Image: Arrow Down © ImageSource, PictureQuest

Related topics: economy, investing strategy, mutual funds, financial crisis, financial crisis

The debate over whether government stimulus poses an inflation threat has given way to new worries -- a possible decline in prices, demand and even wages -- caused by deflation.

For most Americans, deflation is the stuff of history or case studies overseas. There has not been a major deflationary period in the United States since the Great Depression.

It could be about time. As the market has turned flat and consumer spending has stalled, more economists and officials have begun to consider the likelihood and consequences of deflation. James Bullard, the president of the Federal Reserve Bank of St. Louis, has been vocal about the threat of the economy falling into a cycle of waning demand, wages and prices, akin to that of Japan in the 1990s.

Not everyone is convinced. Fed Chairman Ben Bernanke recently dismissed the threat, saying in a statement, "Falling into deflation is not a significant risk for the United States at this time, but that is true in part because the public understands that the Federal Reserve will be vigilant and proactive in addressing significant further disinflation."

Still, many investors who never considered such an environment have at least begun planning for one. Others, including Pimco's Bill Gross, have already adjusted their asset allocations for price declines.

Investment strategies for a deflationary period depend on how low prices go, says Jim Paulsen, the chief investment strategist at Wells Capital Management.

Mild deflation can be bullish and has driven the U.S. economy to booms at times, Paulsen said. Investors might flock to riskier assets during booms led by productivity revolutions -- the Industrial Revolution or the heyday of information technology -- when prices can fall quickly because productivity is growing fast.

However, if companies can't keep up with a decline in top-line prices through increased productivity, deflation sets in, Paulsen said. "When the party is over, companies have no profitability; they fall into themselves, and it becomes a vicious cycle."

A recent stock screen sought to identify areas that industry watchers say may offer cozy nooks to safeguard against deflation. The results pointed to funds with exposure to four areas: municipal bonds, money market funds, Treasurys and emerging-market debt.

On the next page are results for the three top-performing municipal bond, long and intermediate government bond, and emerging-market debt funds for 2010 to date. All of the funds carry no loads, are open to new investment and were in the top 10% for their categories by trailing three- and five-year returns. In addition, we've screened for the top 10 money market funds by trailing five-year returns, which had a minimum initial purchase of less than $10,000 and beat their category average year to date and for the past three and five years.

First, let's look at municipal bonds, which should increase in value as other interest rates decrease in a deflationary environment. They are free from federal taxes, and buyers who live in the issuing state also may get a break on state taxes. However, without diversification, holders run the risk of the municipality hitting financial problems. National municipal bond funds offer less of a tax advantage but more safety.

Many municipal bonds would not perform well in destructive, run-for-the-hills deflation, because issuers would have more trouble making payments. However, in a deflationary period marked by sluggish growth, investors would probably do well in high-quality municipals, according to Paulsen.

The classic deflation hedge is a position in government or high-quality corporate bonds, especially with longer terms. Because longer-term bonds have a higher yield as overall interest rates decline, a nominal yield is effectively worth more, says Adam Leone, an adviser with Modera Wealth Management. On the other hand, many investors don't want to bet the farm on deflation, so they buy Treasury inflation-protected securities, or TIPS, more volatile bonds that hold their value if deflation turns to inflation.

Deflation tends to lift a currency's value, so just holding dollar-denominated assets, like money market funds, is another hedging strategy, says Jack Ablin, the chief investment officer at Harris Private Bank. Investors may earn next to nothing, but their cash gains more purchasing power in a deflationary environment.

Another way to hedge against deflation is to invest in foreign debt. Emerging-market economies would be intriguing in a deflationary environment because they would have inflation and could let their currencies rise "to rebalance the world a little," Ablin said. "That could be a home run."

Investors looking to bet on deflation with equities should stick with high-quality, dividend-paying companies that can maintain pricing power, as well as capitalize on and gain market share in a tough environment, according to Leone.

Deflation-guarding funds
Name Type 1-year return through Aug. 25 (%)
Blackrock Liquidity Funds (BTMXX 0.00%) Money market 0.06
BNY Mellon Money Market Class M (MLMXX 0.00%) Money market 0.07
Delaware Extended Duration/Institutional (DEEIX -0.50%, news) Long government bond 24.68
DWS Institutional Daily Assets (DAFXX 0.00%) Money market 0.25
DWS Managed Municipal Bonds (SCMBX 0.00%, news) Muni national long-term bond 11.05
Elfun Tax-Exempt Income (ELFTX ) Muni national long-term bond 10.26
Fidelity Advisor Emerging Markets (FMKIX 0.00%, news) Emerging-market bond 19.01
Fidelity New Markets Income (FNMIX 0.00%, news) Emerging-market bond 19.45
Fidelity Tax-Free Bond (FTABX 0.00%, news) Muni national long-term bond 10.30
Invesco Treasurer's Secured Premier Portfolio (IMRXX 0.00%) Money market 0.10
Highmark Fiduciary Diversified Obligations (HMDXX) Money market 0.24
Managed Account US Mortgage (MSUMX -0.30%, news) Intermediate government bond 12.92
SEI Daily Income Prime Obligation (TCPXX 0.00%) Money market 0.11
SEI Daily Income Trust (TCMXX 0.00%) Money market 0.12
TCW Emerging Markets Income 1 (TGEIX +0.12%, news) Emerging-market bond 25.97
T. Rowe Price US Treasury Interim (PRTIX -0.17%, news) Intermediate government bond 9.81
Vanguard Interim-Term Treasury (VFIUX -0.36%, news) Intermediate government bond 10.14
Vanguard Prime Money Market Reserves (VMMXX 0.00%) Money market 0.09
Wells Fargo Advantage (WMMXX 0.00%) Money market 0.17
Western Asset Institutional Liquid Reserves (SVIXX 0.00%) Money market 0.12