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By Jason Stipp | 07-28-2010 12:28 PM

Preparing for Inflation and Deflation

As fear of both phenomena is on the rise, investors should seek dual protection with wider-moat stocks, says Morningstar's Paul Larson.

Jason Stipp: I am Jason Stipp for Morningstar. It's an interesting situation in the market today with signals flashing for both inflation and possibly deflation on the horizon.

Here with me to talk about how to think about these mix signals and how you might position your portfolio given those signals is Morningstar's Paul Larson. He is an equity strategist and also the editor of Morningstar StockInvestor.

Paul, thanks for joining me.

Paul Larson: Thanks for having me.

Stipp: So, there are some mix signals out there. Let's start on the inflation side, what signals are flashing that indicate we're going to see higher inflation in the future?

Larson: Well, one, we have a gold, while it's off, its high off recently, it's still very close to an all-time high, and that is certainly signaling that people are worried about the value of fiat currency.

And then also if you look at other commodities like oil and natural gas, when you look at the futures markets, they are in contango, meaning that the futures market at least expects higher prices in the future than what we have today.

Stipp: And on the deflation side, what things are showing that folks are also worried about the deflation?

Larson: Well, the biggest one is Treasuries, and Treasury yields are plumbing all-time lows, at the same time that we're getting gold at near an all time high, which is really interesting, the divergence and signals that we have. And also the recent economic data seems to point towards a deflationary economic environment with the CPI and PPI coming very close to zero.

Stipp: And we're certainly seeing some potential slowdowns in the manufacturing front as well in some recent data. So, I guess given that we have sort of what seem like two extremes, how is it possible that folks could be expecting both at the same time, why the mix signals here?

Larson: Well, I think that people could be expecting one environment then another, meaning that they are expecting deflation in the short-term and then maybe inflation as the reaction to that in the long-term.

But I think the more plausible explanation is that, people are bidding up the insurance on the tail risk in the market. The past couple of decades we had what you might call the great moderation in inflation, where inflation was not volatile at all, it was very tame right around that 2% or 3%, very steadily, and then in recent years it started to wobble from that, and people are worried that, okay, well maybe we are going to get deflation. So they are bidding up the insurance on that environment, bidding up the Treasuries.

And then they are also worried about inflation. So, again I think it's that tail risk that people are worried about and that the great moderation, that the middle part of the bell curve, is much smaller than it once was.

Stipp: So potentially one thing investors agree upon is that the risk of one or the other is greater perhaps than what it had been in the past?

Larson: Exactly.

Stipp: And so given this, given that you have these two concerns on the horizon, what kinds of investments should you think about for a deflationary or an inflationary environment, and are there any kinds of investments that could hold up in both?

Larson: Well, in an inflationary environment, you want to have companies that frankly are levered, that have debt, because the real value of that debt is going to be inflated away, and also it's good to have companies that have hard assets, namely commodity companies.

And looking at the deflationary environment you want almost exactly the opposite. You want companies that are cash rich.

But the one thing that you want to have in common for both environments is, it boils down to economic moats, which is something we talk about a lot here at Morningstar, because you want companies that are going to either be able to maintain their pricing power should prices fall in a deflationary environment or have the ability to increase their prices should we get an inflationary environment.

Stipp: Paul thanks for your insights on this interesting phenomenon in the market.

Larson: Thanks for having me.

Stipp: For Morningstar I am Jason Stipp. Thanks for watching.

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