Escape from the threat of deflation with emerging markets

By Bengt Saelensminde Aug 16, 2010

Bengt Saelensminde

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I'd love to be a fly on the wall in the Bank of England's deliberations on interest rates. Rumour has it that the committee's splitting into two factions. Some think rates need to go up to tackle inflation. Others think deflation is going to mean that rates stay pinned to the floor as we tackle a potential depression. It's time to take sides.

I've put my foot well and truly down in the deflation camp. I'm convinced that we need to take measures to protect our wealth against a painful bout of deflation. Why?

Because if the economy does sink into deflation, it could devastate your wealth. Deflation can ruin stock markets and suck the life out of an economy. Consumers lose all appetite for spending. And anxious saving replaces borrowing as the order of the day. Borrowing to buy things is all well and good when your wage is going up, but in a deflationary environment, things look a little different.

Everything you thought was right is wrong

Most of us have never lived through a long period of deflation. And if that's what we are in for, one thing will be certain – it will take a long time to get used to.

Say you're on £50k today, but you hope to be on £80k in a few years time. You might consider buying a shiny new car for £30k. Bought on finance, paying it becomes easier as your earnings grow.

The same goes for a house for that matter. If house prices are marching upwards and so are wages, then a little bit of leverage juices up returns without too much risk.

But imagine what happens if wages and prices are falling. Why would you borrow to buy the car today if there's a good chance you'll be earning less tomorrow? What's more, you'll be able to buy the car cheaper later.

So you put it off. You save your money and wait for the price to drop. Only everyone else is thinking the same thing. Prices start to spiral downwards. And producers get stuck with goods nobody wants. The economy stagnates. And nobody knows when it will recover.

Japan is a grim example of how bad it can get. The Japanese have been struggling with deflation for nearly two decades. Many investors that started out wealthy in the eighties have been all but wiped out.

And now there's a very real chance that the US and UK economy could be heading the same way.

How do you protect yourself?

Dealing with an economy turned on its head

Now normally you'd be thinking of cash and bonds to help you through deflation. After all, deflation is falling prices, so you want to keep hold of cash and purchasing power.

So cash and bonds are good, but it won't leave your portfolio very balanced. After all, we can't be sure what's coming, so a diversified action plan for deflation may be better.

I'm going to make a suggestion that may surprise and yet excite you.

How I'm protecting myself against deflation

My answer is emerging markets . The fact is that emerging markets are showing very little sign of deflation. In fact, the major emerging economies are grappling with inflation. And inflation has quite the opposite effect on stock markets to deflation.

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So emerging markets could be the antidote your portfolio needs against Western deflation. But I can already here you muttering 'aren't emerging markets already overvalued?' Well, yes. Certainly, they've had a pretty good 'post-financial crisis' run. But there's a good reason to stick with this bull, just ask any Japanese investor.

After twenty down-years on their stock market, I bet more than a few Japanese investors are wishing they'd had some exposure to some inflating economies and their (mostly) inflating stock markets.

Of course there's risk here. Emerging markets can be volatile as they're vulnerable to Westerners moving money in and out on a whim. But I reckon that over time local investors will start to edge out Western money.

And I think that it's local money and local investment that's going to keep these markets going for a while. Remember, bull and bear markets carry on going much longer than anyone thinks possible at the time.

Playing the market without it costing you an arm and a leg

Compared to unit trusts, investment trusts can save you a fortune – and they are a great way to invest in Emerging Markets.

Investment trusts are basically companies set up specifically to buy and hold a portfolio of shares in other companies.

The shares of the investment trust are traded on the stock exchange, so you can buy them through your normal broker, just like buying any other share.

Just look at the JPMorgan Emerging Markets trust (LSE:JMG) for instance. The shares are up 119% over five years. That's pretty good when you consider the index (MSCI emerging markets index) was up 107% for the same period.

Their annual management fee is set at 1%. Compare that to unit trusts, which can charge you 6% up front and then around 1.5% a year, and you'll see why I'm a big fan.

Rolling 12-month performance (as at 31/7/10)
2010/09 2009/08 2008/07 2007/06 2006/05
Share price 28.8 -4.2 -0.3 41.1 26.2
Net asset value 30.6 -2.3 -3.6 43.3 25.6
Benchmark 26.9 -0.6 -1.9 38.3 21.1

Source: JP Morgan Asset Management

Now of course, the fact that they've done better than their benchmark on a five year view doesn't mean they'll continue to outperform. As you can see from the rolling performance figures, some years they've done better, sometimes worse.

• This article was written for the free investment email The Right Side. Sign up to The Right Side here .

