On the surface, the G-20 meeting in Toronto last weekend appeared to be relatively uneventful, especially after a debate on China’s currency policies was effectively canceled by Beijing’s surprising shift. One of the few resolutions to come out of the summit was a pledge by G-20 leaders to cut deficits and bring their respective fiscal houses in order. While many analysts and economists cheered the proposal, some decried the plan as a step in the wrong direction, proposing that governments need to continue to spend in order to keep the economy afloat. One popular economist who has espoused this view is Paul Krugman, a Nobel Prize winner for Economics and one of today’s leading Keynesian economists. Krugman believes that the sudden and premature obsession with austerity with kill any hopes of a recovery and send the global economy into another depression. “It’s almost as if the financial markets understand what policy makers seemingly don’t: that while long-term fiscal responsibility is important, slashing spending in the midst of a depression, which deepens that depression and paves the way for deflation, is actually self-defeating,” writes Krugman in a recent op-ed for the New York Times. Krugman is in favor of continued high levels of spending, arguing that abandoning this path, as many governments around the world seem to be doing, will lead to a Great Depression much like the one in the 1930′s.
Cash Is King
Those who subscribe to Krugman’s school of thought should be unnerved by the events of recent weeks; governments around the world have proposed big spending cuts to reduce mounting debt balances. If this path does indeed lead to a double dip and deflation, turbulent times are surely ahead for global equity markets. Companies with cash-heavy balance sheets and securities that pay out robust dividends would likely do better than most, while consumer related and labor-intensive industries could struggle. In deflationary environments, consumers tend to delay major purchases in hopes of securing desired goods later at a lower cost; labor-heavy businesses are likely to see their profit margins fall since wages are generally more sticky than most CPI components.
If Krugman turns out to be correct, markets may be about to fall off a cliff. While most asset classes would be pummeled by the scenario he envisions, some would hold up relatively well or even gain ground. Below, we profile three ETFs that may be interesting plays if Krugman’s assessment is correct [also see Five ETFs To Own During The Great Deflation].
iPath S&P 500 VIX Short-Term Futures ETN (VXX)
For investors who think fiscal policies now on the table will hinder economic growth, VXX offers a way to insure against future equity market volatility. This ETN is linked to a futures-based index that has a near-perfect inverse correlation with domestic equity markets; the VIX soared to an all-time high in late 2008 when equity markets plummeted, and has spiked again recently as concerns about global growth have weighed on markets [see Guide To Volatility ETNs].
Barclays 20+ Year Treasury Bond Fund (TLT)
If Krugman is right, TLT also makes an interesting play. Long-term bonds offer relatively attractive current returns; more than 80% of TLT’s holdings are in securities that pay a coupon of more than 4%. In a deflationary environment, fixed coupon payments are extremely attractive, since the purchasing power of each payment rises. Some investors have been hesitant to invest in long-term bonds with interest rates at an all-time low; with nowhere to go but up, rate changes have the potential to hammer fixed income securities. But in a deflationary environment, pressure to hike rates disappears altogether, removing one of the biggest threats to TLT.
PowerShares DB USD Index Bullish Fund (UUP)
If markets encounter a deflationary depression, the dollar could become appealing as a safe haven, especially given ongoing trouble in the euro zone. UUP tracks the Deutsche Bank Long US Dollar Index (USDX) Futures Index, a rules-based benchmark composed solely of long USDX futures contracts. The USDX futures contract is designed to replicate the performance of being long the greenback against a basket of developed market currencies: Euro, Japanese Yen, British Pound, Canadian Dollar, Swedish Krona and Swiss Franc. UUP focuses primarily on the euro (57.6%) and yen (13.6%), with other currencies receiving significantly smaller weightings [also read Safe Haven ETFs: Five Funds For Riding Out The Storm].
Disclosure: No positions at time of writing.