Is Inflation or Deflation the Bigger Threat? Readers Weigh In

Is inflation or deflation a bigger threat to your portfolio? And what are you doing to insulate your portfolio against the threat that you see looming?

I recently posed that question to Morningstar.com users in the HandsOn forum on our Discuss boards. Several users chimed in with their insights, and user AKHalea also directed me to a long discussion that users on the Fidelity forum have been having on the same topic.

Deflation (or Do You Mean Disinflation)?
Several users were reluctant to step into the role of macroeconomic forecaster, noting that the cloudy economic forecast makes it tough to gauge threats of inflation or deflation. But several such posters went on to note that they view deflation as the bigger risk in the near term. For example, AlvinSch wrote: "[I] wish I knew but give a slight edge to deflation." He went on to give his prescription for the current and future market environments, which includes both inflationary and deflationary hedges. "I've built a four- to five-year certificate-of-deposit ladder with rebalancing money as I've sold different equity classes as they exceeded their allocation ranges this year. This would give me four to five years of survival money (unless the government were to close the banks).

"I currently have 13% in master limited partnerships (from 0% a few years ago), for inflation protection and hopefully some income during deflation (they are quite leveraged so might not be so good in a deflationary environment). [I] Slightly raised my international exposure but think it should be even higher. I think a Japan-style, long-term 'benevolent' deflation is the best we can hope for, while the worst would be pretty ugly."

The 62 Dawg also puts himself firmly in the deflationary camp. His prescription for a period of declining prices? "Own a stable of excellent bond fund managers and a very big grin."

Other users also said that deflation is on their minds, not so much because they think it's very likely but because of its potentially disastrous effects. Bnorthrop wrote: "I'm more concerned about deflation because it's a nasty animal. But I think the odds are low, though not zero."

On the Fidelity forum, users were concerned about both disinflation (a slowdown in the inflation rate) as well as deflation. CapeCod gave a detailed discussion of why investors should keep deflation on their radar, writing, "I think an extended Japan-style deflationary period is unlikely, but not impossible, in the United States. Much will depend on whether we dip off into a very low or negative growth period again in the next few quarters, and the historically very accurate ECRI LEI (Economic Cycle Research Institute Leading Economic Indicators) unfortunately suggests the risks of such an event are increasing rapidly." CapeCod went on to give a detailed analysis of current economic conditions, culminating in this statement: "Fingers crossed we are not entering Japan II."

Poster itirvin is even more concerned about disinflation and even deflation. "I think disinflation (with the risk of Japan-style deflation) is the immediate risk," he wrote. "It is unnerving today to read books about the Japan real estate stock crash from which Japan has never recovered. I am afraid the same thing is happening now. The banks are hiding their problems and desperately hoarding cash. Companies are firing workers and hoarding cash. I see nothing on the horizon for the U.S. for a good old capitalist expansion like railroads, highways, computers, or real estate. So at my age I take disinflation very seriously. But you can only hedge, you cannot predict." For example, itirvin mentions having a portfolio that includes both inflationary and deflationary hedges.

Helmut, too, is concerned about deflation in the short term, writing, "While I don't think deflation is here to stay, I do believe most investors are not as prepared as they should be for deflation. Most investors think that corporates will protect them in a deflationary period, but if we ever enter a deflationary period similar to the 1930' you will see many corporate defaults. Deflation is the most deadly economic cycle of all, and little chance of deflation does not mean no chance of deflation.

"I don't feel comfortable with funds that use leverage, shorts, and other derivatives to hedge, probably because I don't really completely understand them. For that reason I hold a small amount of Vanguard Extended Duration Treasury Index (EDV) as a deflationary hedge."

Helmut wasn't alone in favoring long-term Treasuries or zero-coupon bonds as a hedge against a deflationary environment. The idea is that such investments would benefit from a declining interest-rate environment, the likely outcome if the economy were stuck in the doldrums for a prolonged period of time.

Poster AKhalea also opined that zero-coupon Treasuries could serve as a worthy deflation hedge, but went on to note that their extreme interest-rate sensitivity would most certainly cause volatility in a period of rising interest rates. AKhalea also noted the perils of poor timing, writing, "It may be too late to buy them as the rates may not go any lower. So this is not an endorsement of zeroes."

PtnewYork, and several other posters, was looking to GNMA bonds as a hedge for deflationary times, stating, "Despite all the concerns that GNMA funds would get whacked once the government stopped backing [mortgage-backed bonds], my GNMA funds have held up quite well--both Vanguard and Fido--which is now leading me to add more to both my SEP GNMA and non-SEP GNMAs. So I guess this is my empirical response to seeing what is working in my portfolio in this interim (slow growth) environment ... now that some of the rising interest-rate hysteria has waned.

AKHalea seconded the enthusiasm for GNMAs before offering up this planning idea: "One of the uncommon ways of benefiting from disinflation and the resulting super-low interest rates is to refinance your mortgage. If you don't own your own home, it is a great time to buy. (P.S.--I am neither a real estate agent nor a mortgage broker, but just an observer). I myself may consider refinancing my own home very soon. Property values are still reasonable, almost depressed, and the mortgage rates are at historically low levels."

Keeping an Eye on Higher Prices
Although deflation worries ran high in some quarters, other posters pointed to improving indications as a signal that inflation could be closer at hand than many think.

