A Framework That Provides Clarity

During periods of “low visibility,” confusion reigns: for every indication of one trend, there seems to be a countertrend. The key is to glean from the collective wisdom of reliable leading indicators a clear signal that the economy is headed for a turn.



Deflation Worries?

There's been a lot of talk about deflation, in large part because the Federal Reserve broached the subject in statements made in May and June.

It would be a mistake, however, to assume that just because the Fed has warned about the possibility of deflation that we're likely to see it anytime soon. Let's take a minute to talk about just what exactly deflation is. Actually, let's start with what deflation isn't.

The mere fact that prices for some goods or services are falling -- as is the case today -- does not mean we're in a period of deflation.

In order to have what most economists consider real deflation, we must have falling prices virtually across the board for goods and services during which an index like the CPI declines for a sustained period, several years at least. The nation's money supply would shrink during this time and short-term interest rates would get close to or even hit zero, while long-term rates wouldn't be much higher.

It might seem good, but it's not

At first glance, that might not seem that bad. After all, who wouldn't mind paying less for a new big-screen TV or getting cheaper loans? But what may seem like a blessing could become a curse.

During periods of true deflation, consumers tend to hold off on purchases, especially big ones. Why buy a new car now when it will it be cheaper later on? That kind of thinking, multiplied by millions of consumers and businesses, can lead to a drastic drop-off in demand, which can lead to falling revenues and profits for companies, which can lead to layoffs, which can lead to falling wages and income, which could further depress demand and start the cycle over again.

"What's really scary about true deflation," says Lakshman Achuthan, an economist who heads the Economic Cycle Research Institute, "is that it becomes a spiral that feeds on itself." The last time we had a sustained period of deflation was during the Depression. In the three years from 1930 through 1932, prices overall plummeted by about 24 percent, while the nation's output of goods and services fell by 26 percent.

Is it really in the cards for us?

So do we appear to be on the road to anything close to such a situation, or for that matter even a milder version of deflation? At the moment, that doesn't appear to be the case.

As the chart below shows (see link at top of story), the "core" CPI -- that is, the regular consumer price index, minus the volatile food and energy sectors -- has clearly been on a downward trend for a number of years, but it's still in positive territory.

In short, we still have inflation, albeit very low inflation. Another characteristic of deflation is a shrinking money supply and a lack of demand. But on both those counts, we're still looking okay. The money supply is chugging along and consumers, though not dipping into their pocketbooks as aggressively as they were during the economic boom, are nonetheless still spending.

There are other factors that argue for an inflationary rather than a deflationary future as well, such as the tax cut, a rising federal budget deficit and a weak U.S. dollar (which contributes to inflation by raising the price of imported goods). Put all this together, says Lakshman Achuthan, and "deflation is not a clear and present danger."

Achuthan is less concerned because he believes we would need back to back to back recessions in order to create a deflationary environment. And none of his organization's economic indicators suggest anything like that is on the horizon.

Even if the economy did slip into recession, deflation would hardly be a foregone conclusion. That's because the Fed has made it clear it will do everything it possibly can to stave off deflation.

Granted, with interest rates so low there's not a whole lot more room for the Fed to lower short-term rates in an effort to stimulate demand. But in a speech last November before the National Economists Club in Washington, DC, Fed governor Ben Bernanke laid out a variety of other possible moves that could flood the economy with liquidity.

He noted that the Fed could do everything from lending aggressively to private banks to buying longer-term Treasuries to printing more money, and he essentially promised that the Fed would use these methods or whatever else it took to avoid deflation. The Fed has seen the pickle Japan has gotten itself into with deflation, and there's no way it wants deflation to gain even a small toe-hold in the U.S.

All of which is to say that I don't see deflation as a big enough threat for people to start restructuring their portfolios for a deflationary episode.

Some cautionary moves

But if I did believe deflation were more likely, I can tell you the moves I would make. The first thing I'd do is try to pay down my debts as much as possible.

Faced with falling prices and lagging demand, many companies trim their payrolls, which means job cuts. And even those of us lucky enough to keep our jobs during a deflationary period would likely see our wages remain flat or even decline. That means coming up with mortgage and other loan payments could be tough.

As for investments, bonds, especially longer-term bonds, would rule. That's because in the Alice-in-Wonderland world of deflation, things work the exact opposite way they do in the inflationary world.

So instead of seeing bonds' fixed payments become less valuable over time because the overall price level is going up, the value of bonds' interest payments would rise.

That said, however, I would want to stick with U.S. Treasury bonds rather than corporates. If the economy really went into a deflationary spiral, the falling demand would lead to lower revenues and profits for many companies, which means they might have trouble making their bond interest payments. No matter what happens, you know that Uncle Sam is going to make his bond payments, even if it means running the government printing presses overtime to do it.

Investing in stocks during a deflationary period is trickier. Basically, you want to stick with companies that, through innovation, some competitive advantage or other reasons, are able to maintain some pricing power and thus continue to churn out earnings despite falling prices.

If you're interested in the types of companies that might make good bets during a deflationary period, I suggest you take a look at economist Gary Shilling's book, "Deflation: How to Survive and Thrive in the Coming Wave of Deflation."

Don't put your portfolio through contortions

As I mentioned earlier, however, I don't think it makes sense to go through a lot of contortions with your portfolio to prepare for deflation. Ultimately, the chances of the U.S. entering a prolonged period of deflation still seem pretty low.

If those chances increase, I think the Fed wouldn't hesitate to use every anti-deflation tool in its arsenal. And the byproduct of those tools is likely to be higher inflation. Which means, ironically enough, that the threat of deflation could actually lead to a bout of inflation, which, of course, would lead to a whole other set of Fed policies.

In short, by the time you get your portfolio ready to profit from deflation, the real enemy could be inflation. My advice: don't try to outguess the economy and the markets by tailoring your portfolio to one specific economic scenario. You could end up chasing your tail, and incurring lots of transaction costs in the process.