Alternative Investments and Deflation

My previous post discussed an asset category that is widely regarded as a hedge against inflation, and subsequent efforts will return to investments that help investors preserve purchasing power. However, recent economic news has revived speculation, which has been recurrent for several years, about the possibility of deflation. Some comments on what alternative investments can do to protect investors in a deflationary environment seem to be in order.

It should come as no surprise that the answer is, “Not much.” Few investments benefit from deflation.  Sovereign debt is usually regarded as a safe haven (although not a hedge) against it, but it is unclear that the debt of a nation such as the U.S., which relies so heavily on foreign purchasers to finance it, will offer such protection. Japan's experience over the last decade is not indicative: Japan is able to fund its borrowing from domestic savings. If deflation discourages foreign interest in funding what would remain of U.S. consumption, the Treasury yield curve could become quite steep despite the Fed’s best efforts. In this connection, it is not clear what deflation would do to the value of the dollar, relative to major currencies, to traditional hard currencies such as the Swiss Franc, or to gold.

A deflationary environment would, however, provide rich pickings for short-bias hedge funds and investors in distressed situations. It should also provide opportunity to macro hedge funds. This may sound odd, since the last several years’ revival in the fortunes of macro strategies has to a large extent been tied to commodity price developments. But fundamentally, macro investment exploits economic dislocation and volatility, of which there would be plenty in a deflationary scenario. High frequency trading and arbitrages (other than risk arbitrage, which would probably see its opportunities evaporate) could still be productive if volatility does not become too extreme and if sufficient leverage to make these activities remunerative is still available. Trend-following CTAs should also be able to take advantage of deflation, particularly because it is likely to be accompanied by backwardated markets, while those whose trade discovery is driven by mean-reversion would tend to have a difficult time. Most other hedge fund categories would also struggle.

Direct lenders could expect to see demand increase and competition wither, but default experience would deteriorate, and those whose loans are collateralized could find that their security is less valuable than they had thought. Deflation could plausibly launch a period of considerable prosperity for the life settlement business, with increased supply reducing acquisition costs, thus mitigating some of the J-curve effect that has plagued this investment technique recently.

Real assets could be expected to suffer under deflation − infrastructure, particularly private infrastructure − probably less so than others. Although it is firmly ensconced in the commodity sector, the agricultural economy has a cycle at least partially of its own. It is conceivable that farmland and agricultural commodities could escape the worst effects of deflation, but they cannot be relied upon to do so. The experience of the Great Depression seems to argue against optimism on this score, but U.S. agriculture had already entered depression in 1920 as a result of the post-war retreat of commodity prices: agriculture was probably more of a contributing cause than a consequence of the economy-wide deflation after 1929. The ability of timber investors to forego harvesting and income, while tonnage on the stump continues to grow, would offer a possible safe haven during a deflationary episode, provided that it was not too protracted. Unfortunately, once under way, deflation is stubbornly persistent. If deflation results in a decline in the value of the dollar, this might be expected to bolster other commodity prices, but demand destruction would probably be a greater influence on their price development.

Private equity and real estate would not thrive under deflation. Even if by some chance a private equity position does well despite the environment, neither the IPO market nor trade buyers are likely to offer an attractive exit opportunity. Mezzanine finance would probably be difficult to come by, so even a successful investment may come under stress. In a deflationary environment, lease rates would be under pressure, few buyers for real estate would be available, and refinancing, again, might be difficult to locate. In both cases, funds may also find that committed capital is not available to meet capital calls. The secondary markets for private equity and real estate vehicles are likely to see a considerable increase in supply, offering attractive discounts to funds with liquidity to deploy, but these will only provide a cushion against losses rather than an opportunity if the deflationary episode is lengthy.

By and large, alternative investments tolerate moderate inflation better than they accommodate deflation − which is equally true of conventional investments. However, some of them at least offer the hope that they can offer positive performance during a deflationary episode, which is more than conventional assets other than sovereign debt can offer. More to the point, a portfolio of alternative investments that is positioned to weather a period of deflation need not penalize the investor’s performance too dramatically if, in fact, deflation does not materialize. The same is not true of a conventional portfolio designed to protect against deflation.