The dreaded D-word, “deflation”, is getting more airplay in financial markets. Australia is following international trends with lower interest rates and expectations are rising that the Reserve Bank will cut interest rates at least once more this year.

Could Australia fall into a deflationary spiral where even zero interest cannot stop price fallings? And where consumers defer purchases because they expect lower future prices, and lower-than-expected inflation increases the real burden of debt?

An all-time low of 2.2 per cent on the 10-year Australian Government bond this week shows just how concerned the market has become about future economic growth. For context, the Government bond yield fell to 4 per cent after the 2008-09 Global Financial Crisis. Even a 2.2 per cent bond yield looks like a luxury compared with several advanced economies that have negative bond yields.

The low bond yields highlight how investors are chasing safe-haven assets, such as government bonds. They are prepared to earn a measly coupon rate to protect their capital.

It is hard to see inflation rising anytime soon. Product oversupply is a growing problem across industry – think the glut of iron ore, coal, oil and gas. Lower food prices also weigh on inflation.

Product and labour-market oversupply is, in turn, fuelling record-low wages growth, evident again this week with weaker-than-expected wage growth. This data does not show those who are working more hours or have had more responsibility dumped on them for the same pay. Or those who lose their job and find a new one at a vastly lower rate than in previous years.

Debt is another deflation driver. Advanced economies are awash with debt across governments, companies and consumers. The borrowing binge brought years of excess consumption forward and paying the debt back too quickly – assuming some countries still can – dampens economic growth and adds to the spiral towards deflation.

Technology is also affecting wages growth and, by default, inflation. Software algorithms and other automations are robbing workers of their bargaining power in some industries. Nobody knows for sure just how much technology is disrupting economies or the possible rate of technological change and its effect on the job market in the next five years.

Yes, I should apologise for this week’s gloomy column. But investors need to consider the consequences of persistently lower inflation or outright deflation, should it take hold, and how to protect their portfolio. It’s time to be “alert rather than alarmed”. 

The good news is the Reserve Bank has more scope to cut interest rates than many advanced economies and it is hard not to see lower rates driving Sydney and Melbourne property prices even higher. This in turn would make homeowners feel wealthier, but create potentially disastrous property-price bubbles that spark the next financial crisis.

Lower inflation and lower interest rates point to the Australian dollar heading south and the prospect of higher sharemarket volatility. If the world is struggling with a fragile recovery now, what will happen if another global financial shock emerges and there is little monetary or fiscal policy ammunition left in the tank to pump-prime economies?

Long-term investors should add more insurance to portfolios given the probability of lower inflation and higher currency and equity-market volatility. Note my emphasis on probability: it does not mean the above will happen; rather, that the chance of it occurring is rising.

I see three simple ways to add some portfolio insurance.

First, ensure your portfolio has a sufficient cash weighting. The amount of cash, of course, varies with investors’ needs and the stage in their investment lifecycle. But cash really is king in deflationary times because it buys more as prices fall.

When building cash holdings, beware dividend-reinvestment plans where dividends are used to buy more stock, sometimes at inflated prices. Take the dividends in cash and have enough set aside to a) protect portfolios and b) put the cash to work during market volatility.

Second, focus on fixed- rather than floating-rate notes and take care with inflation-linked bonds (due to the absence of inflation). Choose floating-rate notes when rates are rising, not falling.

Third, ensure portfolios have sufficient exposure to gold – up to 5 per cent of the portfolio. Gold bulls might have their day as investors favour the metal for its traditional role as a store of value, particularly if currencies are debased and equity-market volatility increases.

From a portfolio perspective, I prefer gold bullion over gold equities because it eliminates equity-market and company risk. An exchange-traded fund over gold is an easy, low-cost way to gain exposure to US-dollar gold via ASX. 

I suggest the unhedged variety, such as the ANZ ETFS Physical Gold ETF, because a lower Australian dollar is likely as rates are cut again this year. Those who want to eliminate currency risk could use BetaShares’ hedged gold bullion ETF. 

Chart 1: ANZ ETFS Physical Gold ETF

Source: The Bull

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Tony Featherstone is a former managing editor of BRW and Shares magazines. He is not a licensed financial adviser and this column does not offer financial advice. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis at May 19, 2016.