Prem Watsa, Chairman and CEO of Fairfax Financial, has made a bold bet on falling prices over the next decade according to an article in The Wall Street Journal.  Fairfax Financial is an insurance company based in Canada which many have compared to Warren Buffett’s Berkshire Hathaway due to Mr. Watsa’s impressive long term track record.  Fairfax posted very strong results in 2007 and 2008 due to large gains in equity hedges and credit default swap positions that were taken based on Mr. Watsa’s correct reading of the economy ahead of the Great Recession.

While the case for deflation has been more popular over the past couple of months as economic news worsens and government bond yields have dropped to levels not seen since the depths of the financial crisis, Mr. Watsa has been worried about deflation for some time.  In December, we noted that Mr. Watsa’s views on deflation seemed to be very different from Warren Buffett’s warnings regarding a potential “onslaught of inflation” in the coming years.

Here is an excerpt from The Wall Street Journal regarding the Fairfax Financial deflation bet:

Fairfax paid $174 million in upfront fees to protect $22 billion of its investment portfolio against the possibility of deflation over the next decade. In exchange, Fairfax will receive a payment amounting to the drop in CPI below 2%—the level of inflation when Fairfax bought its contracts—multiplied by the $22 billion.

If deflation averages 2% annually over the next 10 years, Fairfax’s contracts would rise in value the equivalent of 4% of $22 billion, or $880 million, each year over the next decade, according to traders familiar with Fairfax’s trades. In that scenario, if Fairfax holds on to its investments during the 10-year period, it would reap nearly $9 billion from its $174 million investment. The company wouldn’t get anything for its bet if inflation turns out to be higher than 2% over the next 10 years.

Currently, the market seems to agree with Mr. Watsa’s assessment and is unconvinced by Mr. Buffett’s long term warnings regarding “greenback emissions” that seem like the path of least resistance for governments grappling with record levels of debt.  Essentially, the current market sentiment is assuming that the United States and other major rich economies will experience a Japan-style malaise for at least the next five to ten years.  How else can one justify purchasing a ten year treasury note at a paltry 2.5 percent yield, particularly at a time when many well established blue chip companies trade at modest valuations and offer higher dividend yields?

Time will tell whether the inflation or deflation thesis is proven correct.  With heavyweight investors with stellar track records on opposite sides of the debate, intelligent investors should keep an open mind regarding the risks of deflation even if skeptical regarding the willingness of governments to resist the easy lure of inflation to cure debt woes.

Disclosure:  The author of this article owns shares of Berkshire Hathaway.  No position in Fairfax Financial.