Thursday, November 18, 2010

The Deflation Scenario

You probably worry about inflation-but deflation, too, is a threat you need to understand.

Financial Planning
By David E. Adler
November 1, 2010
These are the total assets of the federal rese...Image via WikipediaMost planners keep their eyes on inflation. But the Fed has worries in the opposite direction: Once unthinkable, deflation is now a threat. In September, the Fed's Open Market Committee Meeting found "measures of underlying inflation are currently at levels somewhat below those the Committee judges [optimal]."
…Extremely low inflation can easily tip into deflation, and several economic indicators are flashing red. Most critically, the CPI is dangerously low, at less than 1%. Investor and consumer confidence and demand are at similarly depressing levels. And the overall economy is still deleveraging.
That's why some economists can't rule out the possibility of deflation. "I would say there is a fifty-fifty chance of deflation occurring within the next 12 months," says Ibbotson Associates' economist Francisco Torralba.
Organization of the Federal Reserve SystemImage via WikipediaThinking through deflation and its effect on … portfolios-and lives-requires new and possibly unfamiliar approaches, since deflation has been rare since the end of World War II. … The bigger challenge facing advisors is that much of their job is helping people to achieve their dreams. What will happen to these dreams if deflation becomes a reality?
Deflation is devastating because people's debts increase in real terms, while the value of their assets, including business inventories, decline. If it tips into a severe spiral, borrowers default, credit becomes impossible to obtain and the wheels of commerce stop spinning. "If the Fed can't stop deflation, we are looking at the possibility of government default," says Jon Ruff, director of research for real assets and strategies at Alliance Bernstein.
Ruff puts very low odds on severe deflation happening-less than 6%-and adds that it's highly dependent on whether we see a double-dip recession. But other analysts, citing new academic research, are less optimistic.
"When the core CPI inflation rate falls below 1.5%, the risk of deflation increases," Torralba says, in part because the Fed can only lower interest rates so far before hitting zero. …
The United States faced similar risks of deflation in 2002, Torralba says. After the dot-com crash and the terrorist attacks of 2001, inflation in the first few months of 2002 barely nudged above 1%. But the economy escaped the threat; economic conditions that year were a far cry from the high unemployment and brutal deleveraging of today.
Consumer expectations about deflation, which can become a self-fulfilling prophecy, are alarming. The 10-year expected inflation rate by consumers, as measured by the Federal Reserve Bank of Cleveland, was only 1.54% as of mid September, and that expectation has been declining since 2008.
Finally, there are signs the economy is undergoing a regime shift, where deflation has replaced inflation as the primary threat. The main reason is that the rise in global labor productivity and supply drive down prices on manufactured goods, particularly without a rise in global demand. However, globalization trends also increase price pressures on commodities and other industrial inputs. The picture is far from simple.
Robert Tipp, chief investment strategist for fixed income at Prudential, believes this is the case. The re-emergence of deflationary pressures in the 21st century goes beyond the high unemployment and debt levels of U.S. consumers to encompass other macro factors, principally globalization, according to Tipp. "Deflation is not a likely scenario, but it will crop up on the risk spectrum for years," he says.
Financial planners searching for insight into how different investments respond to deflation can look to history for guidance. … [The] United States itself offers deflationary parallels, most recently in the 1930s.
Brian Gendreau, market strategist for Financial Network Investment Corp., an RIA based in El Segundo, Calif., says, "I go back to the very slow economy from October 1937 to August 1939. Banks and companies were flush with cash, and deflation was 5%." Gendreau, who is also a finance professor at the University of Florida, notes that during this period equity valuations fell by 36%.
But there were a few bright spots: Stocks that paid high and stable dividends, such as public utilities, did well as investors piled in. During these two years, prices for high-grade corporate bonds and municipals also appreciated. In general, investors sought yield and safety, and they were rewarded for it.
Parallels with the past are not exact, of course. The price of gold, for instance, declined by 1.2% from 1937 through 1939. Although Gendreau does not think deflation is a definite, he does believe that it remains a risk. …
So is it too late to make the bond play Gendreau suggests? If you look at history, he argues, it isn't. Bond yields were already low at the beginning of 1937, but yields continued to decrease (and prices continued to rise) well until 1941, two years after the deflation ended.
Planners may be familiar with the idea of deflation and may even be taking steps to hedge against it via large fixed-income or Treasury allocations. … More critically, Ruff argues, the traditional deflation protection offered by Treasuries could be overwhelmed by the possibility of government default that would accompany severe deflation. Even without a true default, the risk alone could depress prices.
… Many analysts believe that despite the immediate concerns about deflation, the greatest long-term threat is still inflation. So in addition to the deflation protection offered by high-quality bonds, portfolios also need hedges against inflation….
"We are in a multi-flationary world; you can't say deflationary or inflationary," says Ben Marks, president and CEO of Marks Group Wealth Management in Minnetonka, Minn. "Instead, you have different headwinds affecting different asset classes." As Marks points out, there is excess supply in housing, commercial real estate and the labor market. As a result, the United States is experiencing deflationary pressures in all three sectors. At the same time, new demand for commodities from emerging economies is creating inflationary pressures. Finally, he doesn't rule out the possibility of stagflation, last seen in the 1970s….
From an investment perspective, Marks is cautious about fixed income. Even though bonds are the natural hedge for deflation, he believes that the market has already priced this in. Instead, he makes carefully selected equity investments in sectors and companies that can survive deflationary pressures.
His focus is on best-of-breed companies that will win market share as rivals go under. Or he looks at firms with unique products and pricing power.
Marks also invests in growth trends, targeting industries that he believes will flourish regardless of deflation or inflation, such as wireless technology. He focuses on companies that have built up an extensive infrastructure, creating high barriers to entry for competitors….
The Depression-era-type portfolios embraced by many planners are one approach to a dark period. But there are dangers in being overly defensive. The economy could revive sooner than advisors and economic forecasters have planned for. "Investors need some selling discipline. The economy will not be weak forever," Gendreau says.
David E. Adler contributes regularly to Financial Planning. His most recent book is Snap Judgment.
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