The debate over whether government stimulus poses an inflation threat has given way to new worries -- a possible decline in prices, demand and even wages -- caused by deflation.
For most Americans, deflation is the stuff of history or case studies overseas. There has not been a major deflationary period in the United States since the Great Depression.
It could be about time. As the market has turned flat and consumer spending has stalled, more economists and officials have begun to consider the likelihood and consequences of deflation. James Bullard, the president of the Federal Reserve Bank of St. Louis, has been vocal about the threat of the economy falling into a cycle of waning demand, wages and prices, akin to that of Japan in the 1990s.
Not everyone is convinced. Fed Chairman Ben Bernanke recently dismissed the threat, saying in a statement, "Falling into deflation is not a significant risk for the United States at this time, but that is true in part because the public understands that the Federal Reserve will be vigilant and proactive in addressing significant further disinflation."
Investment strategies for a deflationary period depend on how low prices go, says Jim Paulsen, the chief investment strategist at Wells Capital Management.
Mild deflation can be bullish and has driven the U.S. economy to booms at times, Paulsen said. Investors might flock to riskier assets during booms led by productivity revolutions -- the Industrial Revolution or the heyday of information technology -- when prices can fall quickly because productivity is growing fast.
However, if companies can't keep up with a decline in top-line prices through increased productivity, deflation sets in, Paulsen said. "When the party is over, companies have no profitability; they fall into themselves, and it becomes a vicious cycle."
A recent stock screen sought to identify areas that industry watchers say may offer cozy nooks to safeguard against deflation. The results pointed to funds with exposure to four areas: municipal bonds, money market funds, Treasurys and emerging-market debt.
On the next page are results for the three top-performing municipal bond, long and intermediate government bond, and emerging-market debt funds for 2010 to date. All of the funds carry no loads, are open to new investment and were in the top 10% for their categories by trailing three- and five-year returns. In addition, we've screened for the top 10 money market funds by trailing five-year returns, which had a minimum initial purchase of less than $10,000 and beat their category average year to date and for the past three and five years.
