Amidst continued market volatility and mixed economic signals, the inflation-versus-deflation debate rages on. Historical returns and the fundamental characteristics of many asset classes underscore the importance of this debate. But rather than having to make an either/or decision, investors may be best served by following a simple all-weather approach to meeting longer-term investment goals.

In this corner...

The inflation camp is bolstered by expectations for an increase in demand for goods and services from developing markets, as well as demand for borrowed money from developed markets. On the other hand, the deflationists argue that weak economic growth across larger developed markets, coupled with a poor jobs outlook and bloated productive capacity, will only hinder general price level increases for months to come.

Rather than take a bet on either outcome, it is helpful to consider that they both have a reasonable probability of occurring. And under these circumstances, it is more constructive to focus on the most likely timing of each and build portfolios accordingly. This approach requires a disciplined program of accumulating specific asset classes and recognizing that short-term performance may lag at times.

The tug-of-war for the near-term pits slower private- sector growth against a public debt-fuelled intervention. It appears that individuals and corporations remain guarded in their consumption and business plans. And, given their sizable impact on GDP, deflation has become a credible force. Deflation across developed economies becomes further entrenched in an environment characterized by the ongoing de-leveraging in the private sector.

When might these deflationary headwinds subside and give way to inflation due to either the emerging country demand or monetary expansions? Inflation has prevailed more often than not in the past. But, any prediction must be tempered with the fact that the global economy is in transition. Growth and incremental demand is forecast to depend heavily upon economies that have recently arrived, or reemerged, onto the world stage. And their recent progress has been tied to the success of developed economies that are now struggling or in retreat. The extent and longevity of this dependency remains uncertain, as emerging nations are motivated to seek economic autonomy as well as the fact that they have the financial wherewithal to subsidize these efforts. Economic decoupling and the healthy uncorrelated demand associated with it will most likely ebb and flow for some time.

All Weather

With so much uncertainty regarding the nature of price level changes, investors should concentrate on avoiding serious errors rather than depending upon unusual foresight. This is where discipline and accumulation can be brought to bear. Specifically, investors should look to acquire assets having positive inflation sensitivity. And, they should have the discipline to do so when the economy is lagging and deflation appears to be well-entrenched.

Current asset class positioning should be biased toward the idea of slower growth and private sector deleveraging. This appears to be particularly true following a tremendous run-up in borrowing; a condition which often precedes an extended period of deflation. Asset classes that promise a reasonable and secure income payout rise to the top in such a scenario, with high quality bonds leading the charge. Treasury bonds have benefitted from both the depth of the government securities market and the flight-to-quality that frequently grips global capital flows. These phenomena, as well as a fairly benign interest rate outlook, have positioned Treasuries favorably despite serious concerns over U.S. fiscal imbalances and funding needs. Not surprisingly, the U.S. dollar has benefitted from this same dynamic.

The degree of interest-rate risk that is appropriate for an investor will depend largely on their time horizon, with longer holding periods enabling more aggressive maturity postures. For periodic repositioning and risk management, bond index funds and exchange-traded funds can be utilized to rethink the yield-versus-maturity question. The average duration of a bond fund is a widely published measure of the sensitivity of a fund to changing interest rates.

However, this metric bears a closer look. Fund duration can be managed in different ways to change the overall risk profile of the underlying fund. For instance, cash may be used in combination with longer maturity bonds to tamp down average duration. A fund manager can accomplish a similar reduction by selling U.S. Treasury futures. Or, he can simply restrict bond holdings to the stated duration range targeted by the fund.

As for corporate bonds, here again a declining interest rate environment can help returns, with the caveat that a challenged economic outlook will also hurt corporate profits and potentially impair credit ratings. On the brighter side, leaner cost structures and the healthy level of cash held by non-financial U.S. corporations will help support interest payments on debt. The trick here is to seek out companies with stable cash flows that are adequate to cover payouts. Franchise strength, pricing power and sustainable balance sheets are keys to both stock and bond investors in a deflationary market.