In its January 21st, 2014 update, the IMF hinted at the specter of deflation. The United States has only had two experiences with a deflationary economy; the first from 1870 to 1890 and the second in the 1930’s—in both cases, beyond the living memory of most Americans.

Much of our 1930’s our experience with deflation ran concurrent with the Great Depression and as a result, many associate deflation with economic depression. However, this is not necessarily accurate. The two decades of the Great Sag, as the 1870 to 1890 deflationary period is known, was marked by fairly robust growth as the United States segued into the industrial revolution.

A more recent example is the Japanese economy, which has seen deflation since the early 1990’s, although the Japanese economy is categorically not in depression.

How Will Hedge Fund Managers React?

Conventional wisdom suggests that equities, real estate and gold are questionable investments in a deflationary economy.

As readers of our March, 2013 article will recall, several prominent hedge funds have recently made substantial investments in real estate. Among these are Blackstone Group LP and Paulson & Co., Inc. to name but two. Additionally, a significant majority of hedge funds pursue an equity investing strategy and most hold investments in precious metals.

Given the significant numbers of hedge funds invested in equities, real estate, gold or more likely, a combination of all three, one has to ask how seriously the threat of a deflationary trend is viewed by hedge funds exposed to real estate and/or equity investments, and what, if any adjustments, managers are making to their portfolios.

Scant Evidence

While evidence is scant that hedge fund managers are making any sweeping adjustments, there are indications that a few are giving the possibility of deflation some credibility.

Anthony Scaramucci, founder and co-managing partner of SkyBridge Capital, in an August, 2013 CNBC interview was explaining why hedge funds were divesting themselves of gold. He offered four reasons, the most relevant in this statement:

“What’s happening now is the specter of deflation is way, way, way more fearful to the central banking community than inflation, and gold typically works when there’s a devaluation of currency, or inflation.”

Additional evidence that hedge funds are taking the prospect of deflation seriously becomes evident in this Wall Street Journal article dating back to August of 2010 which quotes Bill Gross, co-founder of Pacific Investment Management Company, LLC, as follows:

“Deflation isn’t just a topic of intellectual curiosity, it’s [sic] happening,” In a recent Bloomberg TV interview, he reiterated his concerns. Of course, Mr. Gross’ fervent belief in a deflationary event may be colored by the fact that his firm heavily invests in bonds, long regarded as a relatively safe haven in deflationary cycles.

Consider the recent statement from Saxo Bank’s chief economist, Steen Jakobsen, who suggests that while Europe faces a 50:50 prospect of deflation, the United States’ risk of deflation is nearer 25:75 against a deflationary trend.

While the IMF is not revered for the accuracy of its economic forecasts, the prospect of deflation is certainly one worthy of consideration. Many of the warnings signs are present—interest rates approaching zero, unusually low inflation rates, high levels of unemployment and declines in base metal prices are all classic indicators of deflation.

If hedge fund managers are taking the risk of deflation seriously, it is likely that strong evidence of shifting investment strategies will surface. At the moment, persuasive evidence does not exist.

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