How to protect against deflation
The Financial Post takes a weekly look at the tools and strategies that will help make your investment decisions. This week: How to prepare your portfolio for a sudden bout of deflation.
Aside from the market’s renewed volatility this month, investors have also discovered that deflation fears can hit suddenly and with little warning.
Oil prices have collapsed to a four-and-a-half-year low, while the eurozone is now widely expected to enter a triple-dip recession.
“Deflationary environments are generally bad for equities prices,” note Barclays analysts in a report. “However, different types of companies perform very differently during inflation and deflation.”
But before creating a portfolio that can better withstand deflation, it is important to understand what deflation does to companies.
In a deflationary environment, prices actively fall, which can be good for consumers, who pay less for goods and services, but it is usually bad news for the corporate bottom line.
Barclays notes that companies with high fixed costs — for example, cyclical companies such as miners — suffer during deflation because their costs stay the same while the goods they provide now command lower prices in the market.
This is also true for highly leveraged companies. The amount they owe stays the same, but now their cash flows are lower and they have less ability to service their debts.
“So, if deflation appears imminent, increasing the share of higher-quality, more defensive businesses in your portfolio may help to reduce your risks,” Barclays notes.
It is also important to keep in mind that deflation can be more punishing to certain sectors.
“Tech companies are used to coping with persistently decreasing selling prices and increasing costs,” Barclays notes. “So a downswing in costs caused by a deflationary environment might even be good for profits.”
Of course, simply loading up on blue-chip names won’t keep you protected. Overall, history shows that stock markets decline when deflation takes hold, which is why investors should look beyond equities. Bonds in particular can help investors weather a deflationary storm.
“Stocks of most types are unlikely to deliver gains during significant deflation,” Barclays analysts note. “Instead, bonds are likely to be the main beneficiaries — especially those that offer relatively high yet still reasonably secure yields (the highest-yielding borrowers will be the most indebted companies, who are likely to be badly affected by deflation). These pay fixed income streams, which would become more valuable in real terms as prices fall.”
Of course, a deflationary environment can be a nerveracking ordeal for investors whether investors are prepared or not. Luckily, economists at Deutsche Bank said they do not expect deflation to take root in North America even though such fears have risen in the past few months,
“Goods prices have been soft, but there is little evidence to suggest they are likely to turn sharply lower,” the economists note. “Finally, the U.S. dollar needs to appreciate significantly further to have any noticeable impact on core inflation.”
But with oil prices at multiyear lows and the eurozone heading into another possible recession, it doesn’t hurt to be prepared.