Deflation or Inflation? Be Prepared Either Way
Just like politics, there is no shortage of opinions out there when it comes to the economy and where things are headed.
Is inflation – a general increase in prices and fall in the purchasing value of money – headed our way? Or is it more likely we will be facing the opposite – deflation – and its decline in general price levels, often caused by a reduction in the supply of money or credit?
While our country has gone through bouts of inflation (most notably in the 1970s, when President Gerald Ford declared inflation was “Public Enemy Number One” and rolled out the Whip Inflation Now (WIN) program), we have not seen deflation on any real scale since the Great Depression. At least one observer thinks that could change. Economic consultant A. Gary Shilling says, “We could see annual economic growth of just 2% over the next decade, as well as significant deflation.” Conversely, others foresee high inflation in our future, caused by high levels of government borrowing in the wake of the financial crisis. With $12 trillion in debt, they predict an inflationary spiral is just around the corner.
So, what is an investor to do? Here are some areas of investment WealthTrust Arizona recommends for our clients, to help protect them either way the economy goes.
Stocks with pricing power
Both deflation and inflation can have adverse effects on the economy. When prices are falling, consumers put off purchases, in anticipation of even lower prices in the future. When prices climb, household purchasing power goes down. In either case, we consider leaning your portfolio towards firms which make or sell products which consumers buy no matter what happens with the economy, such as medicine or groceries. By sticking with dominant players in those areas – companies which are stable enough to pass along price increases to customers without hurting sales –portfolios will contain companies which can maintain earnings growth under most economic conditions.
Cash-rich blue chips
If deflation occurs, portfolios should include shares of large companies which have extensive cash reserves and little or no debt. This is a better strategy than being invested in firms which borrow heavily, because it can be hard for firms to refinance or secure loans in difficult economic times. Also, during times of deflation, companies would be paying back loans with dollars which are increasingly valuable.
It turns out that being invested in cash-rich, blue chip stocks might also be a good hedge against inflation, because they are currently trading at better valuations than other shares, including those of smaller companies.
In the event of deflation, developing markets can provide diversification, because fast-growing nations – such as China and India – are likely to keep growing, in part based on rising domestic demand, even if the U.S. remains stagnant. The Chinese economy is forecast to grow around 8% or more every year for the next decade. Developing nations are leading producers of commodities and raw materials – whose prices tend to keep up with inflation.
One potential hedge against inflation is to own international bonds, from both developed and emerging markets. Many of them allow investors a shot at higher yields than investors can find in U.S. bonds.
When investing in foreign bonds, investors are also making sure that all of their investments are not exclusively held in U.S. dollars. It is hard to predict how the dollar will perform in the event of extreme deflation or inflation, in part because so much depends on how bad the situation is here, relative to overseas. By keeping at least a portion of a bond portfolio in international securities, investors can protect themselves if the dollar falls because of either deflation or inflation.
Commodities and real estate
Although there can be long periods where physical assets like commodities can be stagnant, or actually lose money, they can offer good protection against high inflation over short periods of time. That is because when inflation is high, natural resources such as raw materials, food and oil go up in price, as well.
For example, between 1973 and 1981, inflation climbed at an annual percentage rate of 9%, while the Goldman Sachs Commodity Index had a return of 12.1% a year.
During deflationary times, real assets tend to fall in value, which adds to their risk. It can be argued that this is less of a concern today when it comes to one hard asset – housing – because residential real estate had already been going down in value for years.
The bottom line is whether we are dealing with inflation or deflation, the best reason to invest at least a small portion of portfolio in real assets is to increase diversification. If investors can accomplish that goal, no matter what is happening in the economy, they will be a step ahead of the game.