Investing for Inflation vs. Deflation:Asset Classes (Part III)

At the beginning of this series, I noted that financial prognosticators remain divided over the question of whether we should be bracing for inflation or deflation.  Clearly, last year we experienced a drop in the consumer price index, though much of that was due to falling energy prices.  Apartment rental prices have been declining in most major metropolitan areas recently, commodity prices are weak, and most companies have excess capacity, making them less likely to seek price increases.

Perhaps the strongest argument in favor of the expectation that asset price deflation (if not deflation in wages or goods) will continue is the fact that U.S. real estate and stock owners held lots of debt (around $25 trillion, by some estimates) prior to the tanking of stocks and real estate.  Those debts still have to be unwound, either through default, bankruptcy, or repayment.  The assets securing those debts can’t easily be sold off because of the market slump, so asset prices (in the aggregate) should remain depressed until debt loads start to return to reasonable levels.

Still, the “core” CPI, which excludes the cost of food and energy, has not declined, suggesting that producers of many goods and services still have the ability to raise prices.  The economic consensus isn’t predicting long-term deflation (not that we’d expect the economic consensus to know about deflation ahead of time).

The Federal Reserve has been willing to risk future inflation in order to avoid a Japanese-style “zombie economy.” But $6.7 trillion in Fed lending and asset purchases, plus Congressional stimulus spending, could easily have an inflationary effect when the economy begins to expand again.

So let’s consider how different investments would fare under these two different price environments.

Cash is King, Sometimes
In response to the credit crisis and stock market crash, many investors decided that the safest place for their money was in money market funds, CDs, and bank accounts.  Cash-type investments, in return for safety, provide low yields.  Obviously, this isn’t great if the yield is below the inflation rate, but during deflationary periods, holding cash is fine, as even a return of 0% is greater than a negative inflation rate.  But you’d need to be strongly persuaded that we’re approaching long-term deflation to justify holding most of your assets in cash.

Fixed-Rate Debt:  Was Polonius Right?
Individuals can invest in debt in lots of ways, but the most common one is the purchase of bonds issued by corporations and government entities.  Most bonds offer fixed return rates.  In inflationary circumstances, the bondholder’s interest payments decline in purchasing power over time, so that fixed-rate bond investments are not desirable during such periods.  If you expect inflation to dominate the economy over the long-term, buying long-term Treasuries (or other long-term bonds) is a really bad idea.

If long-term deflation is present, the opposite is true: the bondholder’s payments increase in purchasing power even though the nominal amount being paid is the same.  So bonds as a category perform well during deflation.

There’s a caveat, though: a given bond performs well during deflation only so long as the entity issuing it doesn’t default.  High-yield bonds are even riskier during prolonged periods of deflation; if you really want to own them, get a diversified junk bond fund.

The risk of default explains the recent popularity of U.S. Treasury bonds: the government can always print more money to pay its debts.  If the government issues so much money that it causes inflation…see above.

Municipal bonds figure in also.  Muni bonds rarely default, although it does happen.  Again, the buyer of these bonds must make some good judgments about the creditworthiness of the borrower.

Alternatively, one could consider investing in the debt of “real” people by lending money to others.  As in the case of corporate or government debt, you should have a high level of confidence in the borrower. Also, if you’re going to enter into a private loan, you should use an intermediary like Virgin Money to handle the paperwork for a nominal fee and help you make sure that the transaction passes muster with the IRS.

One’s own borrowing should be examined in the context of inflation/deflation.  As already noted, a fixed-rate borrower benefits from inflation and loses out when deflation dominates; it’s less urgent to pay down your mortgage when inflation is rampant than it is during a deflationary spiral.  Given a choice between investing (in stocks or other assets) and paying down debt, you must consider not only the possible return on the investment and the debt interest rate (after taxes), but also the presence of inflation or deflation.  Remember that paying down an existing debt provides a “guaranteed” rate of return, as opposed to the “possible” return of a risky asset.

By the way, much of what I’ve said here also applies to other investments involving fixed payments, e.g. fixed-rate annuities.

Inflation-Adjusted Debt
There are certain debt instruments with returns that are linked to some measure of inflation.  Leaving aside the exotic ones, the safest options are issued by the Federal government: Series I Savings Bonds (I-bonds) and Treasury Inflation-Protected Securities (TIPS).  I’d need a whole post to explain the differences between these two bonds; in the context of this discussion, it’s best that I just point out the difference in the way that each provides inflation protection.

