There’s more talk now about an impending deflationary period than we’ve heard in several years and the thing about this churn is that even if we don’t truly experience textbook extensive deflation, the sentiment alone could easily drive investors in droves into assets that perform well during periods of deflation. For the uninitiated, think of deflation essentially as the opposite of hyperinflation. The historical 2-3% annual inflation we’ve become accustomed to is considered typical, perhaps healthy if you will. Hyperinflation was the fear in 2008 and 2009 as western governments were flooding the system with liquidity with seemingly reckless abandon. These hyperinflation fears drove up the cost of gold and other commodities since it was feared that fiat currency would lose its value and hard assets were the only true store of value in an uncertain future.
Meanwhile, in a deflationary world, hard assets are worth less and less each year, causing consumers to question purchases since they’ll be discounted further into the future and this cyclical black hole keeps broadening. As real estate and hard assets decline in value, people hoard cash. We’re now seeing a phenomena where people are essentially Doubling Down on Housing given the unprecedented low interest rates – so what happens to those mortgages when home prices decline again? Recently, we’ve seen many signs of future deflation. Gold prices have come well off their highs, Treasury yields keep dropping (although the yield curve isn’t flat enough to signal a “definitive” deflationary environment out into the future), and even Federal Reserve officials are hinting at fears of deflation. Finally, it’s looking to be highly likely that the Bush Tax Cuts will expire for at least high income earners, which is that much less spending power in the consumer space moving forward. With this in mind, even if you’re unsure of which scenario we’re looking at into the future, some of these ETFs that would be expected to perform strongly in a deflationary environment are worth a look:
Barclays 20+ Year Treasury Bond Fund (TLT): Just like long bonds suffer when inflation kicks in due to a decrease in buying power, by locking in a current rate now with a future deflationary environment brewing, long bonds with yield are where you’ll want to be. While say, a 3.5% yield may not seem like much when you’re used to the context of 2-3% inflation, if you’re in a -3% deflationary environment, that’s a risk-free “real” 6.5% yield per year which is unheard of. Expect long duration Treasuries to rally and see yields drop if deflation kicks in. Short term bonds don’t have as much room to run as the yields are already at historic lows and the curve has some tilt to it. As the yield curve flattens out in expectation of a deflationary environment, those longer duration yields drop, driving the bond prices higher.
Vanguard Long-Term Corporate Bond ETF (VCLT): Similar to government debt, long term corporate debt will appear to be increasingly attractive if inflation kicks in; that assumes that these corporations can survive a period of declining revenues due to a dip in consumer spending. Since this fund is composes of higher quality issues, the risk of default is modest compared to junk bonds, but of course, we only consider US government debt as the sole risk-free bond issuer.
High Yield Stocks: Depending on your taste in sector and risk, some investors opt to seek out the best high dividend stocks on an individual basis to optimize their income. Such stocks become incredibly attractive in a deflationary environment since that steady income stream is delivering a “real” return often in excess of 10% from the dividends alone. The calculus here is whether or not the dividend payout would be sustainable during a deflationary secular trend. The usual suspects in this environment might include tobacco stocks like Altria (MO), consumer staples like Proctor & Gamble (PG), utility stocks like Dominion Resources (D), and other historical steady payers.
High Yield ETFs: By removing individual issue risk from the equation, investors can benefit from diversification in a multitude of sectors ranging from the venerable steady payout utility stock ETFs which include the Utilities Select Sector SPDR (XLU) and Vanguard Utilities ETF (VPU), MLP ETFs, and even exploit the discounts to NAV coupled with various high yield closed end funds. Finally, don’t forget the Preferred Stocks which offer a hybrid payout/capital appreciation play on the large financials. With all the cash the banks are sitting on, even in spite of the recently enacted financial reform bill, it’s unlikely any of the large financials would go insolvent in the near future.
PowerShares DB Gold Short ETN (DGZ): Fed up with all those late-night gold infomercials? As investors in coins and collectibles realize that they’re paying exhorbitant prices for what amounts to essentially, a scam, deflation or not, we’ve seen gold come well off its highs in recent weeks. This recent dip would pale in comparison to a return to the mid hundreds in dollars per ounce though. This inverse ETF could easily return 50% over a deflationary cycle if gold conservatively retraced to $600/ounce.
Cash: There’s nothing exciting here, but deflation is the only time when it truly makes sense to hide cash under the mattress (on in a safe). Over time, as difficult as it is to contemplate, just sitting on idle cash may be a better investment than stocks, real estate, gold or various other asset classes that historically have held such promise. Because a year from now, that dollar might be worth $1.05 in equivalent terms.
Disclosure: No positions in any ETFs reviewed in this article.