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Investors Fear Deflation
Bill Gross Among Those Bracing for Possible Decline in Prices: 'It's
Happening'
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By GREGORY ZUCKERMAN

Some of the world's leading investors are becoming more worried about
deflation and are re-shaping their portfolios to prepare for a
possible period of falling prices.

Bond-fund heavyweight Bill Gross, investment manager Jeremy Grantham
and hedge-fund managers David Tepper and Alan Fournier are among the
best-known investors who are bracing for a possible bout of deflation,
a development that could cripple global economies and world stock
markets.


The investors cite weak economic figures and a mounting consensus that
global policy makers are reluctant, or unable, to take further steps
to boost economic growth as reasons for their market positions.

"Deflation isn't just a topic of intellectual curiosity, it's
happening," says Mr. Gross, who runs the $239 billion mutual fund
Pimco Total Return Fund, citing an annualized 0.1% decline over the
past two years in the U.S. consumer-price index. "It's an uncertain
world that's tipping toward deflation."

These investors are walking a fine line. Deflation scares immediately
following the 2008 financial crisis didn't materialize, in large part
because central banks intervened.

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Indeed, many of these star investors don't see extended deflation as a
sure bet and predict that, as deflation becomes more likely, the
Federal Reserve and other government officials will take radical steps
to arrest the decline, such as buying bonds or introducing spending
programs.

Still, preliminary signs of deflation are spurring Mr. Gross and the
others to take on larger positions of interest-bearing investments
such as bonds or dividend-paying stocks. They also have begun buying
protection against possible stock-market losses. In a period of
falling prices, companies can find it challenging to generate profits,
putting pressure on stocks.

Recent data are responsible for the worries. The consumer-price index
rose 1.1% in June compared with a year earlier. Friday's report on
second-quarter gross domestic product showed the underlying inflation
rate—which excludes volatile moves in food and energy prices and is
closely watched by the Fed—increased 1.1%, the lowest reading since
the first quarter of 2009. St. Louis Fed President James Bullard last
week warned of a Japan-like period of deflation and slow growth.

View Full Image

Bloomberg News
WATCH FOR FALLING PRICES: A retailer knocks 40% off items in
Washington, D.C., last Friday. The specter of deflation—broader
declines in prices—has some noted investors adjusting their
portfolios.


Such mainstream talk about deflation is a sharp reversal from just two
months ago, when inflation, not deflation, was the focus of traders.
Investors such as John Paulson, renowned for his bets against the U.S.
housing market, piled on gold positions while others dumped U.S.
Treasurys.

Mr. Gross has been aggressively buying U.S. government debt in recent
weeks. Treasurys now account for about 51% of the portfolio of his
Pimco Total Return fund, up from less than 33% at the end of March. It
is as high an allocation to government securities for the fund as at
any time in the past six years, according to Morningstar Inc. The fund
has risen 7% this year.

Mr. Tepper, who runs the $15 billion hedge fund Appaloosa Management
LP, has about 70% of his portfolio in bonds rated "BB" and "BBB"—the
lowest end of the investment-grade spectrum and the upper tier of
"junk"—from banks and others. That is up from 63% earlier in the
year, investors say, helping him score gains of about 12% in 2010. He
is sticking with credits that promise generous yields but still are
relatively safe bets in any period of weak growth and potential
deflation. "I'm concerned that slower growth may lead to a much
tougher environment for pricing," Mr. Tepper says. "That can mean
deflation in some industries, even if we get inflation in the overall
economy."

Others, including the $42 billion Fortress Investment Group LLC, the
$1.2 billion New York hedge fund Argonaut Capital Management and the
$107 billion Boston investment firm GMO LLC, founded by Mr. Grantham,
are warning clients about possible deflation.

Deflation is seen as pernicious and hard to address once it sets in.
Falling prices can make businesses and consumers reluctant to spend
and invest, hurting profits and crippling the economy. It can be
caused by a drop in the money supply and credit, declining spending
and high unemployment, all of which can encourage companies to cut
prices.

"We fear that core inflation readings in the United States could dip
into outright deflationary territory in coming months," Argonaut
Capital, whose returns are flat for the year, recently told investors.
"This should be a positive for longer-dated fixed income."

Mr. Fournier's $4 billion hedge fund Pennant Capital says "political
winds shifted" when European nations recently told U.S. Treasury
Secretary Timothy Geithner at the Group of 20 summit they will focus
on balancing their budgets rather than stimulating economic growth.
The rising clout of the Tea Party movement in the U.S. also has
colored his view that elected officials won't have the ability to spend.

Mr. Fournier and some others say Tea Party adherents are appropriately
worried about hefty government debts, but that without near-term
spending and programs by elected officials, the economy could sink
further.

"The U.S. economy has to grow north of 2% to avoid deflation, and
we're right around there," he says.

Mr. Gross was much more skeptical of Treasurys as recently as about
three months ago. Mr. Gross says he is paying particular attention to
deterioration in an index produced by the Economic Cycle Research
Institute that attempts to predict future economic health. In
addition, he says, a drop in money supply and fiscal tightening in
much of the world are reasons for Pimco's investment shift.

"We said, 'Hey, two-thirds of the world is moving to the zero line,'"
of inflation, he says.

Pimco's team predicts "core" U.S. inflation, which excludes volatile
energy and food prices, might drop a tad below 0% in the next few
years; it could rise as high as 2% if economic growth improves.

There still is a big problem for investors preparing for deflation: It
is hard to find attractive investments when it arises. Some say
utilities and companies with stable cash flows are the best bets,
along with government bonds. But many shares and riskier bonds
depending on rising corporate profits could be losers in such a
scenario.

Mr. Gross urges investors to focus on cash flows that are "relatively
certain," such as dividends and interest from stocks and bonds of
quality companies.

Mr. Fournier is betting further economic difficulties spur politicians
and the Fed to take aggressive actions to stave off deflation. But
stocks may have to fall sharply before that happens; he is buying
protection such as exchange traded funds that rise when the market
falls. Argonaut founder David Gerstenhaber also is avoiding stocks,
though he says the dollar could do well if deflation arises, as all
kinds of borrowers slash debt. In a period of deflation, each dollar
of debt becomes more onerous as wages and prices fall, as opposed to
in an inflationary period, when the value of debt drops.

Deflation is no sure thing, the investors say. Mr. Tepper says that if
the U.S. economy expands 1% or so over in the next few years,
deflation and troubles for stocks will arise. Growth of 3% would boost
profits and stocks, he says.

At Pimco, Mohamed El-Erian, the firm's chief executive and co-chief
investment officer, says "the risk of a deflationary spiral has
increased, but it is still not the most likely scenario."

He says investors need to prepare for an unusually wide range of
possibilities. The risk of so-called fat tails—or extreme outcomes—
including a bout of prolonged deflation, are "not insignificant."

Write to Gregory Zuckerman at gregory.zuckerman@wsj.com