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
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
Total Debt/Assets, (%)
Source: Google Finance Stock Screener.
On the other end of the spectrum, very safe-yielding assets like iShares 20+ Year Treasury ETF
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.