Before the onset of the current recession and stock market slump, the biggest fear among investors was that inflation would rear its ugly head again.
But now investors are worrying about the flip side of that coin. Some fret that deflation Ñ widespread falling prices Ñ may be lurking around the corner. Since falling prices mean that goods and services cost less, which should be good for consumers, what's the problem?
The reason to worry is that as companies lose pricing power, their earnings will suffer and their stock prices will decline even more. To cut costs and stay solvent, they will slash jobs and wages.
This decline in corporate and consumer incomes would in turn sap demand, sending prices plummeting even lower. Real estate Ñ one of the few bright spots in the current economy Ñ eventually would crumble.
The only investments that would retain their value would be ultra-safe bonds, such as U.S. Treasury securities or top-rated corporate debt.
In short, deflation is 'the ultimate nasty thing that can happen to your assets,' says Tige Harris, chief investment officer in the Portland office of U.S. Trust Co., a private bank and investment management firm based in New York.
Luckily, the latest economic tea leaves make deflation appear less likely than earlier in the fall. For one thing, the stock market has rallied during the last month, though whether the rebound has staying power is anyone's guess.
Also, the recent news that the Consumer Price Index for October rose by 0.3 percent.
It's a case of a little bit of inflation being good news.
In predicting deflation, the pessimists argue that we are heading down the same road as Japan, which is in its fourth year of declining prices even though interest rates there are close to zero. Japan's central bank has not been able to jump-start the economy, and stock prices have stagnated for a decade.
But Jeffrey Grubb, managing director of the Portland office of U.S. Trust, believes that the comparison is overstated.
For one thing, he says, the Japanese banking system 'perpetuated the problem of bad loans' to troubled corporations by failing to take action on problem loans. That hasn't been the case here, he says.
Furthermore, the Japanese real estate market collapsed.
Finally, adds his colleague Harris, the Japanese population is older and growing more slowly than the U.S. population.
Grubb does note that deflation has occurred in certain pockets of our economy, such as the consumer electronics and telecommunication industries, for years. But this limited deflation has benefited consumers, who have been able to get cheaper goods and services from those sectors.
'It's just when there is deflation in the entire economy, and the economy cannot generate enough profits to cover its debt' and get out from under, that deflation poses a systemic problem, Grubb says.
A simple strategy
If you side with the pessimists and believe that deflation is coming, your best investment strategy is simple: Cash is king.
You should hold as much cash, or 'cash equivalents' such as money market funds, as possible and lighten up on assets, such as stocks, which probably will lose value. Sitting on a hoard of cash while prices are falling effectively boosts the purchasing power of your money, since the longer you wait the less you have to pay.
Another good investment for a deflationary environment is gold (or gold funds), which serves as an international medium of exchange that tends to hold its value during uncertain times.
With deflation, the corollary to this investment strategy is to avoid debt whenever possible. That's because your declining income (because of lower wages, lower dividends and lower interest rates) may make it difficult, if not impossible, for you to repay your obligations. So, whittle down any outstanding credit card balances.
And if you are refinancing your house, be careful to refinance only what you owe now. Don't increase the balance of the loan to cover other items, since your indebtedness may exceed the value of the underlying assets before long.
'You're left with debt that
doesn't deflate, and other things that do deflate,' Grubb notes.
Investors who fear deflation but still want to have some exposure to equities should apply these same principles in selecting stocks.
'If you believe deflation is coming, you want to invest in companies that have reduced their own levels of debt and can generate plenty of free cash flow,' Grubb says. Companies with such financial characteristics include Microsoft Corp., Intel Corp. and Home Depot Inc., his colleague Harris says.