Analysis from AdvisorAnalyst.com

Is Deflation Still a Risk?

Deflation is an economic problem that has become synonymous with the Great Depression, but in fact, there is little evidence to support the idea that deflation leads to depression.

Bloomberg's Matthew Lynn writes, "Deflation is no threat at all. It doesn't prevent an economy from functioning, and it doesn't stop it from recovering either. The evidence suggests a period of sustained deflation might be what indebted economies need to get them back on the right track."

Deflation is not something to be taken lightly, however, because among other things, it may lead to consumer complacency due to falling prices, inventory surpluses, overcapacity, and thus unemployment. Haven't we already experienced that, globally?

Now that I've said that, the question remains, is it still a risk?

David Rosenberg, chief economist at Gluskin Sheff, maintains that deflation remains a risk. In his morning report called Breakfast with Dave, he says, "It also looks as though Bernanke & Company are going to try and craftily withdraw from its unprecedented incursion into the mortgage market. If 2009 was the year of the policy reflation, then 2010 is likely to be the year renewed deflation. Below we highlight how investors should be braced for such an outcome – it is the opposite of what worked in the 2009 flashy bear market rally that so many pundits are mistaking for a new secular or even sustained cyclical uptrend."

He adds, "Extrapolating what happened from the March lows into the future could well be the most critical mistake an investor can make this year. We intend on not making a mistake that would risk the fundamental goal of capital preservation and growing wealth over time. What happened last year was a policy-driven deviation from the primary trend that is characteristic of a deleveraging cycle and a secular credit contraction, which is towards debt deflation."

James Bullard, President of the St. Louis Federal Reserve Bank, on the other hand, told the Financial Times that though his preoccupation throughout 2009 had been deflation, that the risk had "passed," according to FT.com's Tom Braithwaite.

Bullard, regarded as a Fed centrist, says that it is not yet time to tighten monetary policy, and the Fed must consider factors other than inflation and unemployment, and place more emphasis on factors such as asset bubbles.

And, rather than simply tightening policy interest rates, the Fed could consider using a market measure such as a repo (repurchase) rate as a tool instead.

The broader post-crisis economy was "on track" with its recovery, he said. "It's not a real strong recovery but that's what we had predicted anyway. But it will be above-average growth for the first half of 2010 and we'll probably see some positive jobs growth in the first part of 2010 here."

In a similar vein, Rosenberg discusses the possibility of a housing bubble in Toronto, and a generally strong recovery in Canada housing numbers. Though there is no consensus on the "bubble," media chatter suggests that Finance Minister Jim Flaherty's policy response may be to increase the minimum downpayment, and reduce the maximum amortization to 25 years in order to cool things off, rather than raise policy interest rates.

When it comes to investing, Rosenberg, whose practice it has been to back up his economic calls with actionable investment decisions, says that, "Considering the volatile, alternating character of the financial markets over the last three years there should be no pressure to change our overall cautious investment strategy," with a "focus on capital preservation and income orientation, whether that be in bonds, hybrids, hedge fund strategies, and a consistent focus on reliable dividend growth and dividend yield would seem to be in order."

He adds, "To reiterate, I see the range of outcomes in the financial markets and the economy to be extremely wide at the current time. But one conclusion I think we can agree on is the need to maintain defensive strategies and minimize volatility and downside risks as well as to focus on where the secular fundamentals are positive such, as in fixed-income and in equity sectors that lever off the commodity sector." He also favours stocks of producers of consumer staples, health-care companies, utilities and phone companies. He is also long-term bullish for gold, as with commodities, and he suggests that any meaningful pullbacks this year, in either, should be viewed as opportune.

So is deflation still a risk? Yes, but it's hard to know whether we are in for strong or mild deflation, and secondly, it remains to be seen if deflation leads to economic depression. After all, deflationary concerns arose in Canada for most of last year, simply as a result of the stronger Canadian dollar. At the very least, the question warrants caution, and on that basis, I tend to agree with Rosenberg's rational, yet cautionary investment approach.