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Investment strategies for a deflationary environment

by Elizabeth Moran | Feb 24, 2015

Very low global interest rates, coupled with low inflation and falling oil prices, have forced investors and policymakers to consider the real possibility that deflation may eventuate. This article suggests investment strategies to hedge against deflation.

Australian investors upset about low interest rates can at least be thankful they don’t live in Europe where some governments have taken the extraordinary step of issuing bonds with negative returns.

This situation, which means investors are paying governments to take their money, is partly due to a “currency war” where central banks are trying to discourage foreign investment flows that drive up their currencies.

The very low interest rates, coupled with low inflation and falling oil prices, have forced investors and policymakers to consider the real possibility that deflation may eventuate.

Deflation is the opposite of inflation. Instead of rising, the price of goods and services falls over time. The concern with deflation is that if consumers think that prices will be cheaper in future, it becomes a vicious cycle. They delay purchases, this impacts company profits leading to cost cutting, job losses and, if deflation continues for an extended period, lower dividends. At the same time, government income declines as companies and individuals pay lower overall tax. Even if government debt remains constant, payments must be made from a lower income pool, putting additional stress on government budgets, forcing them to cut spending on goods and services.  

In periods of deflation, a return on capital is a bonus since efforts generally target a simple “return of capital”.

So, what options are there for investors concerned about deflation?  
The most obvious is to lock in a fixed return for an extended period. The best five year term deposit rate is around 3.45 per cent but five years isn’t that long if you consider that Japan has seen many deflationary years since the 1990s and only recently managed to show any inflation.

Government bonds would be the choice of many professional investors. They would target those with the longest terms to maturity, as they would offer the best protection, with bond prices rising in value as returns decline.

The Commonwealth government has a bond due to mature in April 2033 that is paying a yield to maturity of 2.80 per cent. If you are comfortable with slightly higher risk you could invest in a New South Wales government bond maturing in May 2030 with a yield to maturity of 3.10 per cent or a Queensland government bond yielding 3.40 per cent, maturing in March 2033. FIIG make government bonds available to all investors from $10,000.

There are also low-risk, long term corporate bonds available that pay higher returns. For example Rabobank has a bond maturing in 2024 paying 3.60 per cent. If you are happy to take on even more risk, Qantas has a 2022 bond paying 5.36 per cent. Another bond to consider is a US dollar bond issued by Newcrest Mining maturing in 26 years in 2041, paying a very appealing 6.11 per cent. But, for the express purpose of a hedge against deflation, I would stick with low risk bonds.

A higher risk strategy is to invest in shares to hedge against deflation. I would opt for high-quality companies that have paid reliable dividends throughout the GFC such as companies in the consumer staples and health care sectors, which offer products and services that are in demand in any economic environment.

Finally, just in case you call the market wrong and deflation doesn’t eventuate, invest in some inflation bonds. In a deflation scenario, capital on the bonds may decline but the income margin over inflation still has to be paid and will partly offset the lower value of the bonds. The Commonwealth government and various corporations issue inflation linked bonds with a spectrum of returns.

Note: Corporate bonds mentioned in this article are for wholesale investors only. Prices accurate as at 24 February 2015, but subject to change.

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