Stockvapors says higher prices are as close as your local grocery store aisle: "[I] think inflation is already here. Don't agree? Go to the grocery store and check out the cereal section. The prices are the same but the cereal boxes are shrinking again. Sellers are trying to hide it but it is there."

Poster Audreyh1 also pointed to signs of inflation, noting, "Businesses are back to doing OK,  [they're] just a lot leaner. And it does seem like the consumer is spending more than expected. And now it sounds like a lot of people are starting to refinance again and that may also loosen the purse strings a bit. I'm curious to see how this all plays out. Whoever imagined Apple would be selling so many new 'toys' (totally discretionary spending) in this kind of environment, yet they have blown away all expectations, including their own. Consumers (at least the employed ones) are still willing to spend."

Other posters weren't so concerned about higher prices anytime soon, but then noted that inflation was a long-term worry. Bavan opined, "In the present near term (short term of less than one year), I feel the current status quo will continue with neither inflation nor deflation. However, in the medium term (between one and two years), I feel [we will have] moderate inflation. However, over the long term of more than two or three years, it's certainly going to be inflation as printed money and moderate economic growth will increase the prices, especially in the service sector such as health care and education, where China, India, and other countries cannot export to the U.S. at cheaper prices of the above services."

JupiterMars was one poster bracing for long-term inflation, offering the following strategies to combat the threat of higher prices. "One, high proportion of equities (over the long haul performs better in inflationary environments); two, fixed-income investments includes higher-yielding assets (high-yield corporate credit, mortgage funds, and so on) as well as some Treasury Inflation-Protected Securities; three, substantial stakes in hard assets or infrastructure with yield, such as REITs and MLPs; four, 30-year fixed mortgage--yes, this is an inflation hedge if one is disciplined about it. Unfortunately, interest-only mortgages are a thing of the past, but that would be ideal."

Stockvapors also argued that stocks can be a good idea in inflationary times. "I have been shifting my allocation from 50/50 to 60% stock/40% bond. I have too much cash so I'm redeploying some of that cash (which is earning virtually nothing) to dividend-paying stocks when the market dips and they get cheap. I think inflation is still at least a year away. The market always leads reality so I want to get into stocks (if I can pick them up cheap) before the Fed starts to raise interest rates and people start dumping bonds."

Cautious2, also concerned about inflation, favors preferred stock in the current environment. "Preferred stocks offer good value. There has been a lot negativity about them coming from Morningstar for understandable reasons. I'd just like to point out that  Powershares Financial Preferred (PGF) still trades at much lower levels than it did when interest rates were higher. Banks have survived what almost certainly has been the worst period of time they are likely to face in years. REITs that suspended their dividends had no trouble raising capital and paying the preferred dividend,  Hospitality Properties (HPT), for example. I have about 5% of my portfolio in preferreds giving a nice interest-rate boost. I also can't resist some of the MLPs (such as Kinder Morgan), pharmaceuticals (such as  Eli Lilly (LLY)),  Paychex (PAYX), and utilities--all paying far more than 30-year Treasuries.

A One-Two Punch
Many other posters see both threats on the horizon: deflation in the near term, followed by inflation down the road.

For example, Uncleharley wrote: "Deflation is my short-term concern, with inflation being a longer-term concern. For the near future I am holding an unusual amount of cash in my portfolio. When the deflation scare appears to have run its course and the stock market appears to be gaining positive momentum, I hope to invest the cash in stocks that seem to be good long-term investments."

Jnjpascale is also concerned about inflation, but is unconvinced that adding more to stocks is the answer: "I have 25% of my money in alternative investments such as TIPS, I bonds, silver, and commodity fund  PowerShares DB Commodity Index Tracking (DBC). I think it is important to recognize the higher risks in our economy and our currency caused by higher debt and deficit levels. Loss of purchasing power because of a higher risk of inflation needs to be addressed in a portfolio today, in my opinion.

"I have also reduced my overall stock exposure from 65% to 55%. I have more than half of my stock allocation to international funds recognizing the risk of dollar devaluation in the U.S. dollar long term. If you were China would you want to continue loaning money to America? I wouldn't. We will never be able to pay off our debt and the government will inflate its way out of this predicament at the cost to the investor invested in cash areas. Traditionally safe cash type investments will get hammered with inflation or other financial catastrophes."

Mozart325 astutely points out that whether you experience deflation or inflation depends on who you are and what you're buying: "There will be inflation in some items and deflation in others. Depending on age, lifestyle preferences, and so on, some people will experience inflation and others deflation. This has been going on for quite some time. Health-care costs have seen high inflation, while many items made in China, Vietnam, and so on have been undergoing deflation. When the government lumps everything together to come up with a single inflation number for things like Social Security payments and TIPS, they try to minimize the number to save money."

EricTheRon also warned against going overboard to gird a portfolio against the threat of deflation, noting, "It looks like deflation is likely for a time, maybe even a decade, after which inflation will certainly be the problem du jour. However, at any time the issuance of new Treasury debt and/or more quantitative easing may be unsupported, causing Treasury rates to rise. This could hit hard on those who go wholly into Treasuries because they make money during a deflation. So I have gone over to the camp of the late Harry Browne, per his 1999 book, Fail-Safe Investing. I think I'm now ready for any outcome. Yes, there is overall fluctuation in the portfolio's value from day to day, but generally the four investments hedge each other's risk over time (a fourth each in stocks, Treasuries, cash, and gold, rebalanced when one is 10% over/under)."

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