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Deflation demands new strategy for investors Add to ...

A sustained fall in consumer prices is a rare, once-in-a-generation occurrence that few investors have ever experienced.

But after three consecutive months where the U.S. consumer price index dipped lower, a small band of investors is mapping out strategies that should offer protection even in a deflationary environment.

While prices did drop for a while last year, it was considered a one-time blip as a result of the recession and a sharp fall in energy costs. The CPI dropped briefly in mid 1950s, and more ominously, for an extended period in the 1930s.

The consumer price news Friday contributed to the big downdraft on North American equity markets, with the Dow Jones industrial average down 2.5 per cent and Toronto stocks down 1.5 per cent. Gold and other commodities joined the rout, while super-safe government bonds, a traditional beneficiary of deflation, rallied.

Deflation is a frightening spectre because of its association with business collapses like those in the Depression, which tend to happen quickly when consumer demand becomes so weak that companies have no ability to raise prices. In the modern era, Japan is the only country experiencing sustained deflation and people have already dubbed the current period "the lost generation."

While few market players have been anticipating deflation, it's been on the radar screen of some investment pros, who say the trend to falling prices is just starting, will have profound consequences, and will require different investment tactics to survive and prosper.

These deflationists are blaming falling consumer prices on the bursting of the credit bubble in the U.S., which is causing the number and value of bank loans and other debts outstanding to shrink - cutting the supply of fresh money to power the economy through such items as new cars and home purchases.

"We're in negative monetary growth and really the only time we've seen that to this kind of extent was in the Depression of the 1930s," says Ian Gordon, president of Longwave Analytics, an economic forecasting group based in British Columbia.

Another tendency that makes deflation worrisome, is that once entrenched, it becomes self-reinforcing, as consumers conditioned to prices declining either stop buying to hold out for even better bargains later, or demand bigger discounts for anything they buy.

Some deflation watchers say this strength sapping economic development is already under way.

"You could go to a cocktail party and tell anybody that you bought a car at full sticker price and you'd be laughed out of the room. Everybody is waiting for rebates and bigger rebates," says Gary Shilling, the eponymous head of A. Gary Shilling & Co. Inc., a New-Jersey based economic consulting firm.

Mr. Shilling was one of the first market players to warn that deflation was a big risk in the U.S., and he expects prices to fall 2 per cent to 3 per cent for years. While the credit implosion is driving part of the trend, Mr. Shilling also says technological innovation, everything from biotech seeds to the Internet, is also helping to drive down prices of goods by creating excess supply.

To be sure, not everyone believes deflation is a done deal. Douglas Porter, an economist at the Bank of Montreal, says it would take a double-dip recession for core consumer prices to begin a protracted downturn. He assigns this only a 20-per-cent to 25-per-cent probability.

"It would take some sustained weakness that leads to another ratcheting up of the unemployment rate that would really crush household and business confidence," he said.

While deflation implies the economy will be down and out, those who believe it's for real say there still are investments that will prosper, and a long list of securities to avoid.

Mr. Shilling thinks long term U.S. Treasury bonds, now yielding 4 per cent, will fall to 3 per cent. If that happens, buyers will be rewarded by gains of nearly 25 per cent from capital appreciation and interest. Mr. Shilling would avoid junk bonds, bank stocks, shares in debt-heavy companies, and commodities. Among stocks, he'd look for companies with stable, safe dividends, like those from drug, utility and telecom sectors.

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Because debts become more onerous in a deflationary environment, Mr. Shilling also says the old personal finance virtues of thrift and loan repayment also make sense.

In deflation, cash is king, says Brett Owens, editor of the Contrary Investing Report market newsletter.

Money automatically becomes more valuable because its purchasing power increases, and Mr. Owens favours holding cash in the form of government treasury bills. He's also shorting the S&P 500 index, hoping to make a profit if it declines, which he thinks it will. "I don't really think there is anywhere safe to be in equities," he says, and he expects the market will again test the panic lows seen in the aftermath of the Lehman collapse.

Deflation may ultimately benefit the value of the U.S. dollar, in part because it will continue to offer a haven and in part because most international debts are valued in the currency. With U.S. debts being written off or repaid because of the collapse of the credit bubble, Mr. Owens said there is a scramble among remaining debtors to buy the shrinking supply of dollars.

A call that is highly debated is whether gold, traditionally an inflation hedge, also works in deflation. Mr. Gordon thinks so, and says that as deflation undermines the faith in financial institutions, the yellow metal will be become a substitute form of money for many investors, driving up its price.



Deflation primer



Deflation occurs when consumer prices fall over long periods. The U.S. economy is showing early signs that it is slipping into deflation.



Experts say deflation is a monetary phenomenon. As debts are paid, or written off, the money supply shrinks. If inflation is having too much money chasing the available supply of goods, deflation is the opposite: There isn't enough money (or credit, its close cousin) available to buy things, causing prices to decline under the laws of supply and demand.



Deflation is feared because it is associated with steep economic downturns, and monetary authorities try to do everything possible to avoid it. It makes debts harder to repay and causes financial institutions to fail. Canadian economic and banking conditions are far more robust than in the United States, and deflation is considered a less likely prospect here.



In a period of deflation, cash is one of the best investments, as are safe government bonds. People should get out of debt, if they can. Most stocks fall. Some gurus are going for gold, betting that deflation will cause a flight from government-issued currencies.

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