How to Profit From Deflation

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Posted: Feb 02, 2016 12:01 AM
How to Profit From Deflation

By: Martin Hutchinson, Global Markets Analyst

A sharp decline in stock prices has stunned investors in the first weeks of 2016. This rapid decline follows a prolonged and deep decline in commodity prices.

Monetary authorities across the globe are increasingly concerned that headline inflation is close to zero and drifting lower. It appears that we may be in for a bout of deflation, especially if global economies turn down again.

If that happens, income investors will have only one safe haven: prime corporate bonds.

Deflation, Dead Ahead

The glut of money in the economy is one of the primary causes of this deflation, both in the United States and worldwide.

Until about 2012, the Fed’s monetary "stimulus" worked the way we thought it should: The output of goods and services rose and inflation also began to trend upward, as gold and commodities prices headed for the heavens.

Then, in 2012, everything went into reverse. Inflation stopped rising and began to decline, while gold and commodity prices went into a steep decline. Oil prices joined them after mid-2014.

Now, overall consumer price rises are close to zero, even though the U.S. "core" consumer price index is being artificially propped up by the "owner's equivalent rent" sector, a fudge factor invented by the Bureau of Labor Statistics that accounts for 40% of the core index – which is up over 3% in the last year.

Economically, you'd expect this. The Fed, through its monetary policy, has caused the economy to produce more goods and services than it otherwise would. Logically, that should cause the price of goods and services to decline.

The biggest declines should be in areas where a lot of capital is needed. Energy and mining both require huge capital investments up front, so ultra-low interest rates and high energy and commodity prices have produced a huge glut.

You'd expect real estate to be in oversupply, too. Chinese real estate certainly is, and the world hotel industry seems to be heavily overbuilt. U.S. housing is probably in less oversupply, because homebuilders are still recovering from their 2008-10 near-death experience.

Meanwhile, there’s been a glut of mergers and acquisitions and leveraged buyouts, so there will certainly be a shakeout in the junk bond sector – though not necessarily among prime corporate bonds.

In the tech sector, there’s been an excess of private venture funding. Not only will tech company prices decline, but I also expect a decline in the prices of tech products such as iPhones, Uber car rentals, and Facebook advertising rates.

The financial services sector is already seeing a squeeze, and if you look at fourth-quarter profit figures, it appears likely that it will intensify.

Finally, cheap money has enabled governments the world over to run much larger deficits than usual. Many of these governments will struggle with their finances going forward, starting with the most indebted – Japan.

Bonding Time

This evidence suggests that we’re very likely to see deflation, along with a massive liquidation of misguided investments and the debt associated with them.

For income investors, the likelihood of deflation should lead us to buy bonds.

However, government debt is in oversupply, and the markets for it may become difficult. In any case, yields are still very low. Hence the optimal investment in the coming deflationary era will probably be prime corporate bonds with credit ratings high enough to be bulletproof.

More specifically, we should buy long-term rather than short-term bonds.

The most sensible way for an individual investor to buy bonds is through a bond ETF. We must be careful here, though. The great majority of "investment grade" corporate bond ETFs specialize primarily in Single A and BBB credits.

In a deflationary environment, these are dangerous. They can easily be downgraded below investment grade, and some may default.

For example, the largest corporate bond ETF, the iShares iBoxx Dollar Investment Grade Corporate Bond ETF (LQD), a $23 billion fund, is currently 87% invested in A- and BBB-rated bonds.

Therefore, we need to aim higher up the quality scale.

Unfortunately, not many ETFs enable us to do this. The largest such fund (size is important for liquidity in bond funds) is the iShares AAA - A Rated Corporate Bond Fund(QLTA).

This fund is still 75% invested in A-rated bonds, with only 25% in higher-grade ratings – but at least it avoids BBBs. It tracks the Barclays U.S. Corporate AAA - A Capped Index, has an expense ratio of only 0.15%, and currently yields 3.0%. Of course, if the deflation thesis is right, you should see some capital gains as well as income.

Among mutual funds, the Vanguard Long-Term Investment Grade Fund Investor Shares (VWESX), which requires a minimum investment of only $3,000, seems like a good choice. It holds only 10% in BBB bonds and 33% in AA/AAA. This fund has a relatively low fee of 0.22% and a yield of 4.12%.

There’s also an "Admiral" fund – the Vanguard Long-Term Corporate Bond Index Admiral (VLTCX) – with annual fees of only 0.1%. But this fund has a 1% upfront purchase fee.

The deflation thesis is by no means certain, therefore you shouldn't "bet the farm" on it. But a modest investment in top-quality corporate bonds seems appropriate, even if their yields are unexciting.

Good investing,

Martin Hutchinson

For 27 years, Martin Hutchinson was an international merchant banker in London, New York, and Zagreb. He ran derivatives platforms for two European banks before serving as director of a Spanish venture capital company, advisor to the Korean company Sunkyong, and chairman of a U.S. modular building company. In Zagreb, he established the Croatian debt capital markets, set up the corporate finance operations of Privredna Banka Zagreb, and arranged for the monetization of 800,000 frozen Macedonian foreign currency savings accounts. He has been a financial journalist for over 14 years, and is the author of Great Conservatives and co-author of Alchemists of Loss, which details the causes and consequences of the 2008 financial crash. He currently publishes a weekly column called The Bear’s Lair, in which he comments on the economy and market. He is also a correspondent for Reuters’ BreakingViews. Martin has a first class Honors Degree from Trinity College Cambridge and an MBA from Harvard Business School.