Weekend Read: How Do You Invest For Deflation?

A few essays ago, we suggested that given the extreme financial leverage (overuse of debt) in both the governmental and private sectors, the risk of a deflationary period may be higher than many believe.

You might remember the extreme events during the Great Financial Crisis of 2007-2009.  We are still living with the echo from that period. Money market funds failed and had to be rescued. Brokerage houses like Merrill Lynch failed and had to be sold off to Bank of America.  Lehman Brothers failed, and they had been in business since the Civil War.  There were increased bankruptcies.  Real estate declined.  In the Phoenix area, one of the hottest markets in the country, we suffered about a 50% decline in the value of residential housing.  The S&P 500 declined over 50% in value.  In short, it was a scary and painful period, even with all the governmental attempts to reverse the process.

Stocks declined by over 50% and indexing did not help at all.  It took years to recover.

So, while we readily admit that the bias of our system (constant fiscal and monetary stimulation) is towards inflation, deflationary interludes have and likely will occur in the future. 

Inflation is something we are all used to and we know what to do. Buy assets: stocks, gold, commodities, real estate, and valuable collectibles like art and gemstones. Go into debt and pay your creditor back with cheaper dollars than those you borrowed and leverage your inflationary gains. However, what to do in deflation is a bit foreign to many investors.

A deflationary period suggests that authorities either lose control of events or are simply overwhelmed by events.  If history is any guide, they will attempt to re-inflate, and the FED will pivot back to lower interest rates and the use of Quantitative Easing.  That of course will take time and there is still lots of leeway to get hurt in declining markets.

Thus, deflationary investing is more like an intermediate trade rather than long-term compounding based on the historic growth of the economy.  The attempt is to make money and reduce losses elsewhere, for the duration of the contraction, knowing that the inherent bias of our system is towards inflation or currency depreciation.  In this sense, investing for deflation is not long-term investing, but it is not day trading either.  Likely positions will be held for several years, but usually, that is about all.

If we are correct that deflation poses a threat at least at some level of probability, then the question is:  what as private citizens and investors can we do about it?

Assuming we will be able to determine the change in the economic weather in time (this is much more difficult than we are making it sound), here are some basic ideas to work with.

The most important thing to remember is that financial leverage that is so beneficial on the way up, has the same leverage on the way down.  This suggests paying down debt before the recession.  Very often loans are collateralized based on the value of a stock portfolio or a real estate. If those assets decline in value, you might be placed in a liquidity crisis.  The bank may ask you to pay down the loan because the collateral has fallen below or near the value of the loan. You may not have the cash to do that.  The result may be a fire sale environment for your assets that will destroy much or all of their value.

So, the first broad observation is to reduce debt and financial leverage and increase holdings in cash-like instruments.  Today, with interest rates at least as high as inflation, seek those cash-like instruments that have the highest credit rating.  That would include things such as insured CDs and US Treasury Bills.  The returns now are pretty decent and they are not a bad place to set out the storm.  Avoid the siren song of high yields.  Things that have high returns do so for a reason, they are higher in risk.  Deflationary investments are basically de-risking the portfolio.

Notice this is not a strategy to make a lot of money.  It is basically an attempt to get out of harm’s way and make at least a decent return while doing so.

No doubt this sounds boring but boring is good sometimes.

There are some quite dynamic positions that can be taken, but you must understand the trade-offs between risk and return.

Shorting the market (betting on the downside) does not work very well for the retail investor.  Perhaps the safest is buying put options since your risk is limited to the premium you pay for the options, but your timing must be very good or the options can expire worthless.  However, timing is extremely difficult and overwhelmingly retail investors lose when they buy either put or call options.  For most people, this is not a good strategy because timing is just too tricky.

There are now a number of reverse funds available today.  Unlike options, they don’t have the time constraint.  However, they often don’t track the market well and many brokers restrict the retail public from buying them.

In most previous cycles, once it is clear the economy is in trouble, interest rates start to fall for two reasons.  One is the drop in demand for loanable funds since there is little need to borrow money when business is contracting.  Secondly, the government and the Federal Reserve typically respond by pushing rates downward.  Stocks may benefit from falling rates, but it is not a sure thing.  We are talking about conditions where profits are falling and investors are scrambling for cash by selling things, including stocks.

The play with the higher probability of success is to buy longer-dated quality bonds.  Bond prices go up when interest rates go down.  The lower the coupon on the bond, and the longer the maturity, the more “duration” you get.  The ultimate would be a long-dated, zero-coupon bond.  They can be purchased individually or you can buy them in a fund such as Pimco’s ZROZ.

Unlike put options, the longer you hold a zero coupon bond (assuming interest rates are stable), the more valuable they become (they accrete interest).  You also get considerable leverage, without using debt to get that leverage.  Leverage in this sense means you get a lot of appreciation, for a relatively small outlay of cash.  The gains you hope for will offset losses you may be suffering elsewhere.  The term usually used to describe this process is “hedging”.   You use a modest amount of funds to do a lot of work, hoping to protect the overall value of a larger portfolio.

ZROZ was not available at the beginning of the crisis but it went on to go up fourfold in value.  A little bit of zeros did a lot of work. Note that they have fallen sharply after rates began to rise in 2020.  These are very much a creature of the interest rate cycle.

Another popular choice is the exchange-traded fund, TLT.

Bonds went up about 60% during the collapse of many other markets.

Certainly, a decline in rates has been a feature of all the last few cycles.  However, in today’s environment, even this has to be considered a “trade.”

The reason is this business cycle happens to come in the middle of a historic shift in demographics.  The peak of the baby boom was in 1957.  Most people get Medicare at age 65 and basically full Social Security benefits at 66 or so.  Add 66 to 1957 and you get 2023.  In short, a historic wave of the elderly will hit both “entitlements” over the next decade while the number of younger taxpayers is shrinking.  The end result will be to drive spending and deficits through the roof.  Coupled with the wild expansion of spending under Biden, the markets will have to digest a huge outpouring of Treasury Bonds.  These circumstances will likely drive interest rates back up.  If so, the “bond trade” will have a relatively short window:  the beginning of the bond recession and the immediate response of the government to it.

Not too long afterward, the longer-term financial crisis (the government selling huge quantities of debt) could depress bond prices (another way of saying interest rates will rise again), or rates will not fall as far as in past cycles.  We just don’t know.

Gold should get an honorable mention. Gold is still a key international banking asset and its role has been increasing as central banks have been buying at the fastest pace since the 1971 devaluation of the dollar and the end of the Bretton-Woods treaty arrangements.

During the last deflationary cycle, gold just about doubled in price.

Gold can’t default, and therefore, is a good holding during a period where defaulting can be an epidemic. Gold is the only international asset that is not someone else’s contractual obligation. In addition, gold tends to do well when central banks panic about economic contraction and go the other way by printing excessive amounts of money.  Either inflation or deflation, gold can work during times of economic instability.  It tends to do the worst in periods of stability.

We would note that the unwinding of the world’s biggest-ever debt bubble will likely be the antithesis of stability.

We can’t say if all patterns seen in the last financial crisis will prevail.  But history does tend to repeat itself.

Reduce debt, raise cash, have safe cash instruments, have some longer-dated bonds, and own some gold.  These are strategies to consider if deflation develops.

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Charts are courtesy of stockcharts.com and are drawn by the author.