Levente Mady, managing director of derivatives at Union Securities Ltd. at his office in Calgary, Monday, Oct. 18, 2010.(Jeff McIntosh/Globe and Mail)Jeff McIntosh/The Globe and Mail
Ian Gordon makes a hair-raising case that the United States is in deflation's grip.
The U.S. money supply is shrinking, the rate at which money changes hands is slowing, core consumer price inflation is zero, residential real estate prices are down 29 per cent, commercial real estate is even weaker, the real unemployment rate, including discouraged workers, is 16 per cent and pension plans are so under water they won't be able to cover retirees' basic needs.
So large is the nation's debt that the U.S. economy will not recover until the debt is "washed away" by borrowers defaulting and lenders failing.
Mr. Gordon, publisher of the investment newsletter Long Wave Analyst, is a follower of Nikolai Kondratieff, who believed the economy moves in long, wave-like cycles - winter, spring, summer and fall. As he sees it, the ground is freezing and the snow is about to fall.
He outlined this frightening prospect in a recent interview with Jay Taylor of Miningstocks.com, posted on thelongwaveanalyst.ca website.
It's an extreme view - one that few economic forecasters share - and frightening enough to send investors scrambling for long-term federal government bonds or cash. So what is Mr. Gordon investing in now?
Junior gold stocks. Gold miners did very well during the Great Depression even though the price of gold bullion was fixed at $35 (U.S.) an ounce because the cost of mining - mainly energy and labour - fell.
Growing uneasiness about the near future and the dangers that lurk, especially south of the border, is useful to focus attention on the fundamental rule of all investing - preservation of capital. As money manager Adrian Mastracci asks yield-hungry clients: "Do you want a return on your investment or your investment returned?" Mr. Mastracci is president of KCM Wealth Management Inc. in Vancouver.
Deflationary signs are flashing in the bond market as well.
"The bond market is saying the main concern over the next three to five years is deflation," said Levente Mady, managing director of derivatives at Union Securities Ltd. in Vancouver.
Indeed, IBM was able to borrow $1.5-billion (U.S.) for three years over the summer at 1 per cent. Last month, Mexico borrowed $1-billion (U.S.) at 6.1 per cent for 100 years.
So how does one invest for deflation?
"It depends on how dire you think deflation is going to get," said Michael Crofts, lead portfolio manager, bond and money market funds, at Mawer Investment Management Ltd. of Calgary. Mr. Crofts is not in the deflation camp.
In a weak economic environment, investors will want to hold fixed-income securities because yields will be falling and "there will be good returns to be had," Mr. Croft notes. He recommends high quality dividend-paying stocks as well.
"If deflation is moderate, investors will do fine in utilities and telecoms," he says - defensive stocks that can withstand a slowing economy and even deflation. "But talking about severe deflation, you'll want to be retrenching out of equities and corporate bonds into government bonds."
Mr. Mady of Union Securities is recommending investors stick to medium term, highly liquid Government of Canada 10-year bonds yielding about 2.75 per cent. "If there's further deflation, you'll be able to capture some capital gains."
The bond market has a reputation for seeing into the future, sensing shifting price trends, sniffing inflation months if not years before it becomes apparent. Misreading it can prove ruinous for investors. Right now, though, the message it is sending is not clear.
Mr. Crofts and his colleagues at Mawer wonder whether bonds are really signalling deflation. U.S. inflation-linked bonds, known as TIPS or Treasury Inflation Protected Securities, are signalling inflation of 1.7 per cent a year for the next 10 years, Mawer indicated in a recent newsletter.
As well, money is flooding into the bond market as a safe haven, as aging baby boomers and pension funds shift from stocks to bonds and as Asian countries and American banks load up on Treasuries, Mawer says. "The point is that low yields do not necessarily signify deflationary expectations."
Mr. Mady sides more with deflation, arguing that bond yields may have more to do with the declining credit quality of the U.S. bond market than with inflation expectations. "With the huge deficits the U.S. government is running, perhaps the real interest rate premium the bond markets want is rising."
Rob Boeckh, co-editor with his father Anthony Boeckh of the Boeckh Investment Letter, is also suspicious of the bond market. Anthony Boeckh is former editor of the prestigious Bank Credit Analyst and author of The Great Reflation: How Investors Can Profit From the New World of Money.
The bond market has been "heavily distorted by government intervention," Rob Boeckh says. "Quantitative easing (the Fed buying bonds) and a healthy appetite for Treasuries will keep a lid on bond yields for the foreseeable future."