Investing in Deflationary Times

I first sent this email out in late 2008 to clients but I thought it might be useful to revisit the topic.

The most important point, to me, is that you do not necessarily have to abandon investing during a slow growth, deflationary environment. High quality companies with low debt burdens can thrive in today's environment, so purchasing both corporate debt and stocks can make considerable investment sense.

On the other hand, low quality credits should be avoided. This is already happening in the municipal market: while high grade (AA and higher) muni prices have rallied along with Treasurys, lower quality munis (BBB and single-A) have lagged badly.

Hi,

For people like me who have spent most of their careers worrying about inflation, we now have to consider how best to invest in a deflationary environment, even it exists for only the next year or so. We have also studied Japan* as a potential guide as to what might happen.

The most important conclusion: there are numerous ways to have good investment results in a deflationary environment, assuming that general economic conditions recover somewhat in the second half of 2009. However, there are also several sectors that will suffer during deflation, so careful sector and asset allocation are important.

More specifically:

1. As long as we are in deflationary conditions, bond yields and stock prices will move in the same direction. That is, as interest rates move lower (as measured by US Treasury notes), so too will stock prices, and vice versa. Our rationale is that falling government bond yields are a sign of a weak economy, while yields should begin to rise as conditions improve and investors become less risk-adverse. Thus, the credit markets will remain a key variable for stock investors;

2. Credit quality will be vitally important. Companies with strong balance sheets, the ability to raise prices, and the wherewithal to buy other companies selling at depressed prices will be clear winners, while smaller companies (especially leveraged ones) will be at risk. This means that large cap stocks should be favored over smaller stocks;

3. Borrowers are in a tough spot. Deflation favors the lender, who is repaid with in the future with more valuable dollars. While initially this might seem to be good for banks, it actually increases the risk of higher credit problems. We will continue to be very cautious on investing in the financial sector, especially banking and credit card companies, where we anticipate further significant write-offs next year;

4. Corporate bonds offer very attractive real (i.e. inflation-adjusted) yields, but we would stick with high quality names with unquestioned ability to repay debt. In the municipal sector, we’ve been focusing on municipal bonds rated at least “AA”;

5. Foreign markets probably will not recover until the US begins to show some signs of life. This is particularly true of the emerging markets which are importing to the US;

6. Commodities typically do not do well in deflationary times. However, this time may be different. The forces (namely, the emerging markets, especially China) that drove commodity prices higher are still with us even with a weaker economic backdrop. While prices may move lower nearer term, we would not abandon the group.

* Remember that the Japanese stock market peaked in 1989. Land prices soared, spurred by lending practices that were later found to be wanting. As the twin bubbles began to deflate, the government and Japanese central bank tried nearly everything to turn their economy around. Massive public works spending projects ensued; the Japanese central banks cut rates to 0%; and huge doses of monetary stimulus were applied, but nothing seemed to work. By 1998 the major city banks in Japan were essentially nationalized. Lead by Prime Minister Koizumi, by 2002, the Japanese economy was showing signs of life, but by 2007 Japan was once again slipping into economic weakness. Today Japan is once again in a full-fledged recession.