Deflation: How to protect your portfolio

Deflation: How to protect your portfolio
Should you be protecting your portfolio against deflation or inflation, or hedging your bets? Emma Simon looks at the options

By Emma SimonLast Updated: 9:37PM GMT 27 Mar 2009

Investors face some tough choices as "zeroflation" leaves them caught between the Scylla and Charybdis of deflation in the short term followed by the risk of inflation in the medium to long term.

Should they be turning to the safe haven of government gilts as a hedge against deflation and economic depression?

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Or is there a bigger threat on the horizon – with inflation gathering pace again?

Investors could be forgiven for assuming that rising prices are the last thing they need to worry about given last week's figures.

The retail price index – one measure of inflation – has fallen to zero. In other words, prices remain unchanged compared to a year ago. This has prompted fears that recession may bring about a period of flat, or falling, prices.

But the Government's preferred measure of inflation – the Consumer Price Index – jumped unexpectedly to 3.2pc in February, showing that some prices are still rising ahead of Government targets.

Why is there a difference between these two figures? Put simply, only the Retail Price Index (RPI) takes into account monthly mortgage repayments. These have fallen sharply, thanks to an unprecedented series of interest rate cuts. CPI ignores this data, so there has not been any corresponding decline.

Most experts agree that, for the short term at least, we are in a period of zeroflation or even deflation. But many are warning investors to look to the long term instead.

David Kuo, of the financial website The Motley Fool, said: "It's inflation that investors should be guarding against." Like others, he is concerned that the "bail-out" measures adopted by governments across the world to kick-start the economy, could be storing up future inflationary pressures.

"For example the Government in the UK is now effectively printing money in a bid to ease the credit crisis. Mr Kuo said: "It's likely that once quantitative easing [the printing of money] permeates through the economy, we'll see the rate of inflation begin to rise again."

So what steps should investors be taking now to protect their portfolios?

Protecting against deflation
If you think that the British economy is heading into a protracted downturn akin to the "lost decade" Japan experienced in the Nineties then now is the time to play it safe.

In a period of prolonged depression and falling prices, equities will underperform, as company profits suffer. Instead, investors should look at government gilts and high-quality investment bonds, as these are likely to produce the best returns.

Juliet Schooling, the head of research at Chelsea Financial Services, said: "Gilts are considered the safest market instrument and can provide a safe haven in a deflationary environment. This is because the gilt will pay out a fixed rate of interest which will increase in value as prices fall."
Investors can buy gilts individually or through a fund. Ms Schooling recommends City Financial Strategic Gilt fund, currently yielding 3.33pc.

But Gavin Haynes, the managing director of Whitechurch Securities, said: "Deflationary concerns have pushed gilt prices up and yields have fallen to historically low levels. So unless you think we are entering a long-term deflationary environment, then they are starting to look expensive."

Although equities typically perform badly in deflationary conditions, Jason Collins, a multi manager from Ignis, said investors should not step out of the stock market completely.
"The emphasis should be on selecting 'winning companies'. Look at very defensive sectors that are not sensitive to the economic cycle".

He added that investors may also want to target "the strongest companies in more cyclical sectors that will take market share from the weaker players that fail".

He added: "Deflation is particularly bad for those with big debts and physical assets – so property values are likely to fall and the real value of your mortgage debt will increase."

Adrian Lowcock, senior investment adviser at Bestinvest, said: "In the current climate there are a number of steps investors can take which will benefit them if prices fall, but also make good sense for the long term."

Given that debt increases in real terms in periods of deflation, Mr Lowcock said investors should spare funds to reduce the size of their mortgage.

He pointed out that investors should not overlook cash savings. "With interest rates so low, cash savings can look unattractive. But remember if we enter a period of deflation then in real terms your money is growing by 3pc a year."

http://www.telegraph.co.uk/finance/personalfinance/investing/5063248/Deflation-How-to-protect-your-portfolio.html