Deflationary signals are beginning to crop up all over the world and investors need to sit up and take notice of these trends to ensure their portfolios are positioned to effectively deal with the potential onset of such an environment. Deflation is characterized by slumping demand, slower growth, and decreased credit growth which lead to falling prices throughout the economy. There are several investment strategies to help investors during periods of deflationary stress – here are some of the most popular strategies available.
Cash is King
Cash is one of the sure fire investment strategies during the onset of a deflationary cycle. The old cliche “Cash is King” definitely holds its own in these situations. Deflation triggers a mass scramble for cash in anticipation of crashing prices and slumping demand. Its often said that “He who panics first panics best” and this is definitely true in an increasingly overcrowded investment landscape. Having physical cash on hand can be a life saver during extreme periods such as government debt defaults, bank failures and widespread credit market collapse. Having cash can help you remain liquid during tough economic conditions. It means you aren’t overspending on goods that will have lower prices in the future, and you will have capital on hand to buy discounted assets.
There is increasing concern about the value of fiat currencies globally and the unsustainable deficit and debt positions which most countries currently find themselves in. Many investors are turning to gold and precious metals in order to remain hedge against inflation and deflation – precious metals in this instance are acting like a currency and may also be of interest to certain investors.
Control Credit Risk with Municipal Bonds
Muni bonds generally have decent rates of return and are often backed by tax raising powers of the state or county issued – this leads to low default probabilities which is a highly sought after quality during periods of deflationary stress. Longer term bonds in general are a good investment strategy but you need to be careful about the credit ratings of certain companies. Companies which currently enjoy “A” rated debt securities can deteriorate quickly in a slow economy.
Avoid big ticket purchases
Large ticket items, especially if bought on credit like household goods, cars, trailers, and boats are unlikely to be wise purchases during the onset of a deflationary environment. Leverage as a general should be avoided during such periods. The problem with such purchases is that prices are likely to fall during an episode of deflation within the economy. This results in debt repayments on a depreciating asset over a potentially long time horizon. Under such a scenario you are effectively paying back dollars that are worth more than the ones you borrowed.
Reduce Debt
Paying off your existing debt can be one of the most important forms of investment during a periods of sustained deflation. As prices fall throughout the economy, the purchasing power of money increases which ultimately leads to your debt becoming more expensive. By increasing your debt repayments every month, you are effectively investing for the longer term by decreasing the value of your debt burden.
Invest in companies with large stockpiles of cash
The stock market is generally a place to avoid investing when facing the threat of an oncoming deflationary shock. Some stocks however will provide a level of security. Companies with large cash stockpiles are the most likely to benefit, as they face less pressure to deleverage. In a deflating environment such companies may be able to pick up cheap assets, as their competitors struggle with high debt burdens, solidifying their position within the market.
If history is any judge, stock markets tend to get hammered during the initial phases of a deflationary shock no matter how much cash or liquid assets they have on their books. With current stock market valuations at record highs, it’s unlikely that any stock would hold up to the violent selling pressure that a deflationary shock would create. The value of such stocks tend to come into their own during the second phase of a deflationary environment when the overall market has had time to adjust to the new economic realities, and rational investment allocation decisions begin to resume.
Overall, deflationary economic environments require investors to position their portfolios into more liquid, easily transferred securities. Deleveraging while there is still some semblance of market normality is often prudent as once a full scale deflationary spiral starts to unravel its often hard to avoid being caught up in increasingly irrational market moves.
Andrew McCarthy is an expert in all things inflation. He has a Bachelors in Economics and has been working in the finance industry for over two decades.
