Preparing For A Potential Deflationary Scenario

Includes: EEM, GLD, SPY, VDE
by: Disruptive Investor

Marc Faber has voiced his concern on serious asset deflation in his widely read Monthly Market Commentary. According to the summary of his March 2013 report -

I worry about the time when the current asset inflation will give way to a serious asset deflation, which will inevitably happen sometime in the future. As an observer of markets I am, therefore, concerned that the decline in gold prices could be telling us that we are about to enter a period of asset deflation.

I should like to make two points very clear. I am not sure when the asset deflation will start. Most likely, different asset classes will deflate at different times and with different intensity. The second point I wanted to make is the following. In a deflationary environment (whenever it will happen), financial assets (stocks, government and corporate bonds especially high yield bonds) would likely be the most vulnerable assets. In fact, in a deflationary collapse, I would envision money to flow into a sound currency and move out of "funny" paper monies. Therefore, I continue recommending the gradual accumulation of physical gold.

In this article, I will discuss the probability of deflation and the portfolio strategy in order to benefit from any deflationary collapse. I would like to mention here that I am of the opinion that asset classes will witness very high inflation gradually over the next few years. Post this inflationary period, deflation is likely accompanied by a collapse of the financial system. I would also agree with Faber's opinion that deflation might be witnessed at different times across different asset classes. Such an environment would make investment decision more challenging.

Talking about the prospects of deflation, investors might question on how deflation is likely when trillions of dollars of money has been printed. To answer the question, I would take the help of two charts. The first chart below gives the money velocity and the second gives the excess reserves of depository institutions with the Fed.

The money velocity chart shows that the real economic activity remains very weak with money turnover being at a 50-year low. In such a scenario, inflation might not pick up even if central banks pursue expansionary monetary policies. The second chart is a great indicator of the risk averseness in the banking system. Investors need to understand that credit growth leads to a majority of the money creation in the system under the fractional banking system. With banks unwilling to lend and households already highly leveraged, the prospects of rapid credit growth look bleak. Both these charts do point to a possibility of deflation.

However, I have argued in several of my earlier articles that inflation does come with a lag effect and I still maintain my view that we will witness inflation or very high inflation before any deflation. As mentioned by Dr. Faber, different asset classes might deflate at different times. The same holds true for inflation. Different asset classes might inflate at different times. We are already experiencing asset inflation in some sectors.

The equity markets are a good example of the point I am trying to make. Equities are near all time highs with the global economic activity remaining highly uncertain. There is no doubt that a significant part of the rally has been liquidity driven. Asset inflation is also evident in the case of crude. When global economic activity was at its peak in 2007, crude was trading at $75. Currently crude is trading significantly higher with recession in the Euro zone, sluggish growth in the US and very slow growth in China and India. I must also mention here that agricultural land has witnessed significant inflation post the crisis. I had discussed on the agricultural land bubble in one of my earlier articles.

The critical point I am trying to make here is that we are already in a period of asset inflation and the core CPI numbers might not be reflective of the same. Post the crisis, money has been swiftly moving from one asset class to another resulting in short periods of asset inflation and deflation.

However, there will be a time when there is serious "risk off" trade and all asset classes experience deflation. The rationale for the same is as follows - Central banks will continue with their expansionary monetary policies and the dead cat bounce in asset markets will gradually get weaker as investors see lesser impact of each subsequent money printing exercise on the real economy. The diminishing impact of debt theory might partially explain this outcome. At the same time, governments will be loaded with much more debt than it is today. Sovereign ratings will slump over the next 5-10 years and this will seriously impact the way investors trade or consider exposure to various asset classes. In other words, I expect the government bond bubble to go bust resulting in a far serious crisis than the one witnessed in 2008-09. I did discuss the reasons for believing that governments are in an inescapable debt trap in one of my earlier articles.

From an investment perspective, the strategy should be as follows -

Investors need to have 20-25% of the portfolio in cash. An asset deflation scenario is a bull market for cash. As mentioned by Dr. Faber, investors also need to be invested in gold and other precious metals. In a scenario where one or several currencies fail, precious metals will be a store of value and an honest currency. Considering the current environment, it is also advisable to have investments in agricultural and industrial commodities besides equities. The equity portfolio also needs to be diversified across emerging and developed markets with gradual increase in allocation to emerging markets.

Specific investments to consider would be -

SPDR S&P 500 ETF (NYSEARCA:SPY) - It has been proven that beating the index is not an easy task. Therefore, the strategy should be simple -- beat the index or invest in the index. From this perspective, SPY looks interesting. Also, with excess money flowing into risky asset classes, the S&P should trend higher over the next 3-5 years. The ETF provides investment results that, before expenses, generally correspond to the price and yield performance of the S&P 500 Index.

iShares MSCI Emerging Markets ETF (NYSEARCA:EEM) - Global diversification is necessary and exposure to emerging markets is critical. Over the long term, emerging markets will outperform developed markets in terms of equity price appreciation. The iShares ETF corresponds generally to the price and yield performance, before fees and expenses, of publicly-traded securities in emerging markets, as represented by the MSCI Emerging Markets Index.

Vanguard Energy ETF (NYSEARCA:VDE) - The ETF seeks to track the performance of a benchmark index that measures the investment return of stocks in the energy sector. With a low expense ratio of 0.19%, the ETF is a good investment option in a sector, which has good upside potential in the long term.

SPDR Gold Shares (NYSEARCA:GLD) - The investment seeks to replicate the performance, net of expenses, of the price of gold bullion.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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