I-bond holders receive a rate of interest with two components: a fixed rate plus a variable one.  The fixed rate is determined when you purchase the bond and the variable rate is adjusted twice a year in response to inflation.  During inflation, the variable rate adjusts upward, providing a bigger payout.  During periods of deflation, the opposite happens. In response to deflation over the last year, the I-bond variable rate has gone negative.  The newest variable I-bond rate is -5.56%, which exceeds the fixed rate for any I-bond ever issued.  In such situations, the payout is zero but can never go negative.  In extended periods of deflation, an I-bond’s performance would be cash-like (or perhaps a bit worse) but there would still be a positive return after inflation.  An individual can only buy a total of $10,000 worth of I-bonds ($5,000 in electronic form and $5,000 in paper form) per calendar year.

TIPS have a different structure:  the interest rate is fixed, but the value of the principal changes (twice a year) with inflation.  During inflationary periods, the principal increases and though the interest rate does not change, the payout goes up.  The opposite happens during deflation, but the principal cannot drop below its initial or par value.  So if you bought $10,000 in TIPS, when they matured you would get $10,000 back even if you owned the bond during a period of rampant deflation.  You’d also receive, at a minimum, interest based on the original principal value of $10,000.

The TIPS “floor” gives it an interesting appeal.  I-bonds could theoretically yield zero during a long-term deflationary period, but the shortest-term TIPS (5-year) currently yield a bit more than 1%.  Thus, although the yields aren’t huge, TIPS are a simple way to protect against both inflation and deflation.  In the event of hyper-inflation, the fact that the adjustment is only made every six months could cause headaches for a TIPS-holder, but the payout is still guaranteed.

I should offer one more TIPS caveat.  You can invest in TIPS by buying them directly from the Treasury or through the purchase of appropriate mutual funds or ETFs.  If you invest in TIPS via direct Treasury purchase (they can be bought in increments of $100), you can be certain that the principal will never go below the amount that you invested.  However, if you buy a mutual fund or ETF, you probably have no way of knowing how much of the principal of the underlying bonds has increased as a result of inflation.  If there is deflation, the principal of the fund’s bonds will decline.  You can only have confidence in deflation protection by buying new individual TIPS.

Social Security payments are a special case of inflation-adjusted income, but I don’t have time to discuss them here.  Certainly, if you’re receiving Social Security benefits, you should consider them in the mix of your overall investment profile.

Stocks Prefer Stability
Owning stocks during periods of extreme price changes is usually scary.  When inflation is high, companies often have difficulty passing on price increases and their profits are uncertain.  During deflationary periods, demand for goods and services is often weak.  As a group, equities are poor hedges during periods of rampant inflation and tend to perform poorly during periods of strong deflation as well.

I think it’s worthwhile to point out, however, that in both scenarios there are types of stocks that will tend to perform strongly.  When goods price inflation is high, businesses with a strong franchise in goods that are in short supply can do well; this could include agricultural products, energy, or other commodities.  In a deflationary environment, companies with low debt will fare better than their highly-leveraged competitors (see above), as will those that have the power to reduce their product prices more slowly than the drop in the prices of the goods and service they must buy.

Commodities, Real Estate, and (gulp) Gold
Prices of these “hard assets” usually increase in inflationary environments, almost by definition.  During deflation, prices of commodities and real estate will tend to drop.  Moreover, during deflationary periods real estate can be hard to sell because potential buyers may be reluctant to incur debt.

Gold prices probably will not do any worse than cash during deflation, but there’s not much relevant modern historical data.  Since the price of gold was fixed for much of the period between 1871 and 1971, gold’s price performance during the Great Depression is of no help in answering this question.

There are all sorts of esoteric investments that I haven’t discussed so far, including credit default swaps and other derivatives.  Many of these are beyond the ken of most investors.  Moreover, they’re sufficiently exotic that I could not possibly cover all of the potential risks that they entail.  A general observation: in periods of economic instability, complex contracts may not perform as advertised.  These things work best when markets are operating normally.

Parting comments
For those inclined to bedtime reading, there’s a nice paper recently released by the International Monetary Fund that examines how different asset classes have performed as inflation hedges in the past.

This post ended up much longer than I expected, so I won’t be able to address a number of important related issues, such the types of risks associated with different asset classes, the question of whether an asset should be held in a taxable or tax-free account, etc.  Be sure to consider these factors (and obtain advice, if necessary) before making asset purchases in anticipation of future inflation or deflation.

And finally: unless you have absolute certainty about the long-term direction of prices – and no one does – you should not put all your eggs in one basket.  Diversification remains important, and anyone who tells you otherwise is probably selling something.

Part I of Inflation and Deflation (click here)

Part II of Inflation and Deflation (click here)

About the author

Thomas Fisher, CFP®

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