Inflation or deflation? What does it mean for investors?

Jason Collins, of Maia Capital, considers the impact of deflation and inflation on investors and suggests how they might best position themselves.

Inflation is just like Goldilocks' porridge in the tale of the three bears. There is an ideal level, where the economy is not too hot and not too cold. This is why the Bank of England (BoE) does not have a zero inflation target; while high inflation is painful, if it falls too low then the economy will contract and fall into recession.

The credit crunch means that the Goldilocks scenario is now just a long forgotten fairytale. Some investors are focusing on the threat of deflation, driving gilt yields to record lows, while the recent implementation of quantitative easing, effectively printing money, has led others to start worrying more about inflation taking off again.

Deflation

There is a real risk that the UK slips into a deflationary environment as the recession takes hold, jobs are lost and people start saving and clearing their debts rather than spending. The headline rate of inflation is falling rapidly and now stands at just 0.1%, the lowest since 1960 as measured by the Retail Price Index (RPI).

On the face of it deflation might sound appealing - the real cost of living falls, and we all seem richer. If prices fall in one sector, as a result of a huge increase in productivity from new technology for example, then falling prices can really be good.

General deflation is usually bad though. If prices are falling people tend to defer spending - why buy it today when it will be cheaper tomorrow? - and the economy comes to a stand still. This leads to job cuts, which cause further spending cuts, and a deflationary spiral downwards.

Deflation is particularly bad for those with debts and physical assets; property values will fall while the real value of the mortgage debt will increase. Most people with mortgages and houses fall into this category and they should consider an investment strategy that hedges this risk.

Long dated government bonds offer the best protection against deflation, as yields fall and prices rise. Today, however, government bonds already look expensive to many - including Warren Buffet - and will fall sharply if inflation wins through. Equity markets tend to perform poorly in a period of economic downturn, but there will be some winning companies over the longer term; at current valuations they will make a great long term buy. These will include the well documented defensive stocks that are not sensitive to the economic cycle, and also the strongest companies in more cyclical sectors that will take market share from the weaker players that fail. Investors should, however, be wary of companies with a lot of debt, including the traditionally defensive utilities, whose steady earnings are linked to RPI and may actually fall in a deflationary environment.

In the current environment, the big risk is that the authorities run out of tools to tackle the problem and we fall into a Japan style "lost decade" - hence the desperate measures governments are undertaking now to prevent this occurring.

Inflation

However, many commentators are rightly concerned that the now numerous government stimulus plans - particularly plans that involve printing new money - are storing up trouble ahead in the form of inflation. With the recent implementation of quantitative easing, both in the UK and the US, we are now moving into unknown territory.

In March, consumer price inflation (CPI) actually increased to 3.2%, significantly ahead of both City expectations and the Bank of England's 2% target. Rising food costs, seriously impacting all of us, was a key reason behind the rise. The news prompted headlines such as "Shoppers hit by inflation shock" and "Unrest fear as inflation rises".

High inflation is good news for those with debts, as it will erode the real value of those debts, and it is also good news for those with physical assets such as property that should rise in value. So for those with a house and mortgage, a dose of inflation may be no bad thing.

You never get something for nothing, however, and the flip side is that inflation makes daily life more expensive. Too much inflation leads to higher interest rates and increased credit card and mortgage payments, while those in retirement may find that their pensions are not inflation linked and so their spending power will fall. Less obviously, price instability makes it difficult for companies to plan future spending and so investment tends to dry up, which reduces future economic activity which is good for nobody.

Investors should look to buy physical assets in an inflationary environment. Property is usually a big winner, but many people already have significant exposure in the form of their house, and should think carefully before making any further investment in this asset class. Gold is often put forward as an inflation hedge, and although it is an obvious safe haven if people start questioning the value of the paper money in their pockets, the case is less clear cut in less extreme times. Inflation linked investments, such as index linked gilts, can provide protection. Equities also usually do well in periods of ordinary levels of inflation; rising prices mean nominal profits will rise and this will be reflected in rising share prices, and inflation usually coincides with periods of economic boom, helping profits grow in real terms too. On the flip side, inflation means rising interest rates which can be bad news for corporate bonds and fixed coupon government bonds.

Conclusion

There is little chance of a return to the Goldilocks scenario any time soon, and markets are now going to be in for a tough time with much higher levels of volatility. Investors can no longer think purely in terms picking the right asset class to grow their wealth. Investors will need to be more nimble than ever, as global economies veer between inflation and deflation. This environment will make picking the winners even harder, and the difference between winners and losers more marked - many of the losers will go out of business, but the winners will win big.

Now is definitely the time to invest in an actively managed fund therefore, and not the time to invest in an index tracker or an exchange traded fund (ETF). A good active fund manager will be nimble enough to ensure investments are positioned to capture the returns available in the current market by separating the winners from the losers. The rewards for this will be great, and after a couple of years of disappointing returns 2009 should be the year for active management. And of course, for those who are unsure which active manager to pick, they can always leave these decisions to a good multi-manager!