Escape from the threat of deflation with emerging markets

I'd love to be a fly on the wall in the Bank of England's deliberations on interest rates. Rumour has it that the committee's splitting into two factions. Some think rates need to go up to tackle inflation. Others think deflation is going to mean that rates stay pinned to the floor as we tackle a potential depression. It's time to take sides.

I've put my foot well and truly down in the deflation camp. I'm convinced that we need to take measures to protect our wealth against a painful bout of deflation. Why?

Because if the economy does sink into deflation, it could devastate your wealth. Deflation can ruin stock markets and suck the life out of an economy. Consumers lose all appetite for spending. And anxious saving replaces borrowing as the order of the day. Borrowing to buy things is all well and good when your wage is going up, but in a deflationary environment, things look a little different.

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Everything you thought was right is wrong

Most of us have never lived through a long period of deflation. And if that's what we are in for, one thing will be certain it will take a long time to get used to.

Say you're on £50k today, but you hope to be on £80k in a few years time. You might consider buying a shiny new car for £30k. Bought on finance, paying it becomes easier as your earnings grow.

The same goes for a house for that matter. If house prices are marching upwards and so are wages, then a little bit of leverage juices up returns without too much risk.

But imagine what happens if wages and prices are falling. Why would you borrow to buy the car today if there's a good chance you'll be earning less tomorrow? What's more, you'll be able to buy the car cheaper later.

So you put it off. You save your money and wait for the price to drop. Only everyone else is thinking the same thing. Prices start to spiral downwards. And producers get stuck with goods nobody wants. The economy stagnates. And nobody knows when it will recover.

Japan is a grim example of how bad it can get. The Japanese have been struggling with deflation for nearly two decades. Many investors that started out wealthy in the eighties have been all but wiped out.

And now there's a very real chance that the US and UK economy could be heading the same way.

How do you protect yourself?

Dealing with an economy turned on its head

Now normally you'd be thinking of cash and bonds to help you through deflation. After all, deflation is falling prices, so you want to keep hold of cash and purchasing power.

So cash and bonds are good, but it won't leave your portfolio very balanced. After all, we can't be sure what's coming, so a diversified action plan for deflation may be better.

I'm going to make a suggestion that may surprise and yet excite you.

How I'm protecting myself against deflation

My answer is emerging markets . The fact is that emerging markets are showing very little sign of deflation. In fact, the major emerging economies are grappling with inflation. And inflation has quite the opposite effect on stock markets to deflation.

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Soemerging marketscould be the antidote your portfolio needs against Western deflation. But I can already here you muttering 'aren't emerging markets already overvalued?' Well, yes. Certainly, they've had a pretty good 'post-financial crisis' run. But there's a good reason to stick with this bull, just ask any Japanese investor.

After twenty down-years on their stock market, I bet more than a few Japanese investors are wishing they'd had some exposure to some inflating economies and their (mostly) inflating stock markets.

Of course there's risk here. Emerging markets can be volatile as they're vulnerable to Westerners moving money in and out on a whim. But I reckon that over time local investors will start to edge out Western money.

And I think that it's local money and local investment that's going to keep these markets going for a while. Remember, bull and bear markets carry on going much longer than anyone thinks possible at the time.

Playing the market without it costing you an arm and a leg

Compared to unit trusts, investment trusts can save you a fortune and they are a great way to invest in Emerging Markets.

Investment trusts are basically companies set up specifically to buy and hold a portfolio of shares in other companies.

The shares of the investment trust are traded on the stock exchange, so you can buy them through your normal broker, just like buying any other share.

Just look at the JPMorgan Emerging Markets trust (LSE:JMG) for instance. The shares are up 119% over five years. That's pretty good when you consider the index (MSCI emerging markets index) was up 107% for the same period.

Their annual management fee is set at 1%. Compare that to unit trusts, which can charge you 6% up front and then around 1.5% a year, and you'll see why I'm a big fan.

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Source: JP Morgan Asset Management

Now of course, the fact that they've done better than their benchmark on a five year view doesn't mean they'll continue to outperform. As you can see from the rolling performance figures, some years they've done better, sometimes worse.

This article was written for the free investment email The Right Side. Sign up to The Right Side here .

Your capital is at risk when you invest in shares - you can lose some or all of your money, so never risk more than you can afford to lose. Always seek personal advice if you are unsure about the suitability of any investment. Past performance and forecasts are not reliable indicators of future results. Commissions, fees and other charges can reduce returns from investments. Profits from share dealing are a form of income and subject to taxation. Tax treatment depends on individual circumstances and may be subject to change in the future. Please note that there will be no follow up to recommendations in The Right Side.

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