In the wake of reports pointing toward a slowing economy, this past week brought troubling signs that the United States may be facing a period of slight deflation — that is, on average, prices of goods and services are declining rather than rising. While deflation is far from a sure thing, it’s important to understand the impact it would have on our economy, and how it could affect your investments.

First, let’s look at the indicators. On Wednesday, the Labor Department said the Producer Price Index (PPI) fell 0.5% in September, a bigger drop than the expected 0.2% decline. The PPI measures wholesale prices that are part of businesses’ supply chains and have an indirect impact on consumer prices.

Much of the reason for the PPI decline was energy prices. We’ve seen a continuation of the bear market in oil and natural gas — leading gasoline prices to their lowest levels in nine years.

Retail prices show signs of falling, too. As part of its disappointing sales and earnings guidance on Wednesday, Wal-Mart (NYSE: WMT) suggested it would cut prices during the holiday season to attract shoppers. Irish-based Primark, known for rock-bottom prices on apparel, has entered the U.S. market in Boston and plans to expand across the country.

Meanwhile, China, Japan and Europe are all registering ultra-low levels of inflation. In fact, the EU announced that its consumer price index actually fell 0.1% in September (though this was due entirely to energy prices).

With zero inflationary pressure from around the world and major sectors such as energy and retail cutting prices, there’s a chance that U.S. consumer prices will turn negative over the next year. Why is that a problem, and what would be the impact on investments?

Deflation seems positive on the surface, as it means consumers can actually pay less at the register. But lower consumer prices lead to lower wages, creating a vicious cycle that usually throws the economy into recession. Another way of looking at it is that deflation means the dollar is rising in purchasing power, creating an incentive to hoard cash rather than spend it, invest it or lend it — and if consumers stop spending, businesses stop investing and banks stop lending, the economy shrinks. This is the problem that has plagued Japan for most of the past two decades.

That’s why the Federal Reserve Board aims for an inflation rate of 2% — high enough to foster economic growth but low enough to preserve the dollar’s purchasing power in the short run. Just a few months ago, it seemed likely that the steadily growing economy would start to push inflation above that target, forcing the Fed to raise short-term rates. Recent evidence suggests that isn’t happening, at least not yet.

The Best Investments For A Deflationary Period
The classic investment in times of deflation is high-quality fixed-income investments, such as Treasury bonds, municipal bonds and investment-grade corporate bonds. That’s because they guarantee a return of your principal (which is rising in purchasing power as prices fall) plus interest. In addition, deflation causes the Fed to lower interest rates, boosting bond prices. Of course, with interest rates near zero currently, there’s not much the Fed can do on that score. 

Another solid investment in a time of mild deflation is blue-chip stocks of companies whose prospects aren’t dependent on commodity prices or a strong economic cycle: in other words, the types of defensive stocks I discussed in this recent article and this one. Stocks that pay above-average dividend yields are especially attractive, but be aware that some companies might reduce dividend payouts if the deflationary period is prolonged.

Companies with strong long-term growth prospects and prices that are less likely to get caught up in a deflationary cycle also tend to fare relatively well — for example, market leaders like Apple (Nasdaq: AAPL) or Altria (NYSE: MO). That’s because demand for their products is unlikely to wane much in the face of a mild increase in purchasing power.

Finally, it may be time to reduce your exposure to investments that would be hurt badly by a deflationary cycle: stocks and funds tied to non-currency commodity prices — especially gold (which is a proxy for inflation) and industrial commodities.

Risks To Consider: While it’s wise to be prepared if deflation sets in, it’s equally likely at this point that the economy picks up steam and we see rising inflation — rather than deflation. That seems to be Fed Chair Janet Yellen’s outlook, and she has the best data available.
    
Action To Take: Look for opportunities to boost your exposure to high-quality fixed-income investments and blue-chip dividend-paying defensive stocks. Also, pare down your exposure to cyclical, commodity-dependent holdings.

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