For markets, back to worrying about the worst-case scenario

Market Beat

Epic financial collapses are supposed to be rare events. Once in a lifetime, we all hope.

And after you live through one, your investment decisions are forever colored by the experience. That explains many investors’ extreme risk aversion since the markets’ crash of late 2008.

Now, the risk-averse are being forced to ponder whether they feel safe enough given what might be coming at them.

At the depths of the recession it was more than rhetorical to ask, “What’s the worst that could happen?”

Here we go again.

Much of the important economic data of the last few weeks have pointed to slower growth in the U.S. and overseas. That has been enough to spark another worldwide sell-off in stocks, though a modest one compared with what hit the markets in the spring.

More striking has been the rush to buy the bonds of governments that investors believe will always find a way to pay their debts — the U.S. and Germany, for example.

The already low market interest rates on those bonds fell further this week as more buyers piled in, happy to accept ever-shrinking yields in exchange for a sense of security.

With the annualized yield on 10-year Treasury notes at 2.68% on Friday, a 16-month low, “The bond market is telling you a very pessimistic story” about the economy, said Bill Strazzullo, market strategist at Bell Curve Trading in Freehold, N.J.

In other words, the fear pushing bond yields down isn’t about whether the world is facing just a temporary economic slowdown. Rather, it’s dread of another calamity: a further shrinkage of the economy that would set off a deflationary spiral, meaning a broad and sustained decline in prices of goods, services and assets.

Worries about deflation surged amid the credit crisis of 2008, then largely went away as the global economy rebounded last year. They have roared back over the last two months as the U.S. recovery has ebbed while a key measure of inflation has held below the 1% level.

On Friday, the government’s report on July retail spending provided more evidence of an economy that is struggling, though not collapsing. Excluding auto and gasoline purchases, retail sales slipped 0.1% from June as many consumers apparently kept their wallets closed.

A separate report on the main U.S. inflation gauge, the consumer price index, showed that prices overall were up 0.3% in July from June, the biggest rise in a year, boosted by a jump in energy costs.

But the more closely watched “core” index, excluding food and energy expenses, was up just 0.1% from June. And the year-over-year increase in core prices has stayed at a mere 0.9% for the last four months — the slowest rate of inflation in 44 years.

A slide into actual deflation in the core index may be less likely in the near term because of the effect of housing costs, which account for about 32% of the CPI overall. Rising rents in many parts of the country, as more people stay in apartments rather than buy homes, could offset downward pressure on other prices.

Still, the danger of tipping into deflation obviously increases as growth slows.

“We know the economy is losing momentum fast,” said Mohamed El-Erian, chief executive of bond fund giant Pimco in Newport Beach.

He now believes there is a 1-in-4 chance of the U.S. sliding into deflation.

The stock market, for now, doesn’t seem to buy those odds.

Share prices took a hit this week, with the Standard & Poor’s 500 index losing 4.3% from Tuesday to Friday after reaching a 12-week high on Monday. But trading volume has been anemic (it’s August, after all), and there has been none of the panicked selling that Wall Street saw in May, when markets sank on worries about Europe’s debt crisis.

So, while government bond markets are pricing in an ugly turn for the economy, equity investors are relatively sanguine.

“One of these markets is going to be wrong,” Strazzullo says.

If Treasury bond buyers were looking for validation, they got it this week from the Federal Reserve. Citing slowing growth, the Fed said it would resume its 2009 program of buying Treasury securities — a move aimed at pulling down longer-term interest rates in general.

The Fed didn’t mention deflation risk in its post-meeting statement, but bond investors could read between the lines: Chairman Ben S. Bernanke and peers are plainly worried.

But as horrid an event as deflation has been made out to be, the truth is we can’t be sure what it would actually mean for the economy.

The images it conjures are from the 1930s, with widespread falling prices, wages and asset values. That’s one version.

Yet Japan’s deflationary backdrop of the last two decades hasn’t gutted its economy. The country’s growth overall has been sub-par, its stock market has been abysmal and consumer prices have been in a sustained decline, but Japan remains an industrial powerhouse with a high standard of living.

It’s conceivable that the U.S. could experience a mild deflation with a quarter or two of negative economic growth — the “double dip” — that would give way to a pickup in growth in 2011.

Conceivable, maybe, but too dangerous to risk, says Jim Bianco, head of bond research firm Bianco Research in Chicago.

“We’re at the point where it becomes very important that we don’t slip back,” he said. A double-dip recession “could mean that [Americans’] confidence could be shot for many years.”

With the private sector creating few jobs, the employment picture would only worsen if businesses began to expect a double dip and cut costs preemptively. Layoffs would surely mount again.

And any slide into a deflationary recession would almost certainly mean a new dive in stock prices and in the value of many other assets, including real estate.

To protect themselves against deflation, more investors would do what the already worried have been doing: avoid most equities and favor high-quality bonds that should continue to generate interest income even in a new downturn.

Just building up cash also would be a logical defense. If deflation hits, and prices of many goods and services decline, a dollar would be more valuable tomorrow than it is today because you’d get more for the same amount of money.

Deflation works the opposite way on borrowers: Debt becomes more expensive to carry because you’re paying it back with money that is gaining value (as opposed to losing value in an inflationary environment).

By taking yet another step to try to avoid deflation — by pumping more money into the financial system via bond purchases — the Fed this week did what many analysts had expected.

But the central bank also runs the risk of fueling more pessimism about the economic outlook.

With the government already having tried so much in terms of lowering interest rates and spending massively on stimulus, “I think people are realizing that policy is becoming less effective” in influencing the economy, El-Erian said.

As for investors, he said, even if there’s just a 1-in-4 chance of falling into deflation, that is serious enough to change many people’s decisions about where they put their money — because the outcome could be so severe if the worst happens.

His analogy: “Would you accept a lift from a person who has a 1-in-4 chance of getting into a really bad car accident?”