Investment Strategy for Deflationary Times
The bursting of the asset bubble amidst a tsunami of financial problems and the economic recession has already erased more than four years of wealth created by world’s households and corporations. However, the precipitous drop in wealth is unlikely to end anytime soon. Now there is something else to worry about: deflation. Emerging deflation in general consumer prices will likely exacerbate the current economic and financial problems and will lead to the extended, albeit somewhat less severe losses in asset values and therefore in general wealth.
Institutions such as the Central Bank, the IMF, and our own banks such as AIB have all painted gloomy growth, or rather contraction, forcasts for Ireland. A central point is that Irelands recovery is heavily dependent on global economic recovery, and so somewhat out of our control.
Deflationary pressures have already slashed values of various asset classes, especially in the property market. However, these pressures will be sustained as the world’s economies enter into a cycle of falling prices of consumer goods and services. Given that deflation negatively affects household income, corporate profits, asset values, and the overall economic growth, it will be necessary to show prudence when making investment decisions in the current market. In fact, for deflation, there is only one right investment choice: preserving capital.
In deflationary times, the overall investment strategy should be focused on the preservation of wealth rather than on the creation of wealth. Moreover, the goal is to concentrate holdings in safe assets rather that to diversify them across sectors and markets. This conservative approach means steering away from equities, commodities, and high-yield fixed income securities, even from traditionally conservative investments such as property and managed funds, and focusing on safe liquid investments, such as cash and bonds, which do not necessarily produce high returns.
In fact, deflationary times give true meaning to the cliché cash is king. This is so because, by definition, deflation means that the value of your money increases as the price of goods and services declines. There are also other liquid (cash-like) investment instruments, such as certificates of deposit and money market funds, which would preserve your wealth from losses propped up by deflation.
Bonds are also an option. However, investing in bonds when deflation is coupled by financial distresses and the possibility of an extended economic downturn warrants caution in respect to bond issuer creditworthiness. The likelihood of default on certain types of government securities (particularly municipal bonds) and corporate bonds is heightened in the current situation in which corporate bankruptcies, especially in some sectors such as auto industry, are rising. Therefore, one should be very selective when opting for bonds, particularly corporate bonds, making sure that securities with the lowest probability of default are selected. Treasury bonds are the safest investment choice.
Certain undervalued equities may also offer some long-term value. For those who maintain investment positions in equities with a long-term perspective, sectors that could offer some relative security from the generally declining stock market include infrastructure construction-related sectors, consumer staples, healthcare, and utilities such as electric power companies.
However, with this investment strategy one may view deflation as an economic process that reduces opportunities to maximize wealth creation. Quite the contrary! Conservative investment choices in deflationary times preserve wealth from losses and secure capital for the time when high-return opportunities re-emerge. In fact, deflations are the precursors of investment opportunities that will follow it. These opportunities, when identified properly, may offer substantial long-term returns that will assure optimal long-term investment performance. Still, while the coming deflation may not last long, it will take a while before the economy charges ahead again. It will be necessary to clean some of the excesses accumulated during the largest asset bubble in the economic history of the modern world before good investment opportunities sprout again.
This cleansing process is where the National Asset Management Agency (NAMA) needs to make the correct decisions, on behalf of the Irish taxpayer, in order to maximise long-term sustainable growth. Heres hoping…