Should We Worry About Deflation Or Inflation?

Published in Investing Strategy on 7 April 2009

Savers and investors are faced with a dilemma at the moment. Will the price of goods and services rise or fall?

Investors currently face two major threats, but the good news is we will only have to tackle one of them at a time.

The bad news is we don't know which one it will be. And since the two are diametrically opposed, it is hard to know how to prepare yourself.

This double menace is inflation and deflation, and both pose serious dangers to your portfolio, but in very different ways.

Choose your sides

Deflation is widely seen as the most immediate threat, as banks refuse to lend, businesses cease to invest, consumers stop spending and house prices continue to plunge.

But a small if noisy band claim self-serving politicians and City bankers have summoned up the false spectre of deflation to justify their multi-billion dollar banking bailouts.

They argue that rising food costs, the collapse of sterling (which pushes up import prices), and a reckless policy of expanding the money supply through quantitative easing is stoking up inflation instead.

All it needs now is something combustible to set it ablaze -- oil, perhaps, if cash-strapped producers slash production and force up the price of a barrel of crude.

Choose your ism

Both camps leapt onto last month's inflation figures to back their arguments. The deflationists pointed out that the retail price index, which includes monthly mortgage repayments, fell to zero.

The inflationists roared that the consumer prices index (CPI) surprised everybody (except them) by rising to 3.2% and has been above the Bank of England's 2% target for 17 months.

You could argue this all night, but what does it mean for investors?

Down we go

People started panicking about deflation before inflation, so let's take that first. In times of deflation, the cost of living falls, which seems nice, until people stop spending because they expect prices to fall even further, and the economy screeches to a halt.

Job cuts follow, panicky consumers spend even less, and the deflationary spiral sucks everybody into the vortex.

Deflation is dismal news for homeowners, because property values fall while the debt rises in real terms. If you have money to spare, this is a good time to pay down any debts.

Deflation is also lousy news for stock markets, which typically perform poorly in a downturn, says Jasons Collins of Maia Capital. "But there will be some winning companies over the longer term, and at current valuations they will make a great long-term buy. This includes defensive stocks that are not sensitive to the economic cycle, and the strongest companies in more cyclical sectors that will take market share from weaker players that fail."

Investors should steer clear of companies with stacks of debt, which may include traditionally defensive utilities whose earnings can fall in times of deflation.

Government gilts are an attractive hedge against deflation, but they are expensive right now, pushing yields to historical lows.

Corporate bonds are another option, but stick to investment grade bonds, because company defaults inevitably increase in a downturn. Cash may even return to favour, because if prices are falling in real terms you don't need a great return to protect the value of your money.

Up we come

If you've got a large mortgage or other debts then inflation is much better news, because it will steadily erode their real value. House prices also tend to rise, so more good news for homeowners.

Inflation is also a boon for the government, because it will devalue the mountain of debt obligations racked up by their stimulus plans. Some fear this will make them slack about keeping inflation in check.

But it isn't all good news, just ask anybody who lived through the 1970s. It pushes up the cost of living, fuels higher interest rates on mortgages and credit cards, and impoverishes any pensioner living on a fixed income.

But it is better news for equity investors, because rising prices boost nominal company profits and share prices, Jason Collins says. "Inflation usually coincides with periods of economic boom, helping profits grow in real terms too. On the flip side, higher interest rates can be bad news for corporate bonds and fixed-coupon government bonds."

If it's not one thing...

Although we will only have to tackle these threats one at a time, we might still have to tackle them both, one after the other. Deflation first, then inflation.

Deflation is the short-term risk, but inflation is likely to be the long-term enemy, particularly if governments fail to bash it on the head of the moment it appears.

The dilemma for investors is that a strategy to protect against deflation (clear your debts, be cautious on equities, seek fixed interest) is the reverse of what you need in times of inflation (buy property and shares, dump fixed interest and cash).

Worryingly, both deflation and inflation will increase the risk of investing in individual company stocks, by aggravating the difference between the winners and losers.

So be prepared to adjust your portfolio when it becomes clearer which of the two is likely to pose the greater danger.

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