Gary Shilling

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Dr. Gary Shilling is President of A. Gary Shilling & Co., Inc., an economic consulting firm. He has written a column for Forbes since 1983 and has become known as 'Doctor Disinflation'.

Books

How to Survive and Thrive in the Coming Wave of Deflation , McGraw-Hill, 1999

Investment strategies for a deflationary era

Introduction

Long- term , I forecast chronic deflation of 1% to 2% per year. Not the demand- deficient 'bad' deflation of the 1930s, but the 'good' deflation of excess supply - typical of peacetime when excess government spending is absent and especially during periods like the late 1800s, the 1920s and again today when bursts of new tech accelerate productivity. As spelled out in my recent book, Deflation , a successful investment strategy in this environment will be quite different than what worked during the now-ending age of inflation. Here are 11 elements in a winning strategy.

Treasury bonds are beautiful in deflation.

Long Treasury yields will fall to 3%. With deflation of 1% to 2%, real returns will run 4% to 5%, about twice the postwar average, but not especially high by long-term historical standards. Treasurys will also benefit from shrinking supply as federal surpluses lead to debt retirement. Further, Treasurys have three sterling features. They are the world's best credits, have little problem with being called well before maturity and have gigantic liquidity.
Avoid junk bonds.

In your zeal for yield, remember that junk bonds are really low-quality stocks that trade more on the issuing company's earnings prospects or on developing countries ' financial plight than in relation to interest rates. Many junk bonds have been disasters in recent years , and the world of deflation may not be any kinder to them.
Don't expect great returns from stocks.

In mild deflation, stocks in general will be attractive, but a far cry from the tulip bulb-quality speculation of the late 1990s. Profits will grow in line with corporate sales, or about 4% to 4.5% per year in real terms. P/Es, governed primarily by interest rates in the long run, will stabilize along with bond yields. So, stocks will rise in line with profits, or 4% to 4.5% annually in real terms and in line with historical experience. With dividend yields returning to around 3%, total returns will average 7% to 7.5% in real terms, or 5.5% without deflation - very disappointing to those who think that the norm is the 1994-1999 era when the S&P 500 rose over 20% per year consecutively.
Risk-adjusted, Treasury bonds will be at least as attractive as stocks.

In the earlier postwar era, stocks way outperformed bonds, with the S&P 500 returning 13% per year in the 1948-2000 years while Treasury bonds returned 6%. But inflation reigned and real interest rates were low in that era. In mild deflation, the inherent riskiness and volatility of stocks will at least erase the difference between their nominal return of 5.5% and the 3% yield we foresee for long Treasurys.
Forget global diversification to reduce portfolio volatility.

Major country government bond markets move together, especially after adjusting for currency movements, as well they should. Quality differences are similar and any price gaps are arbitraged away quickly. As for stocks, in this age of 24- hour trading in a global economy dominated by multinational companies, markets often move in parallel, especially in times of U.S.-generated trouble. Furthermore, the dollar should remain strong in the forthcoming deflationary era, so many foreign investment gains for U.S. investors will be at least wiped out as foreign currencies fall against the buck.
New tech winners will be tough to find.

The productivity and excess supply spawned by new tech will be great for consumers, but investors will find few consistent long-term winners. As in past bursts of new tech, computers, semiconductors, the internet, telecommunications and biotech will continue to kill themselves with over-investment and excess capacity. Further, new tech is always superseded by newer tech. Product cycles continue to shorten, and competition will remain excruciating while, as in the past, today's new tech gizmos become tomorrow's profitless commodities.
Avoid old tech companies that produce big ticket consumer goods and services.

In deflation, consumers wait for lower prices before buying, which creates excess capacity and unwanted inventories. Price cuts to stimulate sales only confirm buyers ' expectations, leading to further waiting for still-lower prices, etc. in a self-feeding cycle. In addition, American consumers should soon end their two decade borrowing and spending binge and embark on a saving spree. Expensive, postponeable purchases will be delayed. These two forces will damage autos, appliances, conventionally-built housing and airline travel. But don't forget that big ticket new tech gear like PCs are also vulnerable as consumers wait for lower prices and concentrate on saving.
Firms that aid savers and investors will thrive in mild deflation.

The likely saving spree by American consumers and disillusionment with do-it-yourself investing after the collapse in the late 1990s stock bubble will be good news for financial planners, asset managers, savings institutions, life insurance companies, mutual funds, and trust banks and others oriented toward high net worth customers. At the same time, credit card issuers , sub-par lenders and many real estate lenders will be hurt.
Real estate will suffer.

Low real interest rates and inflation spurred real estate in the earlier postwar era. With 20% down on a property with a 10% mortgage and 15% annual appreciation , you made a cool 35% return each year.

Nevertheless, as in the past, real estate prices will fall in the upcoming deflationary era and real interest rates will be much higher. So, with about 4% nominal mortgage rates and the same 20% downpayment, you'll lose 26% each year if the property price falls 2% per annum.

Further, real estate will suffer since the postwar babies are all housed, thrifty consumers will visit malls less and buy less, businesses will put more people in a given office space and encourage more teleconferences and fewer hotel-utilizing business trips, consumers will reduce travel and hotel and motel use and will postpone new houses while more efficiently utilizing already-ample space. In addition, new commercial buildings will be cheaper than old ones so, in reverse of earlier postwar practice, landlords will want long leases while tenants will demand shorter ones so they can threaten to move in a year or two if the rent isn't cut.

Real estate investment won't disappear in deflation, but rents will need to be high enough to cover ongoing costs, falling property values and high real interest rates while still providing an acceptable profit. Note that other tangible assets, including antiques , may also be trying investments in deflation.
Manufactured housing and rental apartments will succeed.

With real estate a difficult investment in deflation, many Americans will no longer combine their investments with their abodes - owner-occupied houses or apartments. This will help manufactured houses, which, due to factory efficiencies, cost about half as much per square foot as site-built structures and often have the same or higher quality. Also, multiwide units, where the sections are attached on site, are often indistinguishable from site-built houses.

In addition, factory-built housing tends to be smaller, which will appeal to thrifty consumers, young families, empty nesters, retirement home buyers and anyone else seeking cost-effective shelter. Similarly, rental apartments will be attractive as people separate their homes from their investments. Young families will rent apartments longer until they really need single-family housing, and older people who don't enjoy cutting the lawn may sell their money pits sooner and move into rental units.

Direct real estate ownership will be difficult in deflation (see #9) so REITs that concentrate on rental apartments may be better for investors than direct ownership.
Commodities will be weak.

Global deflation means an excess supply world with chronically-weak prices for commodities ranging from copper to sugar to crude oil to gold. Furthermore, the world's output will more and more be in products with high intellectual content - goods like semiconductor chips and services such as medical care - not commodities like steel and cement .