Investing for short-term risk of deflation

BOSTON (MarketWatch) � It�s getting harder and harder to read the tea leaves. On Monday morning, pundits were suggesting that deflation, not inflation, was the bigger theme for this year and that you might want to invest accordingly.

Demand for banks loans by businesses both large and small, they said, was falling during the first nine months of 2011. And that suggested the possibility of deflation rearing its ugly head.

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By Monday afternoon, however, the Federal Reserve said banks experienced, on net, somewhat stronger demand for loans by businesses in the final three months of 2011, and all bets on deflation were seemingly off.

Seventeen of 56 banks reported moderately or substantially stronger demand among companies with $50 million in annual sales or more, according to the Senior Loan Officer Opinion Survey on Bank Lending Practices. And six reported moderately weaker demand. Meanwhile, demand among small businesses for loans increased 26.4% from the previous quarter.

Read that survey at this website.

Given that change in demand for banks loans by businesses experts are now saying that the long-term risk of deflation is minimal, but the short-term risk is not.

For instance, John Largent, a CFA charterholder and chief investment strategist for Members Trust Company, said in an interview that the long-term risk of deflation is less than 50%, but short-term risk of deflation is higher because of the �deleveraging� cycle that is ongoing.

Jeff Witt, a CFA charterholder and director of research at Private Asset Management, isn�t forecasting deflation either, but he did say �the risk of deflation is still greater than we would like.�

And Doug Muenzenmay, a CFA charterholder with Medley & Brown and an adjunct professor at Mississippi College, is in the same camp: �We�re not investing our client�s assets with the idea that there is a large risk of deflation, but you can�t completely dismiss it.�

Near term, Witt said the risk of deflation would likely be the result of external factors, such as a �disorderly resolution� to the European debt crisis. �Should this occur, we would expect to see financial institutions curtail lending activity and corporations to further hoard cash,� he said. �Both of these activities would slow the U.S. economy and have the potential to result in a deflationary environment.�

And should that happen, the dollar would also likely appreciate relative to other currencies, given its safe-haven status, he said. And that would put downward pressure on import prices.

According to Witt, most investors are keenly aware of the risk of inflation, a dollar in the future buys less than is does today. But they are not as aware of deflationary risk. �I have heard people ask �Why is deflation a problem, would it mean that a dollar buys more in the future?��

His reaction: �I believe that it is important to note that debt, which we all have too much of, becomes harder to service in a deflationary environment,� he said. �Traditionally, inflation makes debt easier to service over time.�

What�s more, Witt said capital expenditures are harder to evaluate or justify if prices are going down. �Both of these have the potential to slow the economy and lead to a negative feedback loop,� he said. �Deflation leads to slower growth, which leads to further deflation.�

To be sure, Federal Reserve Chairman Ben Bernanke is �keenly aware of these risks and we believe will do everything in the Fed�s power to avoid such an environment,� said Witt.

In such an environment, debt becomes more attractive to investors, Witt said. But it also becomes harder to service for borrowers.