The U.S. economy appears to be heading toward a lengthy period of deflation such as the one that struck Japan, and there is little policy-makers can do to prevent it, says one of Canada’s most accomplished investors.

But it isn’t just the United States and Europe that Prem Watsa is worried about. The potential bursting of a property bubble in China has him even more concerned. And if Chinese demand for commodities dries up at the same time as U.S. consumers are shutting their wallets, then the global economy is in for a lengthy period of pain.

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As pessimistic as he is, Mr. Watsa, the chief executive officer of investment and insurance company Fairfax Financial Holdings Ltd., (FFH-T368.84-5.31-1.42%) is sleeping soundly at night. While banks, insurers, and investors were watching their assets disintegrate in the financial crisis of 2008, Fairfax was raking in profits, thanks to bets it had made against a number of major financial institutions, including American International Group.

Now Mr. Watsa believes that the company’s gloomy outlook is poised to pay off again.

Fairfax has been selling corporate bonds in favour of U.S. Treasuries and selected municipal bonds, both of which have seen yields drop and prices rise in the past week as investors have fled to safety. Mr. Watsa has long predicted that government bonds will continue to be the best performing asset class – even though U.S. government debt loads have contributed to the economic turmoil – because investors gravitate toward risk-free securities.

“We have said for some time that we think this is a 1-in-50-, 1-in-100-year event,” Mr. Watsa said in an interview Wednesday. “Which means that it’s like Japan or the 1930s, because there’s too much debt in the system.”

The recent sharp downward revision of U.S. economic growth in the first quarter, from an already low 1.9 per cent to 0.4 per cent, cemented Mr. Watsa’s view that deflation is all but inevitable. And he believes that U.S. Federal Reserve Board chairman Ben Bernanke has run out of ammunition to prop up the economy, despite the Fed’s promise to hold rates extremely low for two more years.

Mr. Watsa, who has become a fan of Japanese economist Richard Koo, also believes that the Obama administration and U.S. Congress could be making a fatal error by cutting spending.

“The worry is this,” Mr. Watsa said. “You have interest rates at zero per cent, you have had deficits coming down, meaning reduced government spending, which means there’s no ammo left for the governments of the world, particularly the United States. So what do you do next to get the economy going?”

As the U.S. grapples with its debt, Mr. Watsa believes that excessive borrowing in the Chinese property market threatens to take down the world’s second-largest economy. He visited China earlier this year and met numerous people who owned three or four apartments – apartments whose prices had risen fourfold in as many years.

If events unfold as Mr. Watsa thinks they might, Canada will not be immune. If the U.S. economy goes into recession as commodity prices are falling, this country will not skate through unharmed.

“This is not a short-term thing,” Mr. Watsa added. “We think we’ll be going through some tough times for many years.”

And he expects that the pain will weigh on stock markets. “In a tougher economic environment, the earnings that people are predicting for the S&P 500 could be significantly less than what they’re thinking today,” he said.

Mr. Watsa has put Fairfax’s money where its mouth is, making investment decisions that cost the Toronto-based insurer substantially in 2010. The company increased the proportion of its stock portfolio that is hedged from 30 per cent to close to 100 per cent in May and June of last year.

Its timing wasn’t perfect, and the move cost it $936.6-million as markets rose. But now, with about 85 per cent of its portfolio still hedged through total return swaps and shorts on the S&P 500 and Russell Indexes, it is well insulated from a sharp decline in the equity markets, noted BMO Nesbitt Burns analyst Tom MacKinnon. (Fairfax has not removed hedges, but the proportion of its portfolio that is protected fell as certain investments rose in value.) “In addition, its sizable bond portfolio stands to gain substantially from market value gains as rates fall,” Mr. MacKinnon wrote in a note to clients entitled “You can always hide in Fairfax Financial.”

He estimates that a half-a-percentage-point drop in interest rates could add between $15 and $20 to Fairfax’s earnings per share. Long-dated Treasury yields have fallen more than a percentage point since the end of June, while two-year and five-year Treasury yields have declined by 20 and 70 basis points respectively. (Yields fall when bond prices go up.) In order to bet on deflation, Fairfax bought 10-year derivative contracts linked to the consumer price index of various regions. That’s another bet that had been costing the company money of late, but it will reap returns if deflationary pressures take root in Europe and the U.S. More than half of the contracts are based in the European Union, with the remainder largely based on the U.S., Mr. MacKinnon noted.

The pessimistic bets that Fairfax placed on financial institutions and its decision to short the S&P 500 prior to the financial crisis of 2008 paid off in spades. Between June, 2008, and the end of March, 2009, a period during which the S&P 500 fell 38 per cent, Fairfax’s stock rose 25 per cent, Mr. MacKinnon pointed out.

While Fairfax shares have slipped in the latest market downturn, the drop has not been dramatic.

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