Just when you thought it was safe to get back into the investing waters, talk of deflation has crept back into conversation and the press.
Why does it matter? Well, how you position your portfolio to deal with these two scenarios will make a big difference to your personal bottom line now and into retirement.
With inflation, your money is worth less the longer you hold onto it. So you're more likely to spend in the now because prices may be moving up.
With deflation, your money may buy more later the longer you hold onto it as prices continue to drop. (Not good for a seller but a better deal for a buyer - just ask someone trying to sell a house in Florida these days).
Since consumers respond differently to these two opposing forces, the ultimate direction of them can have a decidedly different impact on how the recovery progresses because of the way consumers react and business respond to their actions. Ultimately, this will impact how to position an investment portfolio accordingly.
The Right Hook
During a fight a boxer may expect to be hit from both the right and left. It's just not known when and with how much force. But a good boxer, like a Boy Scout, knows to be prepared.
First the economy has been peppered with jabs from the right that could result in higher inflation: expanding money supply, ballooning government deficits, higher commodity prices, weak currency value.
Given the huge inherited, current and projected government deficits here and abroad, the conventional thought has been that all of this government stimulus will ultimately result in "crowding out" private investment and raise the ugly head of higher inflation down the road. The prospect of higher taxes to pay for these past deficits also lends support to these thoughts.
Recent run-ups in certain commodity prices like oil and energy products have resulted in a rise in consumer prices in January bolstering fears of inflation.
The Left Hook
Now comes the left hook - the deflationary threat: asset prices continuing to fall, increasing slack in industrial capacity, and continuing pressure keeping a lid on labor expenses because of high unemployment.
Credit is still tight with bank lending down. While dollars have been pumped into the economy through the TARP program, it's mostly sitting in bank vaults. Money that isn't circulating isn't a cause of inflation.
Recent economic reports have indicated that core consumer prices actually are flat, well below the 10-year average of 2.2%.
Despite some recent reports, housing prices and rents are down and still expected to fall in key markets, dampening the immediate threat of inflation.
Defensive Portfolios: Lessons from Spencer
The best and strongest home depends on your environment and the threats faced. Each evening before putting our infant son, Spencer, to bed, we read a story. The favorite for now is "The Three Little Pigs" (undoubtedly because of Spencer's dad's animation).
We all know the story: Three pigs, three houses built from different materials, one pig survives because of his well-built brick house.
The same can be said for portfolios. Heck, a house of sticks can provide some shelter in some circumstances but what happens if a big bad wolf shows up?
Since we don't know which type of bad wolf will be showing up at the door (inflation or deflation), it makes sense to be positioned to survive either threat.
The elements of a portfolio will likely be the same regardless of an investor's mind-set. The differences will be in the proportion of the different asset classes used.
Inflation Protection Portfolio
To protect this type of portfolio consider elements more likely to retain value even as inflation increases. Example: Commodity funds or ETFs; inflation-linked fixed income funds that include TIPS and/or floating rate notes; Real Estate Investment Trusts or REIT funds (10%); Cash to take advantage of higher short-term interest rates.
Deflation Protection Portfolio
The majority of this type of portfolio is positioned in long-term Treasurys followed by cash and municipal bonds. As consumer prices and interest rates fall, the fixed income stream from the bonds would be worth more.
To protect against surprise inflation, a smaller proportion would be set aside into TIPS, commodities and higher-quality/large cap US stocks.
Little Pig, Little Pig, Let Me In
Not sure where the market will go? Not sure which threat to expect? Learn from the third little pig: Build the strongest house possible.
If there is inflation, the economy will be expanding. As such equities will be the place to be. So consider an allocation of 20% to 25% in the US and a like amount in foreign equities. (There's more to the world economy than just the S&P 500 so it makes sense to let your money travel overseas to work for your retirement bottom line).
A portion of these equities should include high-quality firms that are dividend-paying. A steady income stream from equities that have a history of increasing their dividend is one way to counter the impact of inflation and help preserve purchasing power.
An allocation to commodities and cash will likely benefit from inflation so a 10% allocation to each is prudent. Why? Commodities by their very nature tend to increase in value as inflation heats up. Cash benefits because as the Federal Reserve increases short term interest rates to combat inflation, the interest rates paid on short-term deposits will also move up. The fixed income component can include some exposure to TIPS (5%) as well as intermediate high-quality bonds (20% - 30%).
To hedge against the risk of deflation, a portfolio with exposure to municipal bonds (5%) and long-term Treasurys (5% - 10%). And some of the equity portfolio should include exposure to consumer staples that tend to do well in such an environment.
To provide some added diversification consider adding positions in companies that focus on infrastructure and firms that can maintain pricing power like utilities, pipeline operators and the like.
Taking these steps should allow an investor to sleep better at night. At least it works for Spencer.
