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Should Investors Prepare for Deflation? |
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It's hard to read a story in the financial press without seeing a commentary about whether the U.S. economy is headed for a period of deflation, a decline in the cost of goods and services. While deflation may sound benign on the surface, a prolonged period could drastically change the lives of American investors and wreak havoc on the economy.
It's difficult to predict exactly what would happen during a deflationary spiral because the most recent example occurred in Japan, where many circumstances differed from the United States. What economists fear is a scenario where deflation feeds on itself. When prices decline, consumers and investors are reluctant to make purchases, holding back in anticipation of even lower prices. Businesses are forced to cut prices repeatedly, which hurts profits. To stay afloat financially, businesses may be forced to lay off workers. Since corporate profits historically have been an important determinant of stock prices, equity valuations could be impacted as well.
Prompting the speculation about deflation is economic data that is weaker than many observers had hoped, especially on the unemployment front. The slower-than-anticipated recovery cycle has fanned concerns about a double-dip recession. For the past several decades, inflation has averaged 3% a year. 1 The Federal Reserve expects inflation of 1% or less this year and next year. 2
Also adding to the fears about deflation; fighting deflation is tougher than fighting inflation. The Fed's key interest rate has been hovering at or near 0% throughout the recession, which means the government would have to go into negative territory to help spur spending.
Portfolio Strategies
Investors who are concerned about the potential for deflation may want to consult their financial professionals and consider a few strategies that could potentially lend a degree of stability to a portfolio during a period of falling prices.
- Focus on quality. Within an equity allocation, focus on high-quality companies that generate ongoing cash flow. 3 Although there are no guarantees, these companies may be able to maintain pricing power better than a company that is forced to cut prices to shore up a cash reserve. The same rationale applies to fixed-income assets and cash equivalents.
- Consider dividend-paying stocks. Although dividends are not guaranteed, should stock prices swoon during a period of deflation, a dividend could provide something in the way of a positive return.
Although there has been recent evidence of downward pressure on the CPI, some commentators believe that changes in inflation trends -- and the federal government's response in tweaking monetary policy -- frequently is gradual, giving investors time to make modest adjustments in their portfolios.
1 Source: U.S. Bureau of Labor Statistics, August 2010.
2 Source: The Federal Reserve, July 2010.
3 Investing in stocks involves risk, including loss of principal.
© 2010 Standard & Poor's Financial Communications. All rights reserved.
© 2010, Kelly Ruggles, Spokane, WA. Web site
Kelly C. Ruggles, Spokane, WA. is a fee-based financial planner located in Spokane.
Kelly C. Ruggles, Spokane, WA. President of American Reliance Group, Inc., a registered investment advisor.
Kelly Ruggles, Spokane, WA. is the author of "The Financial Playbook" for Retirement
Kelly C. Ruggles, Spokane, WA. Does not intend to provide personalized investment advice through this publication and does not represent the strategies or services discussed are suitable for any investor. Investors should consult with their financial advisors prior to making any investment decisions.
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