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Deflation Is Here; Time to Protect Against Future Inflation?

Economics / Inflation Feb 11, 2009 - 11:04 AM GMT

By: Money_and_Markets

Economics

Best Financial Markets Analysis ArticleNilus Mattive writes: It's clear that deflation has taken center stage in the U.S. economy. As I told my Dividend Superstars subscribers last month, you can see falling prices just about everywhere you look.

For example, the Consumer Price Index DROPPED 0.7% in December 2008. That's a marked departure from the gains we had been seeing. Even if you exclude food and gas prices, consumer prices were still flat for the month. What's more, the full-year data showed consumer prices rose a paltry 0.1% vs. a whopping 4.1% jump in 2007.


In fact, 2008 saw the lowest rate of inflation since 1954, when prices declined 0.7%.

With the continued job losses and curtailed consumer spending, you can expect to see further price weakness in the next round of data, too.

Plus, home prices continue their downward spiral. Through December, they had fallen about 24% from their peak in July 2006. There's no reason to expect a rebound anytime soon.

So all this begs the question …

Why Would You Want to Invest in Anything But Cash Right Now?

Let me start by saying that I certainly recognize the value of having a solid amount of your money parked in cash (or cash equivalents) at all times. And with all the uncertainty in the world today, that's never been truer.

There's no way to know when a personal emergency will crop up, or when a family member or friend will need your help. It's easier to sleep at night with some of your money tucked far away from volatile markets.

However, even with deflation in the driver's seat, I do not think this is the time to flee all assets and park everything in cash. In fact, I think this is the time to consider buying more protection from inflation.

I have three reasons why …

First, while falling prices are now the big trend, not ALL costs are dropping. If you dig a little bit deeper into that December CPI number, you'll see that medical care costs actually increased another 2.6%. So although prices for things like clothing are now falling, a trip to your doctor continues to cost more and more.

Second, I do not yet see a reason to expect an all-out deflationary spiral. The deflation we're seeing right now is natural. The global economy is slowing. People are losing jobs and spending less. Restraint is becoming fashionable again.

Health care costs continue to rise, even with the weakening economy.
Health care costs continue to rise, even with the weakening economy.

There is always the risk that psychology will take over, and the cycle will begin self-reinforcing. Should that happen, there's very little that can be done to reverse course. However, I have not sensed that kind of extreme pessimism in my daily encounters around this country. Anger, yes. But not the kind of “crawl-under-a-rock” mentality that leads to prolonged deflation.

More important, Washington is fighting the fire with their money hoses wide open. And while I may not agree with their approach, I don't see how this flood of paper won't get us back to at least a “normal” rate of inflation.

Third, the time to buy flood protection is when the river is low. Right now, the marketplace seems fixated only on the deflationary signs. How quickly everyone has forgotten about $5-a-gallon gas!
In my opinion, the time to prepare for a future event is long before it happens, when nearly everyone else is forgetting how quickly the tide can turn.

So …

Here Are Two of My Favorite Inflation Hedges

As you can probably guess, stocks with steadily rising dividends are my first choice. The reason is simple … they kick off solid, GROWING income streams through thick and thin.

When your dividend payments are growing, so is your effective yield. That's because the price you paid for the stock never changes, but the rising annual dividends come to represent more and more of your original purchase price.

Meanwhile, the companies that tend to pay out rising dividends generally provide goods and services that are able to keep pace with inflation. For example, utilities can hike their rates pretty easily. Food companies find ways to pass along their “input costs” to consumers. Energy concerns just charge you more at the pumps. While this crimps all of our budgets, it does ensure that your dividend checks will keep pace with rising costs.

By the way, even when prices are stagnant or falling, these very same companies are the last ones to have to lower their prices, which means the dividends can keep coming.

The second category of inflation hedges that I really like right now are inflation-protected bonds like TIPS and I-Bonds.

These investments are backed by the U.S. government and are virtually guaranteed to keep pace with rising prices (as measured by the CPI). And even in periods of deflation, you will not lose principal.

So like dividend stocks, these investments help you maintain your lifestyle through inflation or deflation.

The best part is that the big focus on falling prices — along with a massive flight to regular U.S. Treasury bonds — has created a unique situation where many inflation-protected bonds are paying out higher relative yields.

To see what I mean, just compare the Vanguard Treasury Inflation-Protected Securities (VIPSX) mutual fund — which boasts a yield above 5% — to the same firm's regular Intermediate-Term Treasury Bond fund (VFITX). The latter is only paying a yield of about 3.5%.

That essentially means investors are expecting deflation to continue in a major way. And hey, they could be right!

But that doesn't mean now isn't the time to diversify your portfolio with more investments that can still do well during deflation and do even better should inflation rear its ugly head again.

Best wishes,

Nilus

P.S. Want to get more of my thoughts on the markets and investments between my regular Money & Markets columns? Then check out my blog, located right here . You can even interact with me by leaving your comments!

This investment news is brought to you by Money and Markets . Money and Markets is a free daily investment newsletter from Martin D. Weiss and Weiss Research analysts offering the latest investing news and financial insights for the stock market, including tips and advice on investing in gold, energy and oil. Dr. Weiss is a leader in the fields of investing, interest rates, financial safety and economic forecasting. To view archives or subscribe, visit http://www.moneyandmarkets.com .

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Comments

Keith Diepstra
01 Mar 09, 06:22
Catastrophic inflation and money markets

Is a money market fund a good hedge against catastrophic inflationary pressures? Will the shares track with inflationary growth? I am thinking in terms of the trillions of dollars that are going to be printed or borrowed to back all these spending plans. I know stock values would track in most cases but the money market funds are mostly short-term (90 days)instruments. I would like to protect our liquid cash also without haveing to revert to the traditional hedge of buying gold (which can be confiscated).


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