Deflation Risks Increasing

How deflation will impact your portfolio and how to protect against the risk.

With interest rates expected to remain low for the near to medium term and economic growth appearing to be slowing, some experts have shifted their focus from the prospect of near term inflation to the prospect of deflation. Many of us are very familiar with the concept of inflation which is simply when prices in the economy are rising. This has, at least historically, been the norm and the Bank of Canada has targeted an annual level of inflation of between 1% and 3%. If inflation rises beyond the upper level of the target range, the Bank of Canada will act to slow the economy because the rising prices erode the future purchasing power of every dollar. This causes people to buy things sooner than they necessarily need them, increasing demand for goods and services and pushing prices up even higher.

Deflation on the other hand is just the opposite – the level of prices within the economy is falling. On the surface, this appear to be a positive thing, since the prices of goods and services will be going down in the future and we can buy more tomorrow than we can today. While it may be a positive for individuals, deflation can cause some serious economic problems at the macro level. Because everybody expects that prices are falling and if they hold off on purchasing them today, they will be able to buy them at a lower price in the future. Unfortunately, if nobody buys anything companies will be forced to take actions to try to spur sales and maintain their profitability. This may result in further price cuts and layoffs which can lead to higher levels of unemployment and economic recession.

Investment markets will also be impacted by deflation. Let’s take a look at the potential impact for the main asset classes.

Cash – In a deflationary environment cash is king. Because prices are falling, the value of a dollar, at least in terms of what you can buy with it, will increase. From a pure investment standpoint though, you are not likely to be earning a significant return on your investment, as interest rates will likely be very low in an effort to help spur the level of economic growth in the economy. Cash will serve a couple of purposes in a deflationary environment – first, it preserves capital as it will not lose in value and secondly, if you have higher levels of cash at your disposal, you will be able to take advantage of the equity market selloff and pick up some high quality equities at bargain basement prices. 

Fixed Income – Historically, fixed income, particularly long term government bonds have done very well in a deflationary environment. You will likely want to invest in as long term a bond as possible in a deflationary environment. Strip bonds or zero coupon bonds are also expected to do very well in a period of deflation. You will likely want to stay away from Real Return Bonds as there will be negative inflation in the economy, which will likely lead to a decline in value from the Real Return Bonds. 

Equities – As mentioned above, equities will likely be sold off in a deflationary environment. As the economy slows and as companies lose the ability to raise prices, they will see an erosion in their profitability which will result in a lower price for the company’s stock. However, high quality companies with strong balance sheets, significant cash reserves, stable dividends and products that consumers will want or need to buy in almost any market environment will usually hold up the best. Examples would include stocks or funds with significant exposure to the defensive sectors such as consumer staples (food and tobacco), utilities, and healthcare. While financial services may appear attractive given their high dividend yields and quality balance sheets, they do have the potential to be hit hard in a deflationary environment as there is less borrowing and the potential for higher unemployment and a slowing economy increase the potential for increased loan losses. 

Commodities and Real Estate – Real estate, be it commercial or residential will also be negatively impacted by deflation. Most commodities will struggle as there is a lower level of economic activity in a deflationary environment, thereby reducing the demand. That said, there is some evidence that gold, which is often thought of as a good hedge against inflation, will also do well in a deflationary environment, mostly because of its perception as a safe haven investment in times of uncertainty.

So how likely is it that we will experience deflation? According to the Federal Reserve Bank ofAtlanta, it is estimated that in theU.S.the probability of a period of deflation is approximately 18%, or one in six. What is more alarming is that the probability has increased dramatically from April when it was estimated that there was a 6.4% chance of deflation. Clearly, it is not the most likely outcome, but something that investors should be prepared for. 

Fund Picks for a Deflationary Environment: 

Cash

In deflationary environment you’re likely better off using a high interest savings account over a money market fund since the returns will likely be higher. As of September 29, many of the high interest savings accounts were paying 1.75% or higher.

 Fixed Income 

BMO Long Federal Bond Fund ETF (TSX: ZFL) – For a deflationary environment, this is just what the doctor ordered: long term government bonds. This is an ETF that is designed to replicate the DEX Long Term Federal Bond Index which invests in a diversified range of federal government bonds with maturities in excess of 10 years. It is very low cost with an MER of just 0.23%. 

Beutel Goodman Long Term Bond Fund (BTG 871 – no load) – This is a mutual fund offered by one of our favourite firms in the fixed income space, Beutel Goodman. The fund invests in a mix of provincial and federal government bonds with maturities between 9 and 25 years. Given that it is a mutual fund, it is a touch more expensive than the ETFs, offering an MER of 0.70%. 

Equities 

Ivy Foreign Equity (MFC 081 – front end) – This has long been one of our favourite funds for periods of market uncertainty. The management team runs a very concentrated, extremely defensive portfolio. As of August 31, the portfolio was invested 43% in consumer staples and had a very modest exposure to financials. Given the manager’s style and approach, this is one equity fund that we feel will perform well in most down markets. However, because of its very defensive positioning, we would expect that it will lag other funds in bull markets. 

Mutual Discovery (TML 180 – front end) – Like the Ivy Foreign Equity Fund, this go anywhere global equity fund managed by Phillippe Brugere-Trelat and Peter Langerman has been one of our favourites. The fund is also typically very conservatively positioned with an emphasis on protecting investors’ capital. The portfolio currently holds about 10% in cash and about a third of the portfolio is invested in food, drink and tobacco companies. Given the positioning and the manager’s style, we would expect that this fund will hold up well in a deflationary environment. 

Real Estate/Commodities 

Claymore Gold Bullion ETF (TSX: CGL) – This is an ETF that is offered by Claymore Investments which is designed to replicate the performance of the price of gold bullion. Claymore will hedge the currency exposure so the performance will not be subject to the impact of currency fluctuations. The cost is reasonable, boasting a management fee of 0.50%. 

Sprott Gold Bullion Fund (SPR 216) – The Sprott Gold Bullion Fund is a mutual fund that invests in unencumbered, fully allocated gold bullion, gold certificates and closed end funds where the underlying interest is gold. The costs are reasonable for a mutual fund, with a management fee of 0.80%.