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Ever since the financial crisis hit, many have worried about the coming of a second Great Depression. Yet while the possibility of big future economic problems isn't entirely off the table, there's a much more imminent threat that may already be upon us -- and you need to take steps to make sure your finances can stand up to its challenges.
What deflation means to you
There has been an ongoing tug of war among economists in recent years. Some point to the massive stimulus programs around the world as evidence that inflationary pressure will eventually build to dangerous levels. The argument is that with central banks keeping interest rates extraordinarily low, asset bubbles like the ones we saw in tech stocks 10 years ago, in the housing market in the middle of the decade, and in commodities prices during 2007 and 2008 will continue to occur. Moreover, the gold market, which many see as a gauge of potential inflation, has been hitting record highs on a regular basis recently.
But others argue that there's a much greater danger of deflationary price movements in the near future. The Consumer Price Index, which measures prices for a variety of household items, is actually lower than it was in June 2008. After rising for much of the year, prices on most commodities other than gold have fallen sharply from their highs. Even imported goods could see price reductions, thanks to the explosive rise in the U.S. dollar since last December.
Perhaps most ominously, statistics show that the largest measure of money supply, M3, has actually been contracting. Such contractions are rare and in the past have preceded a shrinking economy, raising fears of a double-dip recession.
But isn't deflation good?
Your first thought about deflation, though, might be that it sounds pretty good. After all, deflation means falling prices, which makes all the things you buy cheaper. With so many people out of work or living on limited income, that seems like it might be the answer to your budget prayers.
There are two problems with deflation, though. First, if prices are constantly falling, you have an incentive to put off buying all but the most necessary things. That can restrain the economy and lead to more unemployment and cut wages -- starting a vicious cycle. Meanwhile, if you have large amounts of debt, they're still fixed at their higher amounts, but it's harder for you to keep making payments on that debt as your income falls.
How to invest for deflation
So, if you think deflation is around the corner, what should you do now? Here are some ways to protect yourself:
- Eliminate debt. Debt is deadly in deflation, so get your personal finances cleaned up while you still can. Moreover, avoid investing in companies that have high debt levels compared to shareholder equity. Boeing (NYSE: BA ) and AMD (NYSE: AMD ) , which have fairly high debt-to-equity ratios, do fine when capital is easy to get. But in deflation, they would be at a handicap.
- Invest in companies with pricing power. When prices are falling, strong brands can still drive sales. So Coca-Cola (NYSE: KO ) and Nike (NYSE: NKE ) , which have some of the best brands in the world, could actually benefit from deflation if they can maintain margins while enjoying lower costs for raw materials.
- Take what bonds will give you. Nobody's excited about 10-year bonds yielding barely over 3%. But if those dollars will actually buy you more than they would now, then the 3% is just icing on the cake.
- Commodities can be deadly. Falling prices can murder commodity investments. So steer clear of Monsanto (NYSE: MON ) and other commodities-related companies, which will see falling product prices have a direct impact on their revenues and profits.
- Keep some cash. When most stocks, commodities, and other hard assets are falling in value, there's nothing like cold hard cash. To beat deflation, keep cash handy for your personal use, and put a premium on stocks including CNOOC (NYSE: CEO ) and Google (Nasdaq: GOOG ) , which have plenty of cash on their balance sheets and can therefore take advantage of lower asset prices.
Lastly, be aware that the greatest fear of the Federal Reserve and other economists is deflation, so you should expect resistance from many fronts to avoid it. If those measures fail, however, and we experience something similar to what Japan has gone through over the past 20 years, then you'll be glad you prepared for the worst-case scenario.
There's one stock that's deflating faster than any other right now. So contrarian Matt Koppenheffer asks: Is BP finally a buy?