Will Goldilocks Win the Inflation Debate?

A huge debate has split investors into two camps: those who believe that deflationary pressures will lead us into another Great Depression, and those who fear that huge amounts of government stimulus will cause inflation on a scale we haven't seen for 30 years. But if you look to the credit markets for a sign of which way prices may be headed, things couldn't look more normal.

Putting their money where their mouths are
Predictions of future inflation are all over the map right now. One place you can look for objective figures is the Treasury bond market. Specifically, you can choose from two different types of bonds: traditional bonds that simply pay regular interest and pay back your original investment at maturity, or special bonds known as TIPS, which are indexed to inflation and pay you an inflation-adjusted amount at maturity rather than simply returning what you initially invested.

If you compare the yields across both types for a given maturity date, you'll get the market's prediction for what inflation will be over that time frame. Here's what those predictions are right now:

Source: WSJ, author calculations.
Based on Treasury yields as of July 13.
*Annualized.

None of those calculations looks particularly scary in either direction. In fact, policymakers would likely see an inflation rate around 2% as close to perfect in terms of promoting growth while avoiding any overheating price pressures.

A seesaw in perfect balance
Unfortunately, concluding that this implied future inflation is destined to come in not too high and not too low is going too far. All it tells you is that somewhere around 2% is what market participants expect to see on average. What you can't see from these figures is the dispersion of those expectations.

For instance, say half of all Treasury bond investors expected deflation of 2% annually over the next 10 years, while the other half expected inflation to move up to a 6% annual rate over that period. The average expectation would be around 2% inflation -- but no one would expect that outcome.

Prepare for whatever comes
One solution investors can use is to prepare for both possibilities. Here are some thoughts on how to do that.

First, gravitate toward companies with cash on their balance sheets. Google (Nasdaq: GOOG), Cisco Systems (Nasdaq: CSCO), and Dell (Nasdaq: DELL) have huge cash hoards right now, which makes their stocks a lot more attractive than they might appear by traditional metrics like price-to-earnings ratios. That cash gives them the best of both worlds: It protects them against deflation, but it should start producing substantial amounts of interest if future inflation pushes rates upward.

Second, focus on companies that have the most control over their pricing. Altria Group (NYSE: MO), for instance, has survived huge increases in tobacco taxes over the years precisely because it can pass those costs on to customers and not have them abandon ship. Similarly, General Mills (NYSE: GIS) has retained a strong customer base despite generic competition that's quite a bit cheaper. That's exactly the kind of behavior you want to see if overall prices are moving sharply.

Lastly, for the fixed-income side of your portfolio, mix in some inflation-adjusted bonds with traditional bonds. The iShares Barclays TIPS Bond (NYSE: TIP) ETF mixes well with the Vanguard Total Bond Market ETF (NYSE: BND) to give you an overall bond portfolio that should behave fairly well no matter what happens with inflation or deflation.

Be ready
Even if you can't guarantee a 100% accurate prediction about which way prices will move in the coming years, that doesn't mean you can't invest well. By looking at both sides of the inflation/deflation coin and planning for either outcome, you'll put yourself in the best chance to profit no matter what happens.

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