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Deflation-Proof Your Portfolio

08/30/2010 12:00 pm EST


Marilyn Cohen

President & CEO, Envision Capital Management, Inc.

Marilyn Cohen, publisher of Forbes Tax-Advantaged Investor, and executive editor Chris Malburg say deflation isn’t likely, but they tell investors how to prepare for it.

The well-developed American economy is deleveraging. The specter of deflation remains a risk—though we believe its probability is low.

Deflation is not a good thing. The psychology of deflation feeds on itself. Deflation creates a downward spiral of lower profits. Here’s how it works: Deflation causes companies to cut expenses, which stops expansion and hiring dead in its tracks. [That] reduces the work force by layoffs, furloughs, and reduced work weeks, which creates a loss of consumer confidence since people are afraid for their jobs.

[That] reduces consumer spending, which drives prices down further, which [in turn] creates even more deflationary pressure.

Inflation has been falling since the 1980s. Still, it is inflation. We believe that there certainly exists the potential for deflation to occur. However, the probability is far more likely that we’ll experience either significant inflation in the future as the result of rising interest rates, re-employment, and a recovering economy or at least an inflation-neutral scenario.

With America’s huge national debt, deflation is the last thing our government wants. Deflation would force the US to repay its national debt in more valuable dollars. Naturally, the federal government prefers to repay its debt from a normally inflated economy using less valuable dollars.

The [Federal Reserve] has the tools to ensure this happens. It can buy Treasuries and mortgage-backed securities to quell deflationary pressures. Should the US economy enter a deflationary cycle, investors will need a reliable income stream that does not fall with interest rates or prices. That means allocating a portion of the portfolio to high-quality fixed income securities. Here’s our shopping list:

  • Corporate bonds—investment grade, BBB- or better.
  • Municipal bonds that are pre-refunded and escrowed to maturity. (These bonds cannot default unless the government stops paying on its Treasury-related debt.)
  • Essential-service bonds that won’t default because issuers need the water and sewers for their towns that these instruments fund.
  • Solid issuers with strong balance sheets and plenty of money in reserve accounts.
  • Treasuries.
  • Federally guaranteed bank [certificates of deposit].
  • Bond funds, but with longer durations.
  • There’s nothing wrong with holding cash in a deflationary environment, even though it returns zero. If deflation were to take hold, cash [would] gain in value as prices fall.

If you believe there is a real risk of deflation, then it makes sense to allocate a percentage of your bond portfolio to strategic deflationary securities. Your allocation percentage should reflect how strongly you believe deflation could occur. You can always change the deflationary allocation once we get a better sense of the [direction of inflation or deflation].

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