U.S. Economy Facing Japan-Like Deflation: What Investors Need To Know

With recent weakness in commodity prices, inquiring minds want to know whether the U.S. economy and other advanced nations are entering an unwelcomed period of lingering Japan-like deflation. Using Japan’s lost decades (two decades and counting) as a model, there were many similarities between the Japanese financial crisis to the one we’re experiencing today. To name a few, both experienced bursting of equity, housing, and credit bubbles. However, there are certain nuances that need to be taken into consideration, particularly differences in demographics.

Based on chart below and benefit of hindsight, it appears investors are much more confident of a U.S. and Europe turnaround compared to Japan’s lost decades. Based on this backdrop, it appears U.S. policy makers have administered the right medicine and in right dosages to keep the patient/economy alive and growing (albeit slowly) with zero interest rate policy (ZIRP), quantitative easing, operation twist and a host of stimulus spending/tax cut initiatives.

click to enlarge images

^GSPC = S&P 500 Index (Broad U.S. Equities)

FIEUX = Fidelity Europe Fund (Broad European Equities)

^N225 = Nikkei 225 Index (Broad Japanese Equities)

With massive governmental intervention, commodities (as measured by Thomson Reuters/Jefferies CRB Index) rebounded nicely off March 2009 lows, but they have come under pressure since April 2011 and are still well below all-time high of 469.70 reached in July 2008 (see chart below).

Thomson Reuters/Jefferies CRB Index (TRJ/CRB)

So why the softness and decline in commodity prices? Experts point to a badly overleveraged global economy with no quick escape without a scheme to transfer wealth from creditors to debtors, either through defaults, financial repression, or inflation. Renowned value investor Prem Watsa of Fairfax Holdings (the Warren Buffett of Canada) is hedging his company against deflation (á la credit default swaps) and mentioned that cumulative deflation in Japan in the past ten years and in the United States in the 1930s was approximately 14%. Additionally, he is bearish on commodities, equities, as well as the U.S. and Chinese economies.

Former Chairman of the Federal Reserve Alan Greenspan predicts the recovery to be long and painful because of low to no new investments in long-term assets such as construction. Since the Great Depression, housing construction has led the U.S. economy out of most recessions. While the stock market (S&P 500) has rebounded 97% from March 2009 lows, the housing market is painting a contrary picture (down 40%+ from 2006 high, see chart below).

Because housing is generally the largest asset held by individuals/households, a continued decline puts pressure on household wealth. A decline in household wealth in turn puts pressure on spending as consumer wallets feel much lighter. All things being equal, as demand for goods and services shrink, prices follow due to economic law of supply and demand. As prices deflate, consumers delay spending in hopes for lower prices causing a negative feedback loop for even lower prices. Policymakers and investors alike should pay close attention to these deflationary risks which may derail recovery.

Presently, U.S. core inflation is following Japan’s trajectory since the bursting of Japan’s real estate and equity bubble in 1990 (see chart below).

Another similar path U.S. is following of Japan’s is its net debt-to-GDP ratio (see chart below).

The red line above represents the debt burden of Japan when S&P downgraded the nation's debt from AAA to AA+. This occurred in February 2001, which around the time Japan’s net debt-to-GDP was 60.4%. Fast forward 10+ years later, S&P downgrades U.S. debt from AAA to AA+ on August 5, 2011 when it’s net debt-to-GDP ratio reaches 70%+.

The main favorable difference U.S. has compared to Japan is demographics. According to research from Brockhouse Cooper, a brokerage firm based in Montreal, the percentage of people aged 65 or older nearly doubled in Japan between 1990 and 2008. Meanwhile, that percentage has stayed roughly the same in the U.S. Aging in Japan was a huge issue that led to stagnation," said Alex Bellefleur, a financial economist with Brockhouse Cooper. "Senior citizens tend to have consumption patterns that are a lot different than their younger counterparts. They're not buying as many homes, cars and other durable goods."

Conclusion

While demographics might be U.S. wildcard to avoid Japan-like deflation, investors need be aware that turbulent headwinds of an overleveraged U.S. (public and private) and declining real estate prices might be too much to overcome.

To that end, aggressive and qualified investors might consider a hedging strategy shorting futures contract linked to CPI or similar index. Do your due diligence and be careful of too much leverage.

Retail investors might consider lightening up their equities, commodities and/or selling covered call options into market strength. Holding a healthy dose of cash and bonds (e.g. iShares iBoxx $ Investment Grade Corporate Bond ETF, ticker LQD) in a deflationary environment should at least maintain your purchasing power and provides dry powder for opportunities that present themselves. LQD seeks investment results that correspond generally to the price and yield performance, before fees and expenses, of the corporate bond market as defined by the iBoxx $ Liquid Investment Grade Index.

Investors who want equity exposure might consider drug stocks and/or a healthcare ETF such as Pfizer (PFE) and the Health Care Select Sector SPDR ETF (XLV), respectively. Why drug stocks? Because even in times of economic uncertainty and deflation, people still need their prescription drugs. PFE is a biopharmaceutical company that offers prescription medicines for humans and animals worldwide and yields 4%. XLV seeks to closely match the returns and characteristics of the S&P Health Care Select Sector Index (index ticker: IXV) before expenses.

Disclosure: I hold covered call positions in PFE and XLV.

Disclaimer: Please note that the fact that a general recommendation made of a particular security, commodity, or investment area does not mean it is suitable for you or should be purchased by you. For example, we may already have purchased such securities at a lower cost and/or the position for you may represent too much concentration in one security or industry. Before deciding to invest you should carefully consider your investment objectives, level of experience, and risk appetite. The possibility exists that you could sustain a loss of some or all of your initial investment and therefore you should seek advice from an independent financial advisor if you have any doubts.