Investing During Deflation

How quickly things change. A few months ago, the big fear was inflation as gas, food and other prices climbed drastically. Suddenly deflation is on the minds of governments and central banks - see Canada Faces Deflation Threat from Canada.com.

Deflation is the opposite of inflation. Instead of rising prices, deflation is generalized and persistent falling prices, reflected in negative changes in the Consumer Price Index. With deflation, a dollar tomorrow is worth more than a dollar today.

Just as inflation presents challenges and opportunities for the investor, deflation does too. The investing winners and losers differ, and thus also the investments to survive and thrive in that environment.

Creditors (those who have lent out money) benefit, and debtors (those who have borrowed) suffer. Owning debt securities pays off, even when interest rates may be low since part of the payoff is that the future dollars are worth more. The longer the debt lasts and deflation continues, the greater the benefit, so longer maturity debt benefits most.

However, the conditions that create deflation, like a precipitous fall in demand in a weak economy with attendant job cuts, business failures and such, also considerably raise the risk of default. The safer the debt, the better. At the top of the list is government debt or government-guaranteed debt, the theory being that governments can avoid defaulting by raising taxes. Some governments are, of course, more likely to pay your money back than others, the top of that list generally considered to be the US government. Debt rating agencies do rate government debt - see previous post Seeking Safety. Due to risk of default, corporate debt tends to do less well, though debt of companies perceived to have the ability to survive, like many utilities, may be ok.

Sample investments: Government of Canada 30 year maturity (see various options at CanadianFixedIncome.ca), US 30-year Treasuries, GICs

Equity - the debtor effect carries through into companies/equity. Some companies will struggle and others will thrive.

Losers:

• Companies with a lot of debt on their balance sheet.

Winners:

• Companies with lots of cash or free cash flow will be able to acquire the weak at bargain prices.
• Companies able to maintain profit margins will do well. That includes those which can reduce their costs as quickly as their prices fall and those which can maintain their own prices even as prices fall generally.
  

It is impossible to make statements that entire sectors are good equity investments during deflation. The only way ultimately is to dive into the financial innards of each company. The disciplines of fundamental analysis and value investing serve the investor more than ever,

One interesting security that stays fine in either inflation or deflation is real return bonds issued by governments. In addition to their safety, when there is inflation, the government ratchets them up by CPI to maintain purchasing power and when deflation occurs, they go down by CPI, but again their purchasing power stays the same. You neither win nor lose, just get a steady return in real terms. More at ByloSelhi - RRBs.

Though the idea that things might cost less is certainly attractive from a consumer point of view, deflation is symptomatic of problems in the economy. Governments and central banks are highly likely to step in to stop deflation so in addition to the best type of investment, one must consider whether it will actually occur.

Further reading:
Implications of Inflation and Deflation for Investments from Yanni Partners
How Does One Invest for Inflation and Deflation? at Mish's Global Economic Trend Analysis