Recent events such as the downed Malaysian airplane over Ukraine and Israel’s invasion of the Gaza Strip remind us of how quickly world events can hurt global economic conditions, and how fragile the world economy remains after the 2008 financial crisis. Given this state, and the easy money policy of the worlds’ central banks, the threat of deflation trumps the threat of inflation now.

On the day of the crash, the Dow Jones Industrial Average dropped almost 1% in its biggest one-day point decline since May 15. U.S. oil futures closed $1.99, or 2%, higher at $103.19 a barrel. That was the largest one-day dollar and percentage gain since June 12, when Islamists launched an uprising in Iraq. Also, investors piled into perceived safe havens such as U.S. Treasuries and gold, pushing their prices sharply higher. 

We don’t know the exact impact to the U.S. economy of a protracted period of higher global oil prices if war between Russia and the Ukraine were to break out, or the battle between Hamas and Israel were to spread into a wider war within the Middle East. But we do know that such events, if deep and prolonged, could easily tip the U.S. back into recession.

And given our fragile recovery and these scenarios, the Federal Reserve’s accommodative stance is likely to remain for some time.  

Of course, war is just one of many major concerns that could reverse the economic gains that have been made in the last few years. As we reported recently, The Bank of International Settlements, the institution in Basel, Switzerland that is the central bank for central banks, said that stimulus programs address the immediate problem at the cost of creating a bigger financial crisis down the road. And in the report, the BIS noted that, “the fallout from the financial cycle can be devastating.”

What would a financial bust look like in a post-2008 financial bust world? Well, we got a taste in early July, when worries over the financial health of a major Portuguese lender, Banco Espirito Santo, spooked global markets, causing shares to plunge in southern Europe and sending U.S. stocks down.

What happened? As the Wall Street Journal reported, “a shock in a small country spread across the continent, pulling down every major stock index in Europe, trickled over into Wall Street and sent investors scurrying for the perceived safety of gold, U.S. and German government bonds,” essentially the investors’ crisis textbook response of almost every past crisis. 

Chart A: The Biggest U.S. Contraction since 1Q2009

A large scale financial collapse could start with a bubble in junk corporate and government bonds around the world popping, leaving U.S. investors who have piled into them holding the bag. It would be essentially a reverse 2008 crisis: This time an asset bubble overseas would push the U.S. economy into a recession, or worse.

And what would the Fed do in that event? Would it use even more stimuli to re-inflate the bubble that the U.S. and other global central banks created and then popped? That’s a scary scenario.

Federal Reserve Chair Janet Yellen has argued that in increasing capital at banks around the world has made the financial system more stable, but her central bank colleagues have sounded the alarms that the financial system continues to be at risk, and the Federal Reserve appears to be overlooking this.

As investment guru Seth Klarman put it: “Inside the giant Plexiglas dome of modern capital markets, just about everyone is happy, the few doubters are mocked and jeered, bad news is increasingly ignoredn… The artificiality of today’s markets is pure Truman Show.”

Many financial experts, and your correspondent, still believe that deflation should be the biggest concern on investor minds. The Wells Fargo chief economist said in February that a new model his team developed forecasts a 66% chance of deflationary pressure.

Failure to Launch

It’s difficult now to get excited about inflation, especially when recent revisions show the U.S. economy had a much more dramatic contraction in the first quarter than we thought even a few months ago. In fact, the U.S. economy looks far from reaching “escape velocity,” or exhibiting sustainable growth, the necessary precursor to inflation.   

The Fed’s real GDP growth estimate for 2014 was revised to 2.1%–2.3% from 2.8%–3% at the end of the March FOMC. And the Wall Street Journal found that consensus economist estimates projected lower GDP growth than the Federal Reserve.

As we have advised investors in the past, see A Portfolio Against War, Inflation and Bubbles and The $45 Billion Tipping Point, portfolios can be constructed that simultaneously protect against inflation and deflation, when such outcomes are not clear, and should be implemented well in advance.

Portfolio Update

Protection against deflation and inflation can be done simultaneously by buying utilities to protect your portfolio against deflation, and metals, TIPS or other inflation protection securities and diversification investments overseas. Also, small cap stocks have also been historically a good inflation hedge.

Chart B: Investors Rush for the Safety of Gold

In terms of Inflation:

Gold has offered protection and value creation during the latest period of high volatility in the market over news on Russia and potential rate hikes (See Chart B). The chart shows Thrive Portfolio gold miner Goldcorp (NYSE: GG) is up 27.92%. Gold prices rose 1.5% to $1,319 per ounce, while silver gained 2% to $21.19 per ounce on July 17 on geopolitical concerns. Goldcorp plans to increase its gold output this year by 10% compared to 2013. The company gave annual guidance that the firm will produce nearly 3 million ounces of gold. This means that the recovery of gold will have a compound effect on the company’s revenue due to the expected rise in production. GG is a Buy at 39.

Founded in 2008, SPDR DB International Government Inflation-Protected Bond (NYSE: WIP) is an exchange traded fund (ETF) that seeks to provide investment results that corresponds generally to the price and yield performance of the DB Global Government ex-US Inflation-Linked Bond Capped Index (DBLNDILS).

The ETF holds specific types of foreign sovereign bonds that are linked or indexed to an inflation calculation in another country similar to how in the US Treasury Inflation Protected Securities (TIPS) are indexed to the Bureau of Labor Statistics’ Consumer Price Index (CPI) which measures inflation.

To be included in the Index, bonds must: 1) be capital-indexed and linked to an eligible inflation index, 2) have at least one year remaining to maturity at the Index rebalancing date, 3) have a fixed, step-up or zero notional coupon and 4) settle on or before the Index rebalancing date.

As of July 30, 2013, the ETF recorded a Net Asset Value (NAV) of $1.16 billion and a low expense ratio of 0.50 percent. WIP is a Buy at 65.

In terms of Deflation:

We would want a greater exposure to regulated utilities in constructive regulated environments, or firms that have exposure to unregulated markets or new business lines.

Here we like Duke Energy Corp (NYSE: DUK), which is one of the largest regulated utilities in the US, with 85 percent of revenue coming from its regulated businesses. Duke Energy also offers diversification: It has power plants in Central and South America, and builds and operates wind and solar projects in the US. Duke is a buy up to 75.

According to a Texas A&M study that forecasts energy consumption through 2050, population growth will be the greatest factor in determining long-term trends in energy demand. The model projects an overall national population increase of almost 38 percent from 2010 to 2050. The states with the largest growth rates included Arizona, Nevada, Florida, and Texas. That’s why NextEra Energy Inc (NYSE: NEE), which has a strong regulated service territory in Florida could be ideal.

And like Duke, NextEra offers extraordinary diversification, with over 42,000 megawatts of generating capacity in 26 states in the US and four provinces in Canada.NextEra is also one of the largest generators of renewable energy in North America. It owns and operates about 17 percent of the installed base of US wind power production capacity and operates about 14 percent of the installed base of US utility-scale solar power production capacity, as of the end of 2012.

Finally, NextEra has a stellar Return on Equity (ROE) of 11.95 percent, and its stock currently yields 2.95 percent, with a payout ratio of 56.8 percent. NextEra is a Buy up to 100.