wonder, then, that taking a neutral view of investment strategy has its merits, along with a fair amount of finance theory on its side. In this case, neutrally oriented investors will build a portfolio of all the major asset classes in their appropriate market-valued weight and leave asset allocation among those groups to Mr. Market from here on out. Meanwhile, this risk portfolio's relative weight to a risk-free fund - T-bills, for instance - should be adjusted to account for the investor's general preferences for risk. The total package is at once neutral on the outlook for risk and designed with the investor's particulars notions of risk in mind. Come inflation, deflation or whatever, this is the default portfolio for all seasons for an investor who has no particular view on the future.

Perhaps it's no wonder that few investors subscribe this strategically neutral view of the world. Ill-advised or not, that's the way the world works. We bring this all up only to put the strategic outlook in perspective, and remind that unless you're a neutrally inclined investor, you're making a bet. Some will lose, some will win. So it goes. Bets vary by degree, of course, and some of us are making larger or lesser bets than others and so we'll all be rewarded (or pinched), accordingly.

With that in mind, the inflation/deflation question looks like one of the bigger issues weighing on future results for investment strategy. Simply put, the stakes are high in deciding if Bernanke's right or wrong.

The Fed is again focused on deflation risk for the second time in this decade. The first time, from 2001-2003, Bernanke was the point man under the Greenspan regime. It's fitting that Bernanke is a student of deflation in economic history, and it may explain why he's so focused on the risk. In any case, it turns out that the Fed was wrong about deflation the first time around, and the error came with costs.

There's a case to be made that the real estate boom that's now deflating was a direct consequence of the easy money policies associated with the deflation fight of 2001-2003. In defense of the Fed, one could say that the U.S. was far from alone in promoting easy money policies, in which case one might surmise that the Fed's deflation focus was driven by global economics rather than local events. (In fact, some argue that the deflation risk was quite real a few years back and the only reason that it didn't bite is because the Fed acted pre-emptively.)

Today, the Fed is leading us into another battle against deflation, real or perceived. The problem is that assessing deflation's true risk potential requires knowing how bad the current correction will (or won't) be. There's little doubt that if the economic downturn now underway is deeper and longer lasting than the crowd expects, the deflation threat is higher than is generally realized.

So what's the bottom line? It's that deciding if deflation is or isn't a threat depends on your expectations for the cyclical downturn now underway. All the usual risks apply, of course, and so it's every strategic-minded investor for himself. Meanwhile, perspective helps improve the odds of making intelligent decisions, or at least decisions that are less erroneous than others. Maybe.

On that note, we recommend a recently published commentary that parses deflation's risks in some detail. Brian McAuley, portfolio manager at Sitka Pacific Capital Management, does a nice job of summarizing where we are now, we're we've been and what it implies for the future. Although he writes as someone apparently worried about deflation, everyone should give his paper a read if only to gauge how the view from the other side of the aisle, so to speak, sees the future. Here are two excerpts from McAuley's essay:

With all that has been going on the in the markets with the continued housing decline and the credit market problems, the Fed has over the past two months made their intentions quite clear. As they're fully aware, this is a very risky time for the U.S. economy – and not just because average housing prices are down close to 10% year-over-year. They understand that our current circumstances are similar to past instances in economic history where a major economy faced significant deflationary risks.

Given our debt burden, the Fed understands very well the deflationary risk if prices fall too far for too long. Not only is there is a risk of debt service overwhelming current aggregate demand, there is also the risk that the psychology of consumers and businesses would begin to change from an inflationary attitude of “buy now and pay later” to a deflationary “save now and buy later.” In an economy in which 2/3 of GDP depends on “buy now,” the Fed will do everything in its power to prevent this from happening.