What's Next: Deflation or Inflation?
Trend: The battle between deflation and inflation continues, with significant implications for investment strategy when the outcome is decided.
Many people, especially those accumulating gold and silver, assume that high inflation is inevitable. But deflation is still looming in the shadows, with much uncertainty about how to cope successfully with a deflationary period.
Niels C. Jensen at Absolute Return Partners LLP describes the deflation vs. inflation scenario. He sees deflation as a definite possibility and notes that investing in a deflationary period is much more challenging than dealing with inflation. Excerpts below.
Link: Make Sure You Get This One Right - Absolute Return Partners LLP
The point I really want to make is that the inflation v. deflation story is the single biggest investment story right now and being on the right side of that trade will effectively secure your investment returns for years to come. If I am wrong and inflation spikes, you want to load your portfolio with index linked government bonds (also known as TIPS for our American readers), gold and other commodities, commodity related stocks as well as property.
If deflation prevails, all you have to do is to look towards Japan and see what has done well over the past 20 years. Not much! You cannot even assume that bonds will do well. Recessions are bullish for long dated government bonds but a collapse of the entire credit system is not. The reason is simple - with the bursting of the credit bubble comes drastic monetary and fiscal action. Central banks print money and governments spend money as if there is no tomorrow, and all bets are off. Equities will do relatively poorly as will property prices. But equities will not go down in a straight line. The market will offer plenty of trading opportunities which must be taken advantage of, if you want to secure a decent return.
All in all, deflation is ugly and not conducive to attractive investment returns. It is also not what governments want and need right now. With a mountain of debt hitting the streets of Europe and America over the next few years, as the cost of fixing the credit and banking crisis is financed, one can make a strong case for rising inflation actually being the favoured outcome if you look at it from the government’s point of view. The problem, as the Japanese can attest to, is that deflation is excruciatingly difficult to get rid of, once it has become entrenched. I am in no doubt which of the two evils I would prefer, but we may not have the luxury of choosing our own destiny.
So where does all that leave us? John Mauldin ... makes the point that markets are likely to remain volatile for quite a while yet. On a personal note I will add that if my worst fears are proven correct and we have to fight a bout of deflation, the authorities will have no choice but to try and provoke price increases through aggressive policy measures. Otherwise entire countries could be bankrupted as they suffocate in their own debt. Whether it will work is a different story.
Such a struggle for supremacy between deflationary and inflationary forces will only add to the volatility predicted by John and give rise to an investment environment which is very unlike the one we have seen during the past 20-30 years. You need strategies in your portfolio which thrive on volatility, and they are certainly not the same strategies as those held by most investors today.
