How to invest in a deflationary environment, according to Rosy

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The article below comes from David Rosenberg, Chief Economist and Strategist of Gluskin Sheff & Associates.

The fact that one of the most reliable research departments within the Fed system could publish such a report two years into the greatest experiment with fiscal, monetary and bailout stimulus and reflationary policies speaks volumes. Frankly, what it tells us is that the 4.3% yield on the long bond is extremely attractive in real terms.

The report found that prices are deflating now for 17% of the goods and services that people consume — “evidence that price declines are widespread.” At the start of the recession, only 34% of the consumption basket was posting disinflation or slowing price momentum. That number is now at 72% — nearly three of four items in the basket is disinflating. This is the same ratio we saw in 1981 but back then we had Volcker doing everything he could to kill inflation. Today we have Bernanke doing everything within his powers from a 0% funds rate to radical expansion of the central balance sheet to reignite inflation and all he can do is throw matches on a wet towel.

Don’t fight the Fed, indeed.

Since the first cut in the Fed funds rate on September 18, 2007 …

  • The S&P 500 has gone from 1,520 to 1,223.
  • The unemployment rate has gone from 4.7% to 9.8%.
  • Industry capacity utilization rates have gone from 81.5% to below 75%.
  • The 10-year note yield has gone from 4.5% to below 3%.
  • Housing starts have gone from 1.183 million units to 0.519 million.
  • Median real estate values have gone from $210,500 to $170,500.
  • Core inflation has gone from 2.1% to 0.6%.

Well done!

Below we again highlight the appropriate strategy for such an environment:

1.     Focus on safe yield: High-quality corporates (non-cyclical, high cash reserves, minimal refinancing needs). Corporate balance sheets are in very good shape.

2.     Equities: focus on reliable dividend growth/yield; preferred shares (“income” orientation).

3.     Whether it be credit or equities, focus on companies with low debt/equity ratios and high liquid asset ratios — balance sheet quality is even more important than usual. Avoid highly leveraged companies.

4.     Even hard assets that provide an income stream work well in a deflationary environment (ie, oil and gas royalties, REITs, etc …).

5.     Focus on sectors or companies with these micro characteristics: low fixed costs, high variable cost, high barriers to entry/some sort of oligopolistic features, a relatively high level of demand inelasticity (utilities, staples, health care — these sectors are also unloved and under owned by institutional portfolio managers).

6.     Alternative assets: allocate significant portion of asset mix to strategies that are not reliant on rising equity markets and where volatility can be used to advantage.

7.     Precious metals: A hedge against the reflationary policies aimed at defusing deflationary risks — money printing, rolling currency depreciations, heightened trade frictions, and government procurement policies.

Source: David Rosenberg, Gluskin Sheff & Associates – Lunch with Dave, December 7, 2010.

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