Is Deflation Coming?

by: Roger Nusbaum

Yesterday was kind of an odd day around the ole blogosphere as Market Folly and ETFdatabase each ran almost the same post about how to invest in a deflationary environment. I did not see mention of a cross posting, so I'll just chalk it up to coincidence.

Each post highlighted what to hold in a deflationary environment and both listed cash as one holding. If (almost) everything drops in price then holding cash, even if it yields 5 basis points, is a good hold. Cash is a good hold even if the US dollar drops versus other currencies; not the best hold maybe but a good hold. If you are worried about your brokerage firm failing and SIPC then you might want to put your cash into something like t-bills or the MINT ETF from PIMCO--unless you're worried about them failing.

Long term bonds also made the cut in both posts. This is fairly obvious in that if we do have deflation then interest rates won't be going up anytime soon and as low as they are could continue to to head lower making longer term bonds relatively attractive for the little bit of yield and potential price appreciation. A point I have made before is that while bond prices may not go down in the near term, anyone buying at these levels is buying high. If rates are at or near all time lows then by definition prices are high. We know prices can stay high for a long time but no one should lose sight of the fact that prices are very high.

There are obviously countless bond ETFs with the ones from iShares and Vanguard being the most popular. I would note that Schwab just came out with three treasury ETFs of its own that will attract a lot of assets thanks to free commissions. My own preference in the fixed income market is short term investment grade domestic corporates and short term foreign sovereign debt from countries like Norway, Australia, Denmark and Canada (these would be very difficult for individuals to access due to minimum order size requirements).

Dividend paying stocks are favored here as well, and I think the idea is they will go down less. My suggestion would be to go with foreign dividend paying stocks. If US deflation turns out to be as bad as Japan's deflation we know that many other countries will get along just fine. The US got along just fine during the first eleven years of Japan's deflation. WisdomTree has a bunch of foreign dividend ETFs, iShares and PowerShares also have products in the space and you can find other funds with high yields that are not necessarily "dividend" funds. For example iShares Singapore(NYSEARCA:EWS) has a trailing yield of 3.05% and iShares Australia (NYSEARCA:EWA) has a trailing yield of 3.79%. A few clients own EWA as do I.

Additionally people can buy individual foreign stocks with high dividend yields. Obviously this requires work but there are plenty of ADRs both on the NYSE and the pinksheets to build into a diversified portfolio. Funds or stocks, anyone worried about deflation needs to look at Japan and get a grip on the potential of how much lower US stocks could go and avoid/invest accordingly, again if you think the US is headed toward deflation.

You can read both articles to get particulars on what other things they suggest investing in should there be deflation but let's ponder whether there will even be a meaningful deflation or just a couple of years of what might be a modestly deflationary environment. One thing that probably should be mentioned up front is what deflation is not. Deflation is not lower prices that come about through innovation and technology enhancements. This is an element of creative destruction.

Here are some notes from Marc Faber where he talks about inflation being more likely than deflation because of Bernanke's commitment, as he sees it, to print money for as long as it takes. He believes, among other things, that this effort will result in an even bigger financial crisis in the US but was not specific as to when this might happen. The Fed has taken inflationary steps but thus far these steps have not resulted in price inflation in the government stats but maybe there are subtle signs of inflation elsewhere. One thing is certain we are several years in to an asset price deflation in the US. The stock market and the housing market are both meaningfully lower since 2007 and what remains to be seen is whether this becomes a deflationary debt spiral spurred on, in part, by the writing down of a lot more debt.

I am reminded of a quote that I can only paraphrase which is that inflation is easy to create except when you really need it. Like now. If anyone knows who to attribute it to please leave a comment. I would note that whether or not Faber is correct about inflation some sort of big consequence from the action now being taken would be far from a black swan.

Here is a post from Matt Hougan citing a white paper from Vanguard saying not to worry about a bond bubble. If rates go up a lot then bond investors will get hurt badly; the longer a portfolio's duration the more hurt. I have no idea whether the word bubble would have any relevance should such a thing happen but as mentioned above, bond prices are very high and we also know the extent to which bond funds have had massive inflows going their way. The way to protect against something bad in the bond market hurting you is to keep maturities short. A portfolio favoring two-three year paper won't suffer large price drops should rates skyrocket, it would simply have a below market yield for a while.

This ties into an ongoing theme that predates this site which is need to transition more of the portfolio to other markets. I don't know if we are Japan in more magnitude, less magnitude or not at all but the US has been on a path of at the very least being a less compelling investment destination. The deterioration has been worse than I expected but to repeat from above many countries did very well in the 1990s as Japan went down, many countries did very well as the US went down last decade and many countries will do very well during this decade if the US continues to go down.

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