Your capital is at risk when you invest in shares - you can lose some or all of your money, so never risk more than you can afford to lose. Always seek personal advice if you are unsure about the suitability of any investment. Past performance and forecasts are not reliable indicators of future results. Commissions, fees and other charges can reduce returns from investments. Profits from share dealing are a form of income and subject to taxation. Tax treatment depends on individual circumstances and may be subject to change in the future. Please note that there will be no follow up to recommendations in The Right Side.

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Comments (9)

Published in Tips & advice | More articles by Bengt Saelensminde

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  • 1. Lavinia

    (17 August 2010, 11:36AM)  Complain about this comment

    Hi Bengt,
    When you talk about emerging markets are you talking about countries such as Albania and the BRICS? And how would one start implementing your suggestions?

    And how does Gold figure into all of this?
    Thanks in advance.
    Lavinia

  • 2. PJ

    (17 August 2010, 11:45AM)  Complain about this comment

    I agree we are in for a bout of deflation. Evidence is mounting everywhere, despite today's inflation numbers in the UK

    But I would not risk any equity markets before the end of a significant correction, which I believe is now underway. As we have seen recently, panic selling is contageous once it starts in the US. Once the carnage is over, emerging markets are shaping up to be a more credible growth opportunity

  • 3. Tom O'Neill

    (17 August 2010, 04:27PM)  Complain about this comment

    Well found, Bengt - and many thanks. This JMG is well worth examining.
    I've held the JPM Emerging Markets A Acc in my ISA for more than five years, but the IT is outperforming it - perhaps partly because of the difference in annual costs. I'm going to move my investment from the fund to the IT.

  • 4. steven

    (18 August 2010, 10:27AM)  Complain about this comment

    The article mentions that the JPMorgan Emerging Markets investment trust went up 119% over five years. Looking into this in detail, over that time the value of 1 Brazilian Real went up from £0.2421 to £0.3645, ie an increase of 50.6%. So approximately half the increase in the investment trust over the five year period was due to exchange rate movements. The currency risk/benefit issues have to be considered going forward.

  • 5. Frank

    (19 August 2010, 02:45AM)  Complain about this comment

    Are investment trusts really cheaper than OEICS/Unit trusts ?

    The initial charge can easily be avoided by using a discount broker like Hargreaves Lansdown which I use

    The initial purchase of an investment trust or share is subject to 0.5% stamp duty and they are subject to a buy/sell spread

    Unit trusts are also subject to a buy/sell spread but OEICS are not

    I agree that the annual charges are typically 0.5% less but this can also be negated if the investment is held in an ISA

    Hargreaves Lansdown charge 0.5% plus VAT per annum to hold shares or investment trusts in an ISA (maximum of £200 per annum), I assume all ISA managers do the same. There is no annual ISA management fee for OEICS or shares

    It seems to me that the best way to invest is in an OEIC via a discount broker

    Bengt, please correct me if I am wrong and if not then perhaps Moneyweek need to report more accurately regarding the relative merits of unit trusts versus investment trusts

  • 6. Paul Tilling

    (21 August 2010, 11:32AM)  Complain about this comment

    You can get most of the .5%pa trail commission from a Unit Trust or OEIC refunded if you join a company like Intelligent Money or Cavendish Online etc.. Not many seem aware of this. It adds up over the years.

  • 7. Daytona

    (23 August 2010, 02:49PM)  Complain about this comment

    Bengt, why did you chose to highlight the 2nd place emerging markets trust ?

    Over 5 years, according to Trustnet, Templeton Emerging Markets investment trust (TEMIT) gained 171.6%, outperforming your highlighted fund by 37% (7% annualised). It also outperformed your fund over 1 year and 3 years. That's a substantial and consistent level of outperformance.

  • 8. Bengt

    (27 August 2010, 05:26PM)  Complain about this comment

    Daytona,

    This isn't 'my fund' - I have no holding.

    On a five-year view, Templeton has underperformed their benchmark by quite a way. You can get further details from their website.

    http://www.franklintempleton.co.uk/documents/en/UK/pdf/factsheet/0806_en_public_factsheet.pdf

    I hope this clarifies matters

    Bengt

  • 9. Roger Houghton

    (09 August 2012, 10:00AM)  Complain about this comment

    Hello Bengt, I totally disagree with you on deflation.Financing for todays purchases is the root of the wests problems.People need to understand that wealth comes from producing more than you consume...always.Deflation would provide the discipline that people need.If people wont get rid of the idiotic politicians and bankers that enjoy so much corruption at our expense then deflation will help to concentrate their minds.Bring it on as soon as possible ,I say...Roger

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