Are You Prepared for Deflation?

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As 2011 begins, we here at the Fool can't stop debating one important question: "Is our economic future heading for inflation or deflation?" Correctly answering that question would save us and our portfolios from a lot of anguish.

The folks at Hoisington Management have found that knowing the change in future price levels can significiantly help forecast the performance of stocks relative to bonds. And right now, markets have never been more uncertain about where the future price levels are going. On one side, you have people clamoring about governments printing money and commodities rising  in value. On the other side, you have people calling for the worst in terms of defaults and spending cuts.

Well, my crystal ball keeps showing me deflation. Although it's generally a rare phenomenon, deflation has been known to persist during periods with large declines in demand. And right now, I see a lot of global demand that just doesn't appear sustainable. Here are three of my biggest concerns.

1. Budget deficits. The five largest economic blocs (U.S., Europe ex Britain, Japan, China, and Britain) had combined deficits of approximately $3.06 trillion U.S. in 2010. That's just less than 5% of world GDP. And while you may think the U.S. may resort to the printing press, other governments have their hands tied. Europe is limited by its integrated currency, and China already has inflation racing ahead at more than 5%. Should governments be forced to raise taxes or cut spending, there will be a significant drag on global demand.

2. The crisis of the PIIGS. Portugal, Ireland, Italy, Greece, and Spain. History has taught us that an economy with a fixed and mobile currency facing an emergency can be a terrifying situation. Somehow, Europe has managed to multiply that nightmare fivefold, endangering a combined $4.1 trillion in GDPs.

So far, only government intervention has kept the PIIGS' depositors and creditors from losing faith and pulling their money out en masse for the relative safety of other Euro members. An exodus of capital from banks like National Bank of Greece (NYSE: NBG  ) would choke off the entire economic activity of that country. In effect, it would be a run on a country, which would have disastrous consequences for short-term world demand.

3. China. There are a host of reasons to be excited about China, but also a few short-term causes for concern. The most pressing concern is China's huge fixed investment program: New investment in buildings and equipment accounts for more than half of each year's GDP, or more than $3 trillion. Unfortunately, a lot of this is starting to look unsustainable. With China's property market already looking overheated, and overproduction already present in several product categories worldwide, don't be surprised to see some volatility in this portion of China's economy.

What deflation means for you
Whether you're in stocks or bonds, the deflationary threat from these three scenarios should give every investor something to think about.

Deflation is generally a menace to your stock market performance. Stock market valuations generally do not forecast scenarios of lower prices and revenue, and because costs are generally sticky, the first line item to take a hit are the profits.

Highly leveraged businesses can be particularly susceptible. All of a sudden, they find the real value of their debt increasingly burdensome. Companies that barely cover their interest expense, or which have a large percentage of debt relative to their assets, may find a deflationary environment devastating.

High-debt, low-coverage businesses

Company Name

Market Cap

Total Debt/Assets, (%)

Interest Coverage

Revlon (NYSE: REV  ) $522.32 million 153.9 1.54
Rural/Metro (NYSE: RURL  ) $369.69 million 90.91 1.37
Ferrellgas Partners (NYSE: FGP  ) $1.92 billion 83.51 1.56

Source: Google Finance Stock Screener.

On the other end of the spectrum, very safe-yielding assets like iShares 20+ Year Treasury ETF (NYSE: TLT  ) are most likely to benefit; their real yields would rise as prices fell.

Investors concerned about the already low yields on Treasuries should consider this: Contrary to intuition, Hoisington's researchers found that bonds have actually outperformed in periods with low beginning nominal bond yields.

Fool contributor Nick Nejad does not own shares in any of the above companies. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (6) | Recommend This Article (6)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 24, 2011, at 5:46 PM, ChrisFs wrote:

    You don't answer the question of inflation vs deflation at all. You simply throw out three concerns and then immediately jump to deflation as the answer with no explanation in between.

    There aren't many signs of deflation for 2011.

    Budget deficits are usually a warning of inflation.

    Interest rates in the US are the lowest they have been for decades and they can't get much lower, so it's unlikely that Treasury bonds are going to be a good buy anytime soon. Bill Gross of Pimco has echoed that same sentiment.

    There are signs of a gradual recovery. Unemployment has stopped increasing at the same rate, consumer confidence is better than last year. If a recovery takes hold, the eventual problem will be inflation not deflation.

  • Report this Comment On January 24, 2011, at 5:51 PM, mountain8 wrote:

    the essential problem is government.

  • Report this Comment On January 24, 2011, at 6:02 PM, xetn wrote:

    By deflation, I assume (I know bad word) you mean price deflation. The real meaning of the words inflation and deflation refer to the supply of money and the results of differing amounts of money can and does affect prices of various goods and services.

    A recent post indicates that banks have started to lend freeing up those excess reserves that were created by the Fed purchasing all of those nasty toxic assets. Those excess reserves being held by the banks (are receiving interest from the Fed) have helped stave off price inflation.

    However since last June, prices of all kinds of commodities have risen very rapidly (oats and corn around 70-80%) not to mention oil and precious metals. Inflation is on the rise as indicated by indicating current inflation around 8%. There are various sectors that are experiencing price deflation like the housing market. And that sector is certain to get worse in the near future.

    But with banks starting to lend and the Fed creating another 600 billion in new money I am quite sure we are in for some really rapid price inflation.

  • Report this Comment On January 24, 2011, at 7:58 PM, Kiffit wrote:

    I tried to email this article to my wife. Your security word caption system completely defeated me. I gave up after 20-30 goes.

  • Report this Comment On January 25, 2011, at 4:18 PM, JSniden wrote:

    Nice article. Ralph Whitworth, founder and principal of Relational Investors LLC, runs the $2.2 billion activist investment fund, which was founded in 1996.,28804,16110...

  • Report this Comment On January 26, 2011, at 2:54 PM, jrj90620 wrote:

    I can't believe anyone still writes about deflation.Show me a country with an honest currency and I will show you a country that could have deflation.I don't see any countries using honest currencies.

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