Deflation Now, Inflation Later?

05/07/2009 1:00 pm EST

Focus: FUNDS

Richard Lehmann

Publisher, Forbes/Lehmann Income Securities Investor

Richard Lehmann, editor of the ISA ETF Investor, says we may have deflation for a while and inflation after that, and he recommends two funds to cope with it.

The immediate concern in the market is deflation. Real estate, oil, and gold have all fallen from their highs this year. The housing crisis may have started the economic downturn, but its effects have now spread throughout the economy.

The solution for deflation is its opposite—inflation. Government policy is solidly behind inflation as a cure as evidenced by massive spending, borrowing, and creation of money. The hoped-for inflation will serve to make real assets more expensive and reverse the decline in real estate prices, solving the mortgage crisis.

When prices once again exceed the amount mortgaged, sellers can either unload the property or continue paying the mortgage. It would make little sense to walk away while it pays to do so now.

The areas most likely to benefit from inflation are real estate, oil, and precious metals. Real estate funds had a dramatic comeback in the last month, making up for some of last month’s losses. All of the best performers were real estate-related funds, all of which gained more than 40% for the month.

The only problem is the timing. Deflation may continue for a while, before the stimulus spending creates inflation. The real estate sector may seem counter intuitive considering the current deflationary environment, but income-producing real estate investments may make the wait profitable.

The Neuberger Berman Real Estate Securities Income Fund (Amex: NRO) is a closed-end fund that trades [around] net asset value (NAV), but yields a whopping 21%. The income stream was cut last year, but at a current price of $2.10, the yield is extraordinary. There may be more dividend cuts to come, but we think the eventual capital appreciation will be reflected in an ultimate price increase.

The international outlook for deflation/inflation will mirror the same dynamic as the US. We expect some deflation, followed by inflation. Real assets are one way to deal with the coming inflation. To deal with near-term deflation, high yield and buying equities at a deep discount is a good cushion. The concept is that a deep discount from NAV will limit some of the down side, as will a high yield.

The BlackRock Global Opportunities Equity Trust (NYSE: BOE) provides both a deep discount and a high yield. The fund invests in the international sector, uses a buy-write strategy in addition to investing in dividend-paying stocks, preferred securities and foreign debt. The fund trades at a steeper discount than its one-year average discount of 8.68%.

The fund yields 14.7% and pays dividends quarterly. The fund’s top three investment sectors are in financial, health care, and energy. About 47% of investments are outside the US. It has maintained a stable dividend of 57 cents a share since the end of 2006. (It closed below $16 Wednesday—Editor.)

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