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The inflation vs. deflation debate: Planning for alternative negative scenarios

Inflation versus deflation: the major controversy of today is less an abstemious debate in the hushed, erudite tones of economic policy analysis, and more a shouting match worthy of a cable-TV Friday night smackdown.  The problem for investors is that deflation and rampant inflation are both very real possible scenarios given present economic trends.  In fact there are plausible scenarios for experiencing both – for example a “double dip” return to recession in the short term that causes widespread declines in the prices of goods and services, followed by an inflationary bang when the trillions of dollars of central bank bailouts and government stimulus spending finally make their presence felt.  

In my own assessment we will most likely neither be filling the wheelbarrows with cash just to buy bread, nor hiding bars of gold next to ammunition stockpiles under our beds.  But smart investing is about diversifying, and part of diversifying is preparing for potentially negative outcomes.  The purpose of this post is to consider what approaches may help hedge against either extreme inflation or deflation.

Let’s start with deflation, if only because that seems to be more the buzz this week.  What does deflation mean, and what types of assets can help investors preserve value in a deflationary environment?

Deflation happens when fewer dollars are chasing the same amount of goods.  Households sharply reduce their spending due to falling incomes, crushing debt obligations, job losses and so forth, while government is not providing stimulus through new spending programs, and banks refrain from pumping credit into the market because they are wary of lending risks. 

Deflation turns conventional finance on its head – it says that the dollar I hold in my hand today will buy more tomorrow than today (because prices will be lower).  If prices decline by 5% over, say, a one year period then simply by sticking $100 under my mattress today I will earn an “effective” rate of interest of 5% by holding that cash and deferring spending for one year.  The shorthand way to say this is “cash is king”.  Cash equivalents and the safest of securities – like short-term government bonds – are probably the best bet in this environment because even if the instruments pay barely anything at all in annual coupon, you are earning a positive real return just by getting your principal back.

In the US we have not had a true deflationary experience since the 1930s, and it is not an outcome many have given serious thought to before now.  However we have lived through a period of chronically high inflation.  This unfolded from the early 1970s through the early 1980s, initially brought about by a series of catalysts including government spending on the Vietnam War, the collapse of the Bretton Woods fixed exchange rate system in 1971 to the Arab embargo on crude oil exports in 1973.  Over this period the dollar you held in your hand at one point in time would be worth considerably less in the future.  This was true for corporate earnings as well, and as P/E ratios fell equities proved to be an unprofitable investment.  Bonds fared poorly as well, especially traditional fixed-rate bonds.  The expectation of inflation pushes up bond yields as investors expect more compensation from deferring that “dollar today” for the “dollar tomorrow.”  When bond yields rise bond prices fall and their holders suffer losses.

What worked in the “stagflation 70s” were real assets: commodities like oil and precious metals like gold performed spectacularly well in this period.  Now, that does not necessarily mean that these same assets would be the top performers in any inflationary environment – after all the oil embargo and the departure from the gold exchange standard were distinct features of the 1970s and so assets directly related to those events necessarily did well. But the inherent attraction of real assets is that they tend to hold their value against depreciating currencies, which is something that typically accompanies inflation.  So if it takes more dollars tomorrow to buy your gold bar than it does today, it makes sense to hold gold bars.

Fortunately, today it is easier to position yourself with readily available, liquid investments in anticipation of negative events like inflation or deflation than it was in the 1970s, or certainly the 1930s.  The deflationary hedges of cash equivalents and highly safe government bonds, as well as inflation-beaters like diversified or specialized commodities, are available through a variety of mutual funds and exchange traded funds.  It probably makes sense to have at least a small position on both sides – say a 10% position in cash equivalents / low-risk government bonds and a corresponding 10% position in real assets on the other side.  That is simply prudent diversification, and if you really convince yourself that one of these unsavory outcomes is imminent then you can increase the weightings on that side.  As a word of caution though – there is an old maxim that Armageddon doesn’t happen far more often than it does happen!  Be prepared – but amidst all the hyperventilating commentary in the public media, don’t lose sight of the middle ground.


Disclosure: No specific stocks are mentioned in this article in which the author has a position