BUSINESS

How key investments could fare if deflation fears worsen

Inflation erodes the value of cash, but with deflation a dollar is worth more tomorrow than today

If deflation takes hold, with a sustained decline in prices for goods and services, the rules of the investing game change.

A slow-paced deflation similar to Japan's since the late 1990s might not trigger sudden market crashes, but could change the relative appeal of investments.

The same could be true if the world faces something less serious: another long bout of disinflation, meaning a declining rate of inflation rather than actual price and wage declines.

Here's a look at how key investment sectors could fare if disinflation/deflation fears worsen:

Cash is less trash. With short-term interest rates at or near zero in the developed world, holding cash brings no reward. Outright deflation, however, could make cash king. Inflation erodes the value of cash, but with deflation a dollar is worth more tomorrow than today because it would buy more if prices drop.

Of course, many investors have been holding high levels of cash since 2008, waiting to buy stocks or bonds at cheaper prices. Instead, prices have continued to rise.

This year, increased market volatility could bring new opportunities to put cash to work. But short of deflation, don't expect much of a return from cash itself. Even if the global economy improves and the Federal Reserve begins to raise short-term rates this year, analysts figure the Fed might get to just 1% by the end of 2015.

•U.S. bonds: The rally may not be over. Little has shocked investors as much as the drop in bond yields since the 2008 financial crash. But then, few people expected the Fed to keep short-term rates near zero for this long — or to end up buying $3.5 trillion in U.S. Treasury and mortgage bonds.

The Fed's bond-buying binge halted in October, but long-term Treasury bond yields have continued to slide on global deflation jitters, dragged down in part by the further drop in European and Japanese bond yields.

If deflation breaks out, high-quality bonds such as Treasuries and highly rated corporate and municipal issues most likely would continue to attract money as investors rush for safety. That means yields could go lower.

Lacy Hunt, who helps advise the $313-million Wasatch-Hoisington Treasury bond mutual fund, has bet correctly over the last five years that the global economy would get closer to deflation and that long-term yields would continue to drop. That's still his call. The 30-year Treasury yield, now 2.5%, "has the capability of going to 2% over time," Hunt said.

Yields on shorter-term bonds, however, are likely to take their cues from the Fed's moves with its benchmark short-term rate.

Where investors should be particularly wary is with lower-quality bonds. If the global economy stagnates and either disinflation continues or deflation takes hold, it could become much more difficult for heavily indebted companies and governments to pay what they owe.

As investors continued to exit low-quality bonds, the average corporate junk bond fund fell 1.6% in the fourth quarter, and is down 0.4% in 2015, according to Morningstar Inc.

Jeffrey Rosenberg, chief investment strategist for fixed-income investing at BlackRock Inc., said the overall bond strategy for 2015 should be to "go up in quality, and be defensive" rather than aggressive.

•Foreign bonds: Lower yields, higher risk? With yields on many European and Japanese government bonds already below U.S. yields, the market is betting heavily that interest rates in those economies won't turn up any time soon. And if those paltry yields weren't reason enough for U.S. investors to stay away, the strong dollar is another one: The dollar's rise against the euro, yen and other rivals devalues foreign securities held by Americans.

The result: The average world bond fund lost 1.2% in the fourth quarter. Emerging-market bond funds fared even worse, down 4% in the quarter.

The lesson for the time being is "don't own foreign currencies," Jeffrey Gundlach, head of DoubleLine Capital, warned an investor group in Los Angeles last month.

U.S. stocks: Time to get pickier. Wall Street's almost 6-year-old bull market has been supported by cheap money and rising corporate earnings. Deflation might keep money cheap, but it could make earnings harder to grind out if sales were to weaken because consumers and businesses cut back on spending.

Likewise, the strong dollar means that U.S. companies will face cheaper foreign competition in 2015.

The logical beneficiaries of disinflation or deflation are companies with the ability to raise prices despite the economic backdrop. Those would be businesses that have a product or service that is in demand and that don't face severe competition. Morningstar's favorites include drug maker Actavis, machinery company Emerson Electric and oil pipeline firm Enbridge Inc.

Other potential beneficiaries of disinflation or deflation are companies with little or no debt, and technology firms that supply ideas that help make businesses more efficient.

Many Wall Street pros say investors should stick with stocks of high-quality companies in 2015. Charles Shriver, who manages T. Rowe Price's Spectrum asset-allocation funds, said he has been cutting back on smaller stocks in favor of bigger names. Market volatility is on the rise, and "small-cap stocks tend to underperform in periods of high volatility," he said.

•Foreign stocks: Poor odds. Americans have been far better off staying at home with their money over the last five years than going abroad. The global deflation threat means that may not change in 2015.

Many global investors believe that European blue-chip stocks are relative bargains. T. Rowe Price's Shriver has hefty stakes in European shares, but concedes that "it will take time" to see a payoff, given the Eurozone economy's woes.

In emerging markets, one crucial problem is that diving commodity prices are slamming the economies of major commodity exporters such as Russia and Brazil. The strong dollar makes weak foreign markets even weaker for U.S. investors. The average emerging-market stock mutual fund lost 3% in 2014 and is down 1% year to date.

What's more, the dollar's surge and the steep declines in other currencies pose the risk of unexpected shocks to the global financial system. The collapse of Thailand's currency in 1997 was the spark for a crisis that spread across emerging markets in 1998. "In the past, episodes of sharp currency moves have tended to break things elsewhere," warns Mohamed El-Erian, chief economic advisor to financial services firm Allianz.

Gold: Split decision. If gold is considered foremost a hedge against inflation, what about deflation? Unlike paper currency, which in theory can become worthless in a worst-case scenario, gold would always be expected to have some value. So it has that working in its favor if deflation risks rise.

But as competition for the dollar, gold has been losing. An index of the dollar's value against other major currencies jumped 13% last year, while gold lost about 2%.

Gold fans note, though, that the strength of the dollar means that gold has risen in value in depressed foreign currencies. For the rest of the world, at least, gold is acting like a deflation hedge.

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