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Protecting Your Portfolio Against Deflation

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Investors don't seem worried about a deflationary death spiral, but given the fears of some at the Fed, it's prudent to consider the risk.

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The worry on Wall Street has changed: Inflation concerns have turned to deflation fears.

Fed officials are now clearly spooked about a Japanese-style deflationary scenario, a prospect raised last week by James Bullard, the President of the Federal Reserve Bank of St. Louis. In a paper, Bullard wrote:

Promising to remain at zero for a long time is a double-edged sword. The policy is consistent with the idea that inflation and inflation expectations should rise in response to the promise, and that this will eventually lead the economy back toward the targeted equilibrium... But the policy is also consistent with the idea that inflation and inflation expectations will instead fall, and that the economy will settle in the neighborhood of the unintended steady state, as Japan has in recent years.


Check out the paper for yourself here.

Deflation refers to a prolonged decline in wages and prices, which can cripple an economy as consumers delay purchases because they come to believe that prices will keep falling. This leads to excess capacity and inventories, forcing down prices even more and motivating you and your neighbors to further put off buying goods and services.

The Fed now fears this dangerous downward spiral: Already, the CPI and PPI excluding food and energy are running at about 1% inflation rates year-over-year, below the Fed's implicit target of 1.5% to 2%.

Yesterday brought more data for deflationists to mull over: Personal income, spending, and core consumption were all logged as flat in June, undershooting expectations. This news weighed on retail stocks, with Target (TGT) down 1.5% and Kohl's (KSS) down 4%. (Hat tip: Markman Capital Insight.)

Are we destined to fall into a deflation trap?

On November 21, 2002, before the National Economists Club, then Fed Governor Ben Bernanke outlined a few policy cures for deflation: a commitment to holding the overnight rate at zero for some specified period; ramping up the printing press; and one bullet he hasn't yet fired, specifically for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt. (Hat tip: Yardeni Research.)

Read Bernanke's speech here.

Some of the world's leading investors, however, aren't betting that Bernanke and his PhD-carrying crew of central bankers can necessarily come to the rescue. The Wall Street Journal reported this week that heavy hitters -- including Bill Gross, Jeremy Grantham, and hedge-fund managers David Tepper and Alan Fournier -- are worried about deflation and are reshaping their portfolios in response.

"Deflation isn't just a topic of intellectual curiosity, it's happening," said Gross, who captains the $239 billion mutual fund Pimco Total Return Fund.

Right now, investors don't seem to share those worries about a deflationary death spiral. In fact, over the past month, the SPDR S&P 500 ETF (SPY), which includes holdings like Exxon (XOM), Apple (AAPL), Microsoft (MSFT), General Electric (GE), and IBM (IBM) is up nearly 10%.



Still, given the fears of some at the Fed, it seems prudent for individual investors to consider some of the ways in which they could adjust their portfolios in response to the risk of deflation. It's a question we first raised a year ago and, given the current headlines, seems worth revisiting.

Mike Shedlock, a registered investment adviser for Sitka Pacific Capital Management and dedicated member of the deflation camp, urges investors to line their portfolios with long-term Treasury bonds.

"I believe they are attractive here," Shedlock says, "especially with all this talk of quantitative easing now coming out of the Fed. Frankly, the deflationary forces are so powerful that even without the Fed resorting to quantitative easing, Treasury yields are coming down."

The benefits: In a deflationary environment, investors will flee to the perceived safe haven of government debt. Also, the fixed-income stream would be worth more relative to falling prices.

Treasury bonds performed very well in the first half of the year. Treasury bonds of 30-year maturity returned 13.4% in appreciation in the first half plus 2.3% in coupon yield for a total return of 16.7% as their yield dropped from 4.6% to 3.9%, notes Dr. Gary Shilling, the economist, strategist, and president of A. Shilling & Company.

Shilling recently told his clients that he's looking for 30-year Treasury bonds to rally to 3% yields as slow economic growth of about 2% prevails and chronic deflation sets in. At 3% yield, "the bond rally of a lifetime" -- as Shilling calls it -- would be over, but with 2% to 3% deflation, the resulting 5% to 6% real returns would be still remain very attractive, he says.

Treasury bonds are available through security brokers, banks, and www.treasurydirect.gov as well as via ETFs like iShares Barclays 20+ Year Treasury Bond (TLT).

Shilling also advises investors to think about committing capital to high-grade munis, corporates, master limited partnerships, and preferred stocks, which can be played with an ETF like the iShares S&P U.S. Preferred Stock Index Fund (PFF).

On that same theme of capital preservation and income generation, deflationists advise investors to buy income-producing stocks including utilities, drugs, and telecoms with high, safe, and rising dividends.

Morningstar's favorite dividend-focused ETF is the Vanguard Dividend Appreciation ETF (VIG). The fund boasts a low expense ratio of 0.23%. In addition, the large profit margins, relatively stable revenues, and low leverage of the companies in the portfolio, Morningstar analysts say, make it well-suited to surviving a protracted economic slump while awaiting recovery.

Shedlock says that maintaining a slug of cash makes sense, despite the near-zero yields in the money markets. Zero is still better than negative returns, he emphasizes.

"The idea," the investment advisor says, "is to save your cash for better opportunities."

Finally, let's talk about everybody's favorite metal: gold. Today, columnist James Stewart urged his readers, as they adjust their portfolios to manage the risk of deflation, to reduce their exposure to the barbarous relic.

Shedlock disagrees: The yellow metal will benefit, he says, from reflationary efforts by the Fed.

"No doubt, the Fed is going to react as the economy turns down," he says. "They are going to attempt to put liquidity back into the market. One of the things still in a long-term bull market is gold. It's heading back to $2,000. A percentage of your assets in gold makes sense."
No positions in stocks mentioned.
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