By Natsuko Waki and Jamie McGeever
LONDON (Reuters) - The threat of deflation in the euro zone could reverse a major investment trend of 2013, drawing funds out of stocks and into government bonds and cash.
Europe is still some way from a negative inflation rate, let alone a Japanese-style deflationary spiral - the policymakers' nightmare in which falling prices weaken demand, leading to wage cuts and even lower prices.
But a warning light is already flashing, with euro zone inflation registering a shock drop last month that prompted an interest rate cut.
This year's "Great Rotation" flows away from bonds have propelled many stock markets to multi-year or record highs and fuelled a rally in property and other relatively high-yielding assets.
But it's a potential money loser in an environment of weak inflation or even outright price declines. With chronic price falls, investors become ultra-risk averse.
"Deflation would follow from lower growth than we currently have. It would increase the attraction of fixed income versus equities," said Jan Loeys, JPMorgan's head of asset allocation.
There is certainly scope for equities to pull back. The S&P 500 <.SPX> and Dow Jones Industrials <.DJI> have hit record highs in recent weeks. Germany's DAX <.GDAXI> has hit a five-year peak and Japan's Nikkei <.N225> is up 37 percent this year.
According to Bank of America-Merrill Lynch, who coined the "Great Rotation" phrase, global equity funds have attracted $231 billion of inflows this year. Bond funds have pulled in just $16 billion, and have posted outflows in 12 of the past 14 weeks.
Now comes falling inflation. In the euro zone, it slowed to just 0.7 percent last month, well below the European Central Bank's target of below, but close to 2 percent. The ECB halved interest rates to a fresh low of just 0.25 percent as a result.
And if inflation falls further, the ECB could act again. This puts it on a potentially divergent path from the U.S. Federal Reserve, which most observers say will begin the process of removing its policy stimulus in the coming months.
Deflation alone is not seen as an outright negative for equities, which can still rise if there is moderate growth.
But in such an environment, financial stocks tend to underperform because deflation increases a borrower's real debt burden, contributing to higher non-performing loans and lower net interest margins for banks as the gap between short- and long-term interest rates narrows.
"If we get a deflation psychology beginning to break out in Europe you have to reconsider the relationship between a 'risk' asset and 'non-risk' asset," said Bill O'Neill, chief UK investment strategist at UBS Wealth Management.
"Markets will be focusing on assets that provide nominal guaranteed returns such as government bonds. You would want to be aware of risks in equities, in particular in financials."
Investors may already be wary of such risks. European financial stocks <.SX7P> have fallen 1.5 percent this month, making them worst performing sector in Europe.
European banks are shrinking their balance sheets as they adjust to new, tighter regulations on risk-taking and capital, as well as drastically weaker demand for loans due to the brittle economy and record high unemployment.
The deflationary force of this deleveraging is powerful. As banks lend less, credit creation slows, and so does spending. Morgan Stanley reckons European banks shed 3 trillion euros of assets in the last year, with 1 trillion of that going in the second quarter of this year alone.
If financials are among the most vulnerable stocks, high quality euro zone exporters may be best positioned, assuming deflation remains confined to the euro zone.
"It's all about pricing power," said Nick Samouilhan, fund manager in the multi-asset team at Aviva. "But equities would not be where you generally want to be," he said.
Preferred investments would mostly be cash or government bonds, even taking into account the dynamics in a deflationary environment.
Inflation reduces the value of money, lowering the real value of a borrower's debt and the real value of a saver's savings. Inflation tend to be good news for borrowers, but bad for savers. The opposite is the case with deflation.
In times of low inflation or deflation, cash and government bonds are relatively "safe" assets that protect an investor's capital and ensure a fixed - if low - rate of return.
Within that universe, higher-yielding "peripheral" euro zone debt, such as Spanish and Italian bonds, may be the best bet now that investors have almost priced out default risks.
"If there's a dovish shock, peripheral debt will rally," said Salman Ahmed, strategist at Lombard Odier.
(Additional reporting by Toni Vorobyova, editing by Nigel Stephenson/Jeremy Gaunt)