The threat of deflation is growing, both in Europe and to a lesser extent in the US, and investors who have spent the last twenty years watching Japan try to crawl out of its own deflationary trap are understandably worried about how to position themselves if their fears should come true.

European equities unaffected by specter of deflation

Headline inflation is already extremely low – the consumer price index (CPI) is below 1% in Europe and the producer price index (PPI) has gone negative (with core inflation numbers roughly the same). Southern Europe certainly pulls down the average as Greece is already experiencing deflation and the rest of the periphery is at nearly zero inflation, but even central Europe is seeing its inflation rates drop and could simply be facing the same problem a bit further out.

Europe

“Bond markets imply a significant risk of deflation in the Euro area, yet equities remain resilient. We think that can continue as long as growth indicators continue to improve,” writes Morgan Stanley analyst Ronan Carr.

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Deflation has historically hurt PE multiples, but that hasn’t happened so far in Europe. Coming out of a crisis, many companies’ valuations don’t have much further to drop, but there is also a clear break between the inflation breakeven, the strength of the euro, and confidence levels in the economy.

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Deflation favors strong balance sheets and cash flow

Of course that doesn’t mean that deflation won’t hurt European equities markets (be wary whenever tells you that this time will be different), but strong sentiment does create a window to head off deflation and could delay its impact if it comes. On the other hand, this growing gap between sentiment and fundamentals could be the setup for a big drop in equity values.

Investors who want to bet on deflation might not want to short the economy outright since timing the market’s realization that something is wrong can be quite difficult, but many of the best positions in the current bull market are exactly the ones you want to avoid if you want to be safe from European deflation.

Carr doesn’t necessarily think that Europe will have to deal with deflation, but if you’re putting together a deflationary basket, he recommends looking for companies with strong balance sheets, forward cash flow, and not much leverage. Avoiding cyclicals in favor of defensives and finding companies that are able to maintain their prices (eg with patents or a high barrier to entry) and exporters all have strong advantages when the rest of the economy is dealing with deflation.