Since July, global markets have violently transitioned from one obsessed with inflation to deflation, or an environment of falling prices. Though I have no doubt the Fed and other central banks will ultimately win the battle against falling prices through the aggressive expansion of credit, the near-term direction of asset prices remains down. This implies a very defensive investment position, including only the highest quality debt securities, limited exposure to large-cap multinational blue-chip stocks and alternative investments, including reverse indexing and gold.

Emerging markets and major markets face a different macroeconomic battle.

Though emerging markets still face the growing tribulations of rising prices this year affecting consumption, it’s deflation that has gripped Western economies, including Japan since commodities hit a peak in mid-July.

Asset prices continue to rapidly deflate everywhere with global stocks as measured by the MSCI World Index down 21% and the MSCI Emerging Markets Index off 30% in 2008. These are the worst calendar year returns so far since 2002. A few percentage points lower from these levels and we’ll have to go all the way back to 1974 to show similar percentage declines.

Inflation-based indicators now flash “green” with gold prices, TIPs (Treasury Inflation Protected Securities), Treasury bonds and the U.S. dollar confirming inflation is yesterday’s worry.

Until central banks, including the Federal Reserve, significantly boost the supply of credit and cut lending rates again, deflationary forces will continue to gather momentum. This marks the first time since the Great Depression that financial assets and real estate are declining in value simultaneously, threatening a hard economic landing in the United States and other industrialized economies. Over the last 12 months residential real estate prices in the United States have plunged 15.4% through June; the Dow is down 15% and global markets have tanked more than 20%.

Thus far, 13 months into the credit crisis, policy responses from major central banks have worked with limited success as inter-bank lending rates remain elevated and credit grows harder to secure for borrowers. These are the classic symptoms of deflation or in this case, an unwillingness of major financial institutions to lend amid a complete breakdown of inter-bank confidence.

The entire process of de-leveraging the excesses of the 2003 to 2007 bull market will take more time as banks and investment banks work through their clogged inventory of synthetic securities; a bottom in U.S. housing values would trigger a bottom for asset values and, probably, an end to the credit crisis.

Unfortunately, we’re at least six to nine months away from a housing bottom. The government’s bail-out of Fannie Mae and Freddie Mac this week has accelerated this hopeful outcome by several months as a starved mortgage market will now get a dose of liquidity and confidence, courtesy of the United States government.

Deflation is now firmly in control since July. Let’s hope it fades soon.