Protecting Your Portfolio from Deflation

Here are some investment plays that may be likely to withstand a sustained bout of falling prices

By David Bogoslaw

The knots in economists' and investors' stomachs tightened on Dec. 17 with the release of consumer price data for November, which showed prices falling for the second straight month—and the fastest rate of decline since the government started tracking these numbers 61 years ago. A 17% drop in energy prices, with gasoline down a staggering 29.5% since October, was the primary driver of the drop in prices.

Food and beverage prices continued to climb, albeit at a a snail's pace of 0.2% in November, their slowest rate of growth this year, and clothing prices rose 0.3%. The core rate of inflation, excluding volatile food and energy prices, was flat for the month and up only 1.1% from a year ago.

It's a dramatic turnaround from less than six months ago, when oil prices peaked at $147.40 a barrel, prompting inflation hawks on the Federal Reserve Board's policy committee to vote against measures intended to minimize, if not entirely stave off, a severe economic downturn. The central bank's decision on Dec. 16 to slash the Fed funds rate to between zero and 0.25%, the lowest rate ever, makes clear that the Fed has shifted its target to preventing widespread deflation.

Deflation is about as dirty a word as you can find in the realm of economics and it's usually associated with the other dreaded "D" word, depression. Indeed, the Great Depression was largely driven by deflation nearly 80 years ago. The consumer is sure to love falling prices at first, but the fear is that if deflation becomes deep and pervasive enough, it will eventually spur employers to cut wages and axe jobs, sending worried consumers deeper into their foxholes. The most pernicious aspect of deflation is how it raises the cost of repaying debt by boosting the value of the dollar,

But concern about a deflation threat to rival the one that afflicted Japan during the 1990s is by no means universal. Barry Boswell, an economist at the Brookings Institution, sees deflation as primarily affecting commodity prices until now and doesn't expect it to become an economy-wide threat.

Along with the Fed's aggressive use of its balance sheet to combat economic contraction, "other lines of defense include the wide dispersion in price changes (which obscure the trend) and some indications that businesses are reluctant to cut prices and wages outright," Goldman Sachs (GS) economist Edward McKelvey said in a research note on Dec. 18.

The extensive destruction of credit is also contributing to deflation, but Joseph Trevisani, chief market analyst at FX Solutions, a currency brokerage firm in Saddle River, N.J., says he doubts "we'll see a textbook case of deflation," the economy-wide version seen in the 1930s and to some extent in Japan 10 years ago, "because the Fed is so diligent in trying to reflate the economy." The effectiveness of the Fed's efforts began to be reflected in the value of the dollar, which fell sharply on Dec. 17 against other major currencies, reaching a 13-year low against the yen.

Still, consecutive monthly declines in consumer and producer prices are enough to make even the most optimistic economy watchers sit up and take notice. For investors, defense against a possible episode of deflation will come down to identifying those sectors of the economy that provide goods and services that consumers and businesses can't afford to do without. Here, BusinessWeek looks at some sectors and stocks best positioned to withstand the scourge of deflation: