As the global economy probably slips into an economic recession over the next several months, investors will yield some fat profits riding currently unloved and unwanted securities.

The last time the global economy suffered the tribulations of a major economic recession was back in 1990. That contraction of output was triggered by the last U.S. real estate “bubble” (a.k.a. Savings & Loans Crisis) and later in September 1992 by the demise of the European Exchange Rate Mechanism (ERM) or the euro’s predecessor -- the European Currency Unit (ECU).

Asia, however, saw the biggest decline in economic output since WW II starting in 1997 when Thailand triggered the Asian economic crisis. That watershed event resulted in the massive destruction of credit, currencies and stock-market values as regional economies plunged into the abyss until bottoming in late 1998.

The last U.S. recession in 2001 was mild by historical standards. That’s because housing values continued to appreciate during that span while financial assets were decimated. Basically, money had somewhere to flow, unlike in 2008 where commodities until recently were the only “game” in town for investors.

Why this Recession is Unavoidable

The economic slowdown now threatening the United States and other industrialized economies is likely to result in the worst recession in almost 20 years.

As the world economy struggles amid the heavy burdens of rising food and energy inflation accompanied by deflation in housing and bank credit, consumption will continue to erode as consumers save more and spend less to address balance-sheet erosion.

For the first time in the post-WW II era consumers are facing a bizarre mix of lethal food and energy price inflation and deflation or declining prices in real estate and financial assets (stocks and bonds). Never in the post-war period have consumers and investors alike faced such a challenging environment whereby two powerful economic forces are converging with lightening speed.

Deflation, not inflation, does far more destruction to consumers and the global economy since debt burdens become increasingly difficult if not impossible to finance. That’s the lesson of the 1997-1998 Asian economic crisis, the Russian rouble collapse in 1998 and now, the credit and real estate deflation attacking the United States and Western Europe since August 2007.

Inflate or Die

In a typical deflation credit “bubbles” deflate. This process or monetary phenomenon can take several years to contain until the forces of inflation eventually win as global central banks attempt to print their way out of economic distress. The only way to beat deflation or an environment of rapidly declining prices is to expand bank credit like there’s no tomorrow. That’s what Asian central banks did in 1998 and the United States starting in 2001.

The last U.S. deflation, back in the 1930s, was eventually cured by the Second World War, which resulted in renewed economic production as the United States converted from a peacetime to a wartime economic juggernaut.

But today, the sub-prime crisis has morphed into a diabolical monster as it spreads from one facet of credit to the next. In the process, debt deflation or credit destruction is now underway.

The entire gamut of credit deflation reads like a bad movie still unfolding.

Bank credit continues to tighten in the United States and Europe, particularly in the United Kingdom, Ireland and Spain. As a result, default rates are now rising for companies and consumers; credit card delinquencies are surging and even top-notch investment-grade companies are being denied credit. Corporate bond spreads trade at multi-year highs, banks’ capital ratios have plunged amid a blizzard of unprecedented losses and mortgage markets are hemorrhaging.

The Debt Deflation Strategy

According to data from Morgan Stanley, only U.S. Treasury bonds posted gains during the last deflation or Great Depression of the 1930s. Gold, however, might have gained in value had FDR not confiscated ownership in 1933.

In my view, gold along with the U.S. dollar would post significant gains versus most assets, including foreign currencies in a debt deflation.

Silver, however, might not appreciate as strongly as gold in a severe recession.

Silver remains mostly an industrial metal and I doubt it would appreciate in the same context as gold amid price deflation. That’s because industrial demand for silver would collapse in a hard recession, unlike gold, viewed universally as a surrogate currency and a long-term store of value against fiat currencies.

Other commodities, including oil, are unlikely to rise in value if the current economic situation deteriorates further. There’s no historical case to be made for holding raw materials in a debt deflation. Not even China will save commodities from a major decline.

High quality Treasury bonds and non-financial A and AA-rated corporate bonds are also ideal hedges against credit destruction. As interest rates collapse amid an outright deflation or severe recession, long-term debt prices should rise markedly. Avoid junk bonds and any other category of bonds that aren’t of the highest quality.

The U.S. dollar is also poised to rise vis-à-vis most currencies as the recession unfolds. That’s because foreign economies lag behind the U.S. credit squeeze by about 12 months and will increasingly find debt deflation at their doorstep. Foreign central banks will begin cutting interest rates in 2009 to offset rapidly deteriorating output. That makes the dollar more attractive on a relative basis because the Fed has already aggressively reduced lending rates to boost growth. That’s certainly not the case in Europe and Asia.

Get out of Dodge while You Can

I would also consider opening a foreign bank account to hold some gold and U.S. dollars as a safe-haven strategy. It is not unfathomable that some sort of foreign exchange control may arise over the next few years restricting overseas transfers or allowing individuals to open a foreign account. The British government imposed such controls in the early 1970s amid an economic crisis; it can happen again.

I have little faith that other assets will protect investors apart from the above short list of strategies. Debt deflation is the absolute worst nightmare for investors, central banks and the general populace. The key is to protect what you have. At some point, as the crisis eventually subsides, great bargains will beckon in distressed debt, bankruptcy reorganization securities, common stocks and real estate.

For now, I’d brace for some difficult years ahead and start planning for a hard economic landing. In a worst case scenario, it’s better to be safe than sorry.