Fearing that Japan-like deflation may be coming to the United States, some money managers and financial advisers are building portfolios that can withstand falling prices and contracting credit.
Fearing that Japan-like deflation may be coming to the United States, some money managers and financial advisers are building portfolios that can withstand falling prices and contracting credit.
In addition to standard deflationary smart bets including long-term government bonds and cash, advisers should consider dividend-paying stocks, convertible bonds, shorting selected indexes and ratcheting up savings, experts say.
Financial adviser Sam Jones, who contends the U.S. entered a deflationary cycle six months ago, has allocated 40% to 50% of his clients' assets to safe income-producing securities such as long-term Treasuries, which he believes will increase in value because already-low interest rates will decline further.
In earlier times, he allocated only 20% to 30% to such investments.
'AN INCOME GAME'
“Deflation is an income game; you can forget about capital appreciation because there won't be any,” said Mr. Jones, president of All Season Financial Advisors Inc., which has more than $100 million under management.
But like other market watchers and advisers, he also sees plenty of opportunities to temper deflation's impact by owning quality dividend-paying stocks, including utilities.
Indeed, since most equities will suffer during a deflationary period, investors should focus on building income through dividends, said Barnaby Levin, managing director at HighTower Advisors LLC, which controls $16 billion in client assets.
“If rates are falling and prices are falling, you want to be looking for yield, as opposed to growth,” Mr. Levin said. “You need to think about staples like utilities and health care, where you should find some high-quality companies with pricing power, although the health care sector is not doing well right now because nobody understands the reform laws.”
Among dividend payers, Mr. Levin likes The Blackstone Group LP (BX), with a 3.9% dividend yield, as well as pipeline stocks Enterprise Products Partners LP (EPD) at 6.2% and Kinder Morgan Energy Partners (KMP) at 6.5%.
One way to hedge the risk of owning a dividend-paying stock at a time of declining prices is to short a comparable index, said Mr. Jones.
“You might make a little on that kind of spread trade,” he said. “But you have to make sure your long positions [in dividend payers] have a high correlation to the indexes you're shorting.”
For example, he said, an adviser could buy Johnson & Johnson for its 3.7% dividend yield, and simultaneously short an index fund representing the Dow Jones Industrial Average. “You can stay fully invested and diversified, but the core position should be income-oriented,” Mr. Jones added.
Another possible deflation hedge, Mr. Levin said, is to buy select convertible bonds. Such bonds can be converted to common shares of the issuer when the stock price reaches a certain level; the appeal is that until the stock hits that price, the investor is earning a coupon on the relatively safe bond, he said.
One of the more resilient stock categories in a deflationary economy is high-end retailing, according to Quincy Krosby, market strategist at Prudential Financial Inc., which manages $693 billion in assets. If the U.S. suffers deflation, some level of consumer discretionary spending will hold up, she said.
“Even though they're facing tax hikes, the top 3% of earners are still responsible for 25% of spending,” said Ms. Krosby, who plans to gauge the level of deflation by monitoring the performance of top-tier retailers like Coach Inc. (COH), Tiffany & Co. (TIF) and Nordstrom Inc. (JWN).
The technology sector is another area identified as likely to navigate a deflationary cycle successfully, according to Scott Kubie, chief investment strategist at CLS Investments LLC, which manages $5 billion.
“The technology industry is used to dealing with deflation because the constant technology advances continually drive down prices,” he said.
EMERGING OPPORTUNITY
While a slumping U.S. economy will affect the world's faster-growing economies, emerging markets still represent pockets of opportunity, according to Wyatt Crumpler, vice president of asset management at American Beacon Advisors Inc., which manages $44 billion in assets.
Collectively, emerging economies are growing at a 6% annual rate, compared with 2% in developed economies.
“Lower growth here will certainly reduce growth in export nations, but China is not going to be deflationary right now,” Mr. Kubie said. “When growth is extremely scarce, you will want to pay up for it.”
Saving — even in low-yielding money market or savings accounts — and paying off debt also become attractive strategies during deflation, experts say, because as prices drop the value of money rises.
“Deflation is a good time to pay down debt, because the dollar is worth more and the fixed cost of debt becomes more expensive,” said Christian Hviid, chief market strategist at Genworth Financial Asset Management, which has $7 billion under management.
E-mail Jeff Benjamin at jbenjamin@investmentnews.com.
