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Deflation vs. inflation — the investor’s dilemma

Are we facing deflation or inflation — or both, asks this British advisory, which outlines just how investors should respond in either situation.

It’s a funny thing about deflation and inflation. Deflation often requires a bit of explanation (a decline in prices when money or credit is tight).

But inflation gets instant recognition — money doesn’t buy as much.

But at this point, it isn’t just a matter of words. It’s a matter of strategy. How should we act when prices go down and the economy contracts further? How should we act when prices shoot back up?

As with so many issues in the markets these days, there are two schools of thought.

To take instruction on the debate, we will cross the pond to London, and The Fleet Street Letter. While this British advisory deals with the situation in its own backyard, the story is really no different over here in the New World.

Mr. Theo Casey begins by informing his readers that this is a question that has two correct answers.

Their worst nightmare

Are we facing deflation or inflation? Mr. Casey puts the two sides in their corners.

The deflationists “believe the UK economy is heading into a spiral of lower output causing job losses, price cuts and wage cuts, ad infinitum.” It is, he adds, the worst nightmare of Prime Minister Gordon Brown and Bank of England Governor Mervyn King.

“How can we defend ourselves from deflation? Historically, cash and fixed-income investments prosper in deflationary times.”

In the other corner are the inflationists “predicting that our policy makers’ desperate and relentless bailouts and buy-ups will ‘put cash in the hands of those who might spend it’,” says Mr. Casey.

That fuels inflation. “In an inflationary environment, index-linked bonds and gold perform well.”

They’re both right

So who comes out on top in this debate? “They are both right,” says Mr. Casey. “We will see deflation today and inflation tomorrow.” The investment opportunity comes tomorrow, with inflation.

This year, inflation is on the verge of falling into negative territory, the author continues. With the bubbles in food, fuel and housing popping all at once (and in more than one country), prices have fallen significantly.

“On top of that, consumers and businesses are actually consuming less of these cheaper products.” That’s deflation with a vengeance. The author quotes an investment management group in Britain that expects deflation to take hold, with the Retail Prices Index (RPI) coming in at -4.4 per cent.

But it’s likely to be temporary.

Pounds swilling around

“The UK, in its bid to stave off depression, is going through one of the largest increases in money supply in its history,” says Mr. Casey. “

“Currently, we have a money supply of £1.95 trillion swilling around in the UK. Only £50 billion of that is in cash, while the rest is in banks as savings and investments.”

That figure will get bigger, the author insists. The Bank of England and the Treasury have agreed to inject another £100 billion into the economy. This operation goes under one of those euphemisms — “quantitative easing” — that effectively stands for “bailing as fast as we can.”

Expect more of this in the future, says the author. And it will create a major inflationary problem.

“The only questions are how can we protect ourselves and when should we buy protection?”

Inflation-beating arsenal

“There are three time-tested solutions to inflation,” Mr. Casey states. “Stocks, gold and index-linked bonds.”

The first two you know about. The value of stocks when inflation arrives is that “they have the potential to appreciate in value greater than the rate of inflation.”

Gold, of course, is not devalued by inflation.

Index-linked bonds are a British creation that has been adopted in Canada under the name “real return bonds.” These bonds are designed to keep up with inflation. The payment of income on the principal is related to a specific price index like the Consumer Price Index (CPI), the North American equivalent of Britain’s RPI.

“For a true hedge on inflation,” Mr. Casey, “index-linked bonds would be a great part of your inflation-beating arsenal.”

The window of opportunity

When should investors buy these inflation-fighting bonds? When they are cheap, says Mr. Casey. These bonds differ from other issues in that both the semi-annual coupon payments and the principal are adjusted in line with the rate of inflation based on the underlying price index.

“Of course these investments will be cheapest when inflation is least feared and investors do not favour them,” he adds. That means when the price index is negative.

When the level dips below zero, adds the author, there will be an opportunity to buy this protection cheaply. “However, we do not believe it is time to get into the market. Inflation is a lagging effect. It will come as a result of printing money.” This advisory does not expect deflation to bottom out for another 3-6 months.

So the window of opportunity, in Britain at least, would be from May to August. Those who buy too soon, warns Mr. Casey, could suffer some serious losses.

Over here, the Bank of Canada’s latest data on CPI inflation has a figure of 1.1 per cent. And it would be rash to predict that deflation and inflation will follow precisely the same time line in Britain and Canada.

But you will find very few experts who do not see a mushroom cloud of inflation in our future. And in this advisory’s opinion, that’s where both danger and opportunity lie.

In short, investors will once again have to try and make the best of a bad situation. No rest for the weary.