Funds: How to profit from the deflation scare

"For now the imminent danger is deflation," says John Authers in the Financial Times. Thanks to George Osborne's emergency budget, Britain faces an "age of austerity". Meanwhile, there is "violent agreement" on deficit reduction overseas. Last weekend's G20 meeting in Toronto echoed the sobering rhetoric of the British budget.

Internationally the only remaining area of discord is timing. While the US seems to favour a 'talk now, cut later' stance, Britain, following the path taken by several European nations such as Ireland is taking a 'cut now and cut deep' approach. There's much at stake: cut public spending too quickly and a double dip could become a depression if private-sector growth fails to pick up sharply enough.

Countering the deflationists are those who argue that the forthcoming rise in UK VAT from 17.5% to 20% (enough by itself to hike the consumer price index rate by 0.6%) means talk of price falls is premature.

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On the flipside lies the spending slowdown that could be triggered by big public-sector job cuts and pay freezes. As it is, unemployment rose in the three months to April and must surely rise further as 25% government departmental budget cuts arrive.

In the US, investors are braced for a grim non-farm payrolls figure analysts expect unemployment to rise above 9.7% as census work is scaled back. That comes as US core inflation (minus fuel and food) is at its lowest level since 1961.

So what should investors do about looming global deflation fears? Government bonds (gilts) are one option. Most pay a fixed coupon and are virtually 'risk free', being backed by the British taxpayer. And as deficit reduction gets underway, the British government should be borrowing less, and therefore issuing fewer bonds. That bodes well for the prices of those currently in circulation, even with yields already low. For example, in Britain analysts are already pencilling in a cut in debt issuance of around £20bn in 2010/2011.

This may not last. Indeed, if a double-dip arrives as we think it will, our politicians may well take fright and abandon austerity. But for now, if you want to bet on deflation as the next big worry, then the M&G Gilt & Fixed Interest Income Fund looks a good option. It has been outperforming its peers as gilt prices have risen in the run-up to, and following on from, the budget. The M&G fund also boasts a low annual expense ratio of 0.9% and no initial fee. It is managed by Jim Leaviss a professed deflationist and is up by 27% over three years.