How to position yourself for deflation

If we are right in believing that inflation is not the risk but deflation is, then short- and long-term interest rates are destined to remain low. Such a belief justifies our faith in long-dated UK gilts, though it must be said we hold these with a relatively tight stop loss. When everybody finally agrees that asset prices are in an irreversible decline, then investors will hunt out safe long-term fixed income investments and gilts will soar.

As deflation bites, the present unwillingness of banks to lend to other than undoubted households and businesses, will be magnified, the authorities will print money with impunity and the banks will mimic what Japan has done in similar circumstances; hoard money on their balance sheets, probably invested in government bonds.

Today, everybody says inflation is the problem because governments are printing so much money. But the economic conditions of unemployment, lack of wage growth, asset price weakness and above all else, dramatic over-capacity, means that inflation just can't gain traction.

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We quote from Martin Wolf's recent article "The latest consensus forecast for growth in the high-income countries of 2010 will be below potential yet this is also at a time when the admittedly uncertain estimate of output gaps (or excess capacity) are at extreme levels. For 2009 the OECD estimates these at 4.9% of potential GDP in the US, 5.4% in the UK, 5.5% in the Eurozone and 6.1% in Japan. risks of deflation are self-evident June's hysteria over rising yields on conventional bonds looks absurd."

The fear of inflation is probably deflation's strongest ally. Governments and their advisers are more concerned about printing too much money than too little so they won't print enough.

As the economy continues to struggle, central banks will be forced to maintain virtual zero interest rate policies and will only change that policy if inflation raises its head. As we reported a couple of issues ago, Japan has been running interest rates below 1% for about 15 years and still no end is in sight!

This article was written by Full Circle Asset Management, as published in the threesixty Newsletter on 17 July 2009