In the midst of a deflation conundrum...

Sovereign issuer default risk scare apart, the deflationary bears are once again taking center stage as worries grow over the longer term impact of the mountainous debt that governments of the troubled economies have accumulated over a very short time span. If this actually translates into a protracted period of anemic growth, it could trigger a deflationary spiral with real consequences on an already troubled economy. The recent substantial rally in U.S. treasuries are partly symptomatic of this fear. Recall that an out of control deflation causes damage to the economy by shifting longer term expectations for both producers and consumers. As businesses face the prospect of downward spiraling prices they anticipate this by laying off a growing number of workers. Consumers feed into the frenzy by postponing consumption to a future date not only in anticipation of almost certain lower prices but also because of the growing job insecurity as unemployment inflates. All this bodes very badly for stocks which are likely to experience shrinking margins in such a scenario. Same goes for commodities that are a proxy for economic activity. Sovereign debt, on the other hand, tend to shine (which it is already doing) when deflation rears its ugly head as investors flock to it in search for greater security and income that becomes more valuable as prices take a nose dive.

What makes this downturn interesting is that we don't really know how investors are going to behave if real deflation takes hold. Will they be willing to park their hard earned cash into troubled sovereign debt which has lost its traditional "risk free" status or will they go elsewhere? I guess time will tell.