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(See Correction & Amplification item below.)
Will it be deflation, inflation— or both?
The answer to this economic puzzle could have a big impact on stocks over the next few years. Either scenario could be damaging to businesses. During high inflation, rising costs eat into the bottom line, and companies may not be able to boost prices to fully compensate. The deflationary worry is that consumers, expecting prices to fall, will cut back on purchases. That can lead to more layoffs, and less demand, and trigger a crippling spiral of sliding prices.
Uncertainty about the direction of the economy has spooked stocks for much of this year. Only in September did investors appear finally to have seen enough positive economic data and corporate earnings growth to budge stocks upwards again. The average U.S.-stock fund (excluding sector funds) returned 10.68% in the third quarter, bringing the year-to-date return to 4.84%, according to preliminary data from Lipper Inc., a unit of Thomson Reuters PLC.
The September rally, however, did nothing to settle the inflation vs. deflation debate. So, we asked fund managers and investing pros what investors can do to guard their portfolios in the event of deflation or inflation. They weren't short on ideas. Some also pointed to companies that could fare relatively well in either environment. Most often mentioned: blue-chip stocks that pay dividends, and technology shares.
First, A Short History Lesson
Over the past 70 years, U.S. stocks have performed better during deflationary periods than in high inflationary periods, according to data compiled by Bespoke Investment Group, Harrison, N.Y. For the three deflationary periods since 1940, as defined by a year-over-year fall in the consumer-price index, the Standard & Poor's 500-stock index rose an average of 24.9%, the group says. The figures aren't annualized. Bespoke looked at the performance for each period, then came up with an overall average.
One reason for the rise: Markets were in recovery mode. For the 12-month periods preceding each deflationary episode, the S&P 500 fell an average of 4% in sharp economic slowdowns that prompted the Federal Reserve to slash interest rates in order to get the economy moving again. And investors snapped up stocks as rates hit bottom.The most recent deflationary period, from Jan. 1, 2009, to Oct. 31, 2009, was no exception. Over the preceding 12 months, the economy was in recession and the S&P 500 declined 38.5%. The index then gained 14.7% during the deflationary period as stocks at first continued to swoon but recovered after massive government interventions helped restore confidence in markets.
By contrast, during the five periods of high inflation since 1940, as defined by a jump in the CPI of more than 8.5% year over year, the S&P 500 fell an average of 2.15%. The inflationary periods averaged 21 months, compared with 10 months for the deflationary periods. This doesn't mean investors should hope for deflation. Stocks could perform worse during a lengthy bout of deflation, such as Japan has suffered over the past [two] decades.
But the periods of high inflation in the Bespoke data were longer and more painful than the deflationary interludes. And current members of the inflation-is-coming camp worry that the magnitude of the government's spending to fight the recession and financial crisis will spur a surge in inflation down the road. Jason Hsu, chief investment officer at Research Affiliates, a Newport Beach, Calif., investment-management firm, thinks inflation is on the way. Maybe not in the next year or so, but he says the market could start pricing in the risk ahead of time.
Preparing For Inflation
"Investors should be worried about long-horizon inflation," Mr. Hsu says. Commonly suggested inflation hedges include mutual funds and exchange-traded funds that invest in Treasury inflation-protected securities and in securities linked to commodity prices. Within the stock market, meanwhile, Mr. Hsu likes property-focused funds that invest in real-estate investment trusts, or REITs. Such funds have had a big run in 2010, gaining about 19%.
In part, that is due to a rebound from depressed levels after the housing bust. It's also a bet that property values will recover once inflation picks up, Mr. Hsu says. He favors REITs that focus on residential property over commercial property because he believes residential REITs fell far more sharply and represent a better bargain now.
