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This article was originally published Nov. 21, 2008, as the deflation scare in the United States was beginning to gain some traction. Since that time, the major central banks around the world have gone to extreme measures to fight deflation and its negative economic effects.
It has now been six months since that initial scare, and the March PPI and CPI numbers continued a trend of negative inflation measures.
This PPI number was the fifth in seven months to show negative producer price growth. And the March CPI number showed the first annual decline in consumer prices since 1955
As central banks in Europe and the United States continue to fight deflation, I think it is useful to talk about what deflation is and how it is possible to profit from it. Although deflation can be extremely disruptive to an economy, it has happened before, and if you know what to look for it may be the source of opportunity rather than hazards.
Four of the major symptoms of deflation are:
1. A trend toward lower consumer, commodity and producer prices.
2. Falling consumer demand and spending with increased savings rates.
3. A tighter credit market.
4. Negative risk-adjusted rates of return. (Have you checked your 401(k) lately?)
Ultimately, deflation represents a shift from spending and investing to interest and savings. You can judge for yourself whether we are seeing the signs of deflation in the U.S. and European economies.
The reduced aggregate demand in the economy ultimately reduces prices, which increases buying power or “deflates” the currency. In this situation, savers benefit because the value of cash and cash equivalents increases. Borrowers suffer as the money they spend on debt service and interest costs them more. Deflation is like a tax credit on savings and a penalty on interest.
One of the reasons deflation is feared from an economic perspective is because so much growth is funded by debt and leverage.
If debt becomes cost prohibitive and investors are unwilling to take larger risks, then companies built for an inflationary economy can’t grow like they have in the past. This is bad for most stocks.
Click here to watch a video where I will show an example for why deflation would hurt even strong stocks like Apple (AAPL) should it continue to spiral.
Prepare Your Portfolio for Deflation
However, despite the risks, deflation is not necessarily all bad if you have prepared your portfolio for it. And I will walk you through some of the things savvy investors should consider if deflation starts to take a real hold on the economy.
Another side benefit of the current economic trend is that we have a great deal of information from the Fed’s management team about how they would deal with deflation should it occur. This can provide a certain amount of prescience for managing your portfolio.
For example, here is an excellent article written by Ben Bernanke, before he was the Fed chairman, about deflation and how he suggests the Fed should deal with it. It is an interesting read now that we have seen what he has done so far as Fed chairman to fight deflation over the last six months.
Ways to Profit From Deflation
The signs of a deflationary period, including a preference for cash and cash equivalents, falling consumer spending and a bearish equity market, are all here.
This doesn’t mean that deflation is currently in effect, it just means we may be heading there.
We suspect the Fed and other major central banks will continue to fight this possibility, but it doesn’t mean we can’t turn those risks into a few opportunities.
For example, the yield on the 10-year note is still at multi-decade lows. Demand for safer assets, cash equivalents and the expansion of the Fed’s balance sheet is driving the value of government bonds up and yields down.
The bull market in bonds is available for retail traders through exchange-traded funds (ETFs), savings bonds, and government notes and bond futures.
In the following video, I will go into more detail about how these work and why they may be an attractive way to diversify your portfolio. (For more information about how ETFs work, click here.
This is just one illustration for how you can turn the effects of a shift in assets toward cash and away from growth-oriented assets like stocks or commercial bonds to your advantage. In the next article in this series we will discuss some other alternatives.
John Jagerson is a contributor to LearningMarkets.com. To learn more about him, read his bio here.
This article originally appeared on the Learning Markets Web site.
