DEFLATING HOPES

News of a Russian debt swap plan worsened the slump in emerging-country stock markets Wednesday, and the continued fall in commodity prices--now at a 12-year low--on top of other falling indexes keeps a lot of money managers thinking about deflation risk.

It’s not just stock and commodity market indexes that have been declining. In Europe and the U.S. alike, all kinds of prices--and profits--are sliding.

Officially, inflation in the U.S. is approaching zero, but “for all practical purposes it’s probably already in negative territory,” observed Jean-Philippe Cremers, a portfolio manager who helps pick stocks for GAM International and GAM Global mutual funds.

David Tice, manager of the Prudent Bear Fund, said that easy credit in the U.S. has been masking deflation by pumping up the price of real estate, restaurants, cigars and luxury products while the cost of manufactured goods falls. As a result, prices looked flat. “We probably should have had 2% to 3% deflation over the past few years--thanks to easy money, we’ve had mild inflation,” Tice said. “The credit bubble is another balloon waiting to pop.”

But it’s the numbers coming out of Europe that are startling. Cremers called them “exceedingly strange for an economy in the first phase of recovery.”

In Germany, for instance, June retail sales dropped more than expected--off 3.1% for the month--and down 2.7% from a year earlier.

Italian industrial production fell a greater-than-expected 2.1% from May to June. In France, consumer prices fell faster in July than in more than 40 years--down 0.4% after rising only 0.1% in May and June.

So what do investors do if they expect more price drops? Cremers is avoiding cyclical stocks--retail, chemical, steel--and focusing instead on banks, insurers and drug companies.

Roughly 40% of GAM International’s assets are invested in financial companies because, in a deflationary environment, it’s always better to be a lender, he said.

This sounds like good news for bondholders--and it may be. But Cremers sees better prospects elsewhere. “We prefer to play the bond market through the financial sector [since] we expect interest rates will favor earnings,” he explained. Four banks account for 15% of the fund’s holdings.

Pharmaceuticals seem safe from deflation too. “Drug companies can still increase prices--in the U.S. they’ve gone up 3% in the last few months,” Cremers said.

Novartis ranks among the 10 biggest holdings in both GAM Global and GAM International.