Gradually over the last month, the drumbeats around deflation have been getting louder. More and more serious economic commentators now accept that this is a more serious and immediate threat to the US economy than inflation. In the last weekend alone, there were more than half a dozen articles on the topic in the mainstream print media in the US. Many commentators now worry about deflation in the near term and then eventually inflation as authorities globally put policy measures in place to fend off the deflation bogey. Signs of deflationary worries in the markets are spreading.
The yield on the two-year note is at a record low of 0.5 per cent, and the 10-year note is at a 15-month low of 2.82 per cent. The bond market seems to paint a far more worrying picture on the outlook for the US economy than equity markets. These markets are not pricing in any fears of oncoming inflationary pressures. The Fed funds futures contract suggests the first move on Fed tightening will take place only in August next year. Year to date, the best returning security in the US has been the 30-year zero-coupon bond, and bond markets have beaten equities hands down. Inflation expectations as measured by the yield on five-year Treasury Inflation-Protected Securities(TIPS), have sharply dropped from their peak of 4 per cent in mid-2008 to less than 0.5 per cent today. Another pointer to market fears around deflation is the rising correlation between bond yields and stock prices. We have been taught that the traditional relationship between bond yields and stock prices is an inverse one, when bond yields rise, equities fall and vice versa. Today, however, the correlation has turned positive, in that falling bond yields are causing equity markets to weaken, with markets hoping for rising yields. This positive correlation has a few historical precedents, all periods in which deflation was either a reality or distinct fear.
Deflation fears were also highlighted recently when regional Fed president Bullard warned of the US economy getting caught in a Japanese-style deflationary outcome over the coming years. Wall Street is full of rumours of the Fed setting the stage for quantitative easing Part 2, some sort of a trillion-dollar package designed to benefit home-owners with negative equity. Fiscal stimulus of some type to kickstart the economy and job creation seems inevitable, despite severe political opposition.
Deflation halts every type of activity as consumers, investors and business people go into a postponement mode in the expectation that costs/prices will only go lower as time goes by, and is thus corrosive to economic growth. Japan is, of course, the poster child of what deflation can do to an economy and markets if it gets embedded in the psyche of the economy and consumers. Consumer prices have been falling in Japan for 15 years now, but never more than 2 per cent a year. Japanese equity markets remain down by 70 per cent from their peak.
Given the fears around deflation and the Japanese experience, the Fed will do all it can to prevent the US economy from slipping down this road. Mr Bernanke and the Fed have extensively studied the mistakes made by the Bank of Japan (BOJ), and are determined to not let it happen in the US. They are prepared to throw everything they can at the problem, as they have highlighted the weak, delayed and unimaginative response of the BOJ as being one of the principal reasons why Japan collapsed as it did.
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While I do believe that Mr Bernanke and company will be able to prevent a Japanese-style outcome in the US, it is worth thinking about how investing will change if deflation were to truly emerge. This is not a type of investment environment that many in the US or Europe have experience with.
First of all, cash is king becomes the operative buzz word, as capital preservation trumps any attempt to make a return on capital, and cash is one of the very few safe investments you can make in this scenario. Cash will also give you huge options in an environment where asset prices are tumbling and distress sales common. Anyone trying to move down the quality curve in search of yield will get punished mercilessly.
Short highly leveraged equities, as companies will find it very difficult to generate enough cash to pay off debt, and refinancing will become constrained. In a deflationary environment where prices, margins and cash flows are declining, debt of any type is a killer as real interest rates get magnified, and debt burdens in real terms keep rising. The days of leveraged buyouts will be history, and companies will focus on rebuilding balance sheets. Banks will also have a tough time as credit quality issues surface and credit demand weakens.
Avoid real estate, rent property rather than own, as prices will come down and foreclosures will spike. Anyone with a heavy property exposure will simply drown in the debt. Go long the dollar, as the economic and balance sheet uncertainty surrounding a deflationary period should make the greenback hold up well.
Go long technology stocks, as these companies have experience in handling falling end-product prices. Technology pricing curves are continuously downward sloping, and thus the whole business model is designed to handle negative average selling prices. Tech companies are also very cash-generative, and thus have no debt overhang. Other industries will have to ramp up investments in technology so as to adapt their business model to falling prices, and cut costs. Productivity-enhancing and cost-cutting tools like technology will be in demand.
Buy long-term bonds as another alternative to cash. As the Fed eases to fend off the deflationary threat and bond yields decline, the underlying bond should hold its value. While equities are in general to be avoided, high-quality, dividend-paying companies may still hold their value, if they are debt free, can sustain their dividends and have dominance and pricing power in their respective industries. Short leverage in any form, as deleveraging will be a dominant theme across asset classes.
While deflation may be a risk for the West, in the emerging market world, inflation is a far greater bogey. In an inflationary environment, your asset class selection is almost exactly opposite of what has been outlined above. In inflationary periods, cash is trash, and one should go long real assets like metals and oil, while leverage is cheap and to be embraced. Given current yields, fixed-income investments will be a disaster in an inflationary environment, and one should be short.
Given the two-speed world we are in, and the differing risks to each, investors may have to handle investing in the emerging world very differently from how they position their portfolios in the West. It will be interesting to see how investors balance the investment styles and asset allocation frameworks needed to succeed in the competing scenarios.
The author is the fund manager and chief executive officer of Amansa Capital