One housing-focused possibility among ETFs: iShares FTSE NAREIT Residential Plus Capped Index. Morningstar Inc. analyst Christine Benz says investors worried about inflation should consider stocks with exposure to commodities. Exxon Mobil Corp. or ConocoPhillips fit that bill. Big energy companies also tend to spit out a healthy dividend, providing benefits during deflation. The steady payments provide a welcome safety net when prices for other assets, including stocks, are on the wane.
In Case Of Deflation
A number of people we talked to say dividend-paying stocks of large, stable companies are a reasonable choice for a deflationary period, even if inflation follows hard on its heels. There are numerous mutual funds that specialize in large dividend-yielding stocks. Some, such as Vanguard Dividend Growth, focus on companies expected to raise their dividends. Others, such as American Funds Washington Mutual and T. Rowe Price Equity Income, focus on high-yielding stocks.
Ben Inker, director of asset allocation at investment firm GMO LLC, believes shares of household names such as Coca-Cola Co., Johnson & Johnson and Wal-Mart Stores Inc. can withstand a bout of moderate deflation. And if inflation kicks in, he says, such companies will often be able to pass on higher costs to consumers. GMO has several funds, including GMO Quality III, tilted toward blue-chip stalwarts. Top holdings include Coca-Cola, J&J and Wal-Mart, as well as Procter & Gamble Co. and Oracle Corp.
Money managers with the Davis Funds said in a recent report that dividend yields on many blue-chip stocks are currently higher than the yield on the 10-year Treasury bond, a paltry 2.5% as of Sept. 30. The Davis New York Venture Fund focuses on large businesses with decent dividends, including Hewlett-Packard Co. and Microsoft Corp., Walt Disney Co. and Becton Dickinson & Co., the big medical-device maker. One risk of dividend investing, experts warn, is being drawn into mature companies with poor growth prospects. The companies are returning extra cash to investors instead of putting it into new businesses.
For better growth prospects, some tech stocks could be immune to both deflation and inflation. Technology as a whole has experienced deflation for years: Computers and semiconductor chips keep getting cheaper. Thus, economic deflation could have little impact on tech outfits' businesses.
Moreover, inflation can be a spur for technology stocks as companies look for ways to operate more efficiently in the face of rising wages. Vitaliy Katsenelson, portfolio manager of Investment Management Associates in Denver, likes Microsoft for its strong balance sheet and the steady demand for its Windows products. But experts recommend that investors not lose their focus on the long term, regardless of economic forecasts.
Straddling Scenarios
With inflation or deflation, pricing power is key, says Mr. Katsenelson. "In the case of inflation, you want companies that can raise prices, and in the case of deflation, you want companies that can maintain prices," Mr. Katsenelson says. He favors dividend-yielding drug giants such as Pfizer Inc. that will see demand no matter what direction the economy takes, he says. Pfizer sports a dividend yield of about 4%.
He also likes defense firms, such as L-3 Communications Holdings Inc.. Mr. Katsenelson expects spending on defense to keep rising about 3% a year for the foreseeable future. Joseph Barrato, chief executive of Arrow Investment Advisors LLC in Olney, Md., thinks investors should keep their eyes on the long-term risk of inflation. He worries that investors who currently own commodities, for instance, could be chased out of those assets by a short bout of deflation at just the wrong time— when inflation is beginning to kick in.
"When inflation comes back, they're going to regret that they don't have that stable component in their portfolio," he says. In other words, investors should work out a game plan and stick with it, rather than try to twist and turn with every shift in the economic forecast. Ms. Benz at Morningstar agrees investors need to remain concerned about inflation, even if deflation is the biggest worry near term. "Rather than casting your lot with one scenario," she says, "give your portfolio a chance to perform reasonably well under both."
Correction & Amplification:
There have been three deflationary periods since 1940, during which stock prices rose an average 24.9%. An earllier version of this story stated incorrectly that there have been four such periods, with stocks rising an average 19.7%. An early version of the chart accompanying the article shouldn't have included the month of May 1944, when consumer prices were flat rather than down from a year earlier.
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