NEW YORK -- Wall Street has rallied in the past three months on expectations of a solid economic rebound. But the Federal Reserve is maintaining its caution about the threat of deflation, where a listless economy sets off a prolonged decline in prices.
Since a recovery often brings at least some inflation, investors might be wondering whether inflation or deflation is the greater threat. The answer could have dramatic implications for investors' portfolio strategies, financial planners say.
"We do see mixed evidence of the economy's rebound," said Sherry Cooper, global economic strategist for Harris Bank of Chicago. "On top of that, the Fed is very concerned about deflation, which raises the prospect of a stagnant economy into the indefinite future. So it definitely creates confusion."
For the most part, financial planners expressed confidence that the Fed will work to prevent deflation and said mild inflation, if anything, is likely the bigger concern. They also cautioned against making reactionary changes in a diversified portfolio which should be structured according to an investor's age, income, assets and financial goals rather than short-term economic phenomena.
But for investors who wish to protect themselves against these potential economic dangers, planners offer the following advice:
During deflation, which hasn't occurred in the United States since the Depression, consumers defer spending on goods and services on expectations they can get better bargains in the future. As spending declines, businesses cut back on activity and capital investment and lay off workers, creating less purchasing power and leading to a price spiral downward.
In such periods, then, cash is the key asset, since a dollar buys more as prices fall. Stocks, meanwhile, suffer as companies are unable to raise prices, leading to smaller profits.
"The equities of anything would be more suspect in your investment, and the dollar would reign king," said Jack C. Harmon, a certified financial planner in Atlanta. "Any fixed income type of investment would be considered far superior."
He suggests long-term government bonds, which would lock an investor into a set interest rate that is paid by a reliable entity - the U.S. government. In contrast, corporate bonds are much riskier because of a greater likelihood of default.
If deflation is mild, dividend-paying stocks might be advantageous since they guarantee an investor a return on their investment. "It's more a bird in the hand," said Harmon. But if deflation persists, companies would likely be unable to have earnings to maintain their dividend payments.
Other investments to avoid: real estate, which would decline as prices fall, as well as foreign investments.
"Traditionally if we catch a cold, the rest of the world gets the flu," said Gerald A. Townsend, a certified financial planner in Raleigh, N.C. "If we had significant deflation, we'd see it worldwide."
Some inflation is typical as an economy rebounds and low interest rates prompt a wave of consumer and business spending. If inflation remains mild - say, 2 percent to 3 percent - stocks flourish as the costs of goods increase. But if inflation persists, the dollar's value eventually falls as consumers find they can't buy as much as they previously could.
Planners say those who have faith in an economic recovery should follow Wall Street's current path and devote money to stocks. Stock funds that track the Standard & Poor's 500 index often have low costs and are a safe investment.
If inflation worsens, however, hard assets such as gold and real estate become the better bet.
Many planners also suggest government bonds that protect against inflation, such as the Series I savings bond or Treasury inflation-protected securities, also known as TIPS. These vehicles tie the return to the rate of inflation, protecting an investor's purchasing power.
"Those are a great hedge for investors," Townsend said.
William B. Howard Jr., a certified financial planner in Memphis, Tenn., said a well-diversified portfolio would have hedges against either deflation or inflation, with a collection of bonds as well stocks, real estates and some hard assets.
But he maintained that in the long run, investors are better off defending against inflation.
"Over the longer period, you have greater risks of protecting your money from inflation than deflation," Howard said, noting that the United States has had many more occurrences of inflation. "At some point in time, we will have inflation again."
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