Protecting Your Portfolio From Deflation

OCEAN CITY – The national debt is rising, but prices are falling — and that combination could put a further damper on investors’ profits. That’s why it’s important to choose assets that are likely to resist deflation’s downward pull.

The government’s ambitious rescue plans for the economy have printing presses working overtime at the Treasury Department. Normally, a flood of new dollars would raise the threat of imminent inflation. Although that possibility worries investors, many analysts fear that today’s extraordinary conditions could actually fuel inflation’s opposite: an ominous deflationary cycle in which prices, wages and employment all drop.

A month or two of dropping prices may come as a relief to hard-pressed consumers. But history shows that once a deflationary cycle takes hold, it can be hard to break.

“Deflation, like inflation, can be self-perpetuating,” says David Rosenberg, Chief North American Economist at Banc of America Securities-Merrill Lynch Research.

As asset prices slide, consumers sharply rein in spending, anticipating that prices will fall even further. This slashes business profits, forcing companies to cut back.

For all of 2008, the consumer price index rose just 0.1%, the smallest increase since 1954. Rosenberg projects that inflation will sink into negative territory early in 2009.

In an attempt to spur economic activity, the Federal Reserve has already cut its target for short-term interest rates effectively to zero and taken many other measures to supply liquidity to financial markets, buying everything from mortgage-related securities to the short-term debt of industrial companies. Meanwhile, the Obama administration is increasing government spending to historic levels with its $787 billion economic stimulus package, hoping to help offset the contraction in the private sector with massive spending on infrastructure projects and other job-creation initiatives.

It’s too soon to know when these efforts will yield results and how successfully they can counter deflationary pressures. But it’s not too early for investors to work with their financial advisors to make sure their portfolios are prepared to withstand a period of falling prices. Rosenberg suggests these investment categories and characteristics.

— Safe yield. Look for security and liquidity in fixed income options to protect the value of your principal in a deflationary environment.

— Reliable dividends. There’s no question stocks are riskier than bonds, and stock prices may not appreciate quickly — particularly during a period of deflation.

— Healthy balance sheets. Whether you’re investing in stocks or bonds, avoid highly leveraged companies at all costs, says Rosenberg, because deflation pushes up the real cost of debt and debt service.

— Products in steady demand. Rosenberg expects this year’s leading sectors to be such defensive stalwarts as technology, health care, staples and utilities — in other words, industries selling products or services that consumers need even in a deflationary environment that might incline them to wait for lower prices.

Whether or not the U.S. will enter a deflationary cycle is still an open question. Under the circumstances, giving yourself a degree of protection against the possibility of deflation seems a highly sensible course of action.

(A Merrill Lynch Senior Financial Advisor. She can be reached at 410-213-8520.)