The Deflation Specter
While inflation is the perpetual worry of investors, many observers today think that the risk is still that prices will decline in absolute level; in other words, that the U.S. could experience deflation. This was the Fed’s worry for much of the 2008-2013 period, and European policymakers share that worry today. Why are falling prices bad? The usual answer is the interplay of debt and deflation.
Deflation is when the price of everything decreases. If the price of everything is decreasing, the price the debtors are paid for their labor—their wage—is decreasing. At the same time, the debt contracted by the debtor has not changed in value, so the debtor must spend less on other things to keep current on payments.
When these two facets of deflation are coupled, debtors typically have little room for fiscal maneuvering, and the resulting contractionary impact on an economy can be large.
Japan has struggled with falling prices for much of the past 20 years, so it could offer some hints as to how to position a portfolio in the event deflation becomes a problem in the U.S. I took the deflationary period to be the end of 1998 to the middle of 2012, before the current Prime Minister Shinzo Abe—the anti-deflation crusader—consolidated the leadership of his party. The chart below shows total nominal returns over this 13-year period.
The fixed-income world is the mirror of what we found when looking at inflation, which is to say the bond market has the highest returns, and the T-bill market breaks even.
Riskier assets, such as stocks and property, suffered major declines over this long period. The preliminary lesson I draw from Japan’s experience is that long-maturity bonds are the best hedge in a portfolio against deflation.
Sometimes the best tools are the oldest tools.
After looking at the data and thinking about the issues, I think the best shifts to make to a portfolio if you are afraid of an inflation spike is to cut long-term bonds and perhaps even stocks and add very short-term bills. As short-term interest rates increase, the returns will help weather the volatility on core stock holdings.
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