When deflation comes knocking ...

/ Source: msnbc.com

In the space of just a few short weeks, the possibility of widespread, lingering deflation has gone from a relatively obscure topic of academic debate to center stage in the arena of economic concerns. Does that mean you should consider changing your investment strategy?

Financial planners say they have been peppered with questions in recent weeks from clients trying to understand the potential implications of deflation — a lasting period of broad price declines not seen in this country since the Great Depression of the 1930s. But deflation is only one item on a long list of concerns for investors in a highly uncertain time for the economy and financial markets.

In general, planners advise investors to stay the course with whatever strategy they have devised to save for retirement, college or other personal goals. For younger investors with a high tolerance for risk, that might mean a portfolio 90 percent invested in the stock market. For older, more conservative investors it might mean a portfolio heavily salted with government, corporate and high-yield bonds.

“Diversification is paramount, especially in these times,” said Barry Glassman, a fee-based investment advisor with Cassaday & Co. in McLean, Va. “For every person who is worried about deflation, there is someone else worried about higher interest rates. It all depends on the time horizon.”

Options to consider
For investors who believe deflation is the most likely scenario over the next five to 10 years, there are investment options to consider.

One strategy might be to buy long-term Treasury securities. After all, in a deflationary environment, interest rates would sink even lower than their current, historically low levels. Investors who locked in long-term rates now would be poised to profit.

To follow that strategy to its logical conclusion, a truly bold investor would stockpile long-term zero-coupon bonds, which pay all their interest at maturity and rise sharply in value when interest rates fall.

“The classic play would be to buy the longest dated, lowest coupon you could buy,” said Stephen Barnes of Barnes Investment Advisory in Phoenix.

A similar strategy for a mortgage borrower would be to take out a one-year, adjustable-rate mortgage on the theory that rates will continue to drop. Businesses would avoid long-term commercial leases, betting that rents will come down.

It is telling that just as mortgage borrowers have been gravitating toward 30-year fixed contracts, most bond investors appear to be strenuously avoiding long-term securities and pouring resources instead into relatively short-term notes maturing in no more than three years. That is because the slightly higher returns of longer-term notes are far outweighed by the risks of rates going higher, which would drive down the value of the notes, said Glassman.

“The yield that we’re getting is not worth the risk,” he said. “Even if I did believe in deflation, I’m not sure I would go long because the risk is so high.”

Glassman is hardly alone in his skepticism about deflation.

While wholesale and retail prices fell in April, Federal Reserve Chairman Alan Greenspan described long-term deflation in congressional testimony Wednesday as a potentially serious but “minor” threat.

”(W)e have moved fairly considerably ... to recognize this not as an imminent, dangerous threat to the United States, but a threat that, even though minor, is sufficiently large that it does require very close scrutiny and maybe, maybe, action on the part of the central bank,” Greenspan said.

Bill Gross, the hugely influential PIMCO bond fund manager, told CNBC in an interview this week that he was buying five- and 10-year Treasury inflation-protected securities — or TIPS — making a big bet that inflation will be back in the 2 to 3 percent range “a few years down the road,” up from about 1.5 percent currently.

Stock investors also could make a few choices if they wanted to hedge against deflation, said Sam Stovall, chief investment strategist for Standard & Poor’s. Although the United States has no recent experience with deflation, Stovall studied returns on the Japanese stock market from 1995 to 2002, a period when the world’s second-largest economy was wracked by years falling prices, as it still is.

Only four of 10 sectors posted net gains over the eight-year period, with health care by far the leader at an average 8.8 percent annual return. The other stock categories in positive territory for the period were consumer discretionary products, with a 1.8 percent annual return rate, consumer staples at 1 percent and information technology at a scant 0.2 percent.

Stovall believes that some Japanese companies were able to avoid the worst ravages of deflation because they had a multinational customer base and were able to take advantage of rising demand — and prices — overseas. A deflationary spiral in the United States would probably be more global in nature, he said.

So even if health care, consumer staples and some other sectors were able to buck the deflation trend, most sectors of the economy would suffer. Banking and financial services likely would be especially hard hit, both by a downturn in borrowing and a narrowing of profit margins, or spreads, according to the S&P analysis.

“In general the feeling is if we do enter a deflationary spiral like the 1930s — which we don’t expect - there is no place to hide,” Stovall said.