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Friday, 17 July 2009 16:18 Written by James Van de Voorde

The stock market rally off the depths of the early March bottom finally lost some steam during June, with the Dow Jones Industrial Average down by .63% and the S&P 500 Composite up a scant .02%.  The NASDAQ Composite, however, continued its ascent by rising 3.42% for the month, confirming the technology sector’s leadership and relative strength.  The NASDAQ is now up 16.36% for the year through June while the S&P 500 is up 1.78%.  The Dow remains negative at –3.75% through June.   

There has been much hype recently about the outlook for deflation versus inflation and the best way to posture portfolios for each potential outcome.  Because deflation is arguably the worst of all financial afflictions and much more difficult to counteract through conventional monetary policy, the possibility that we have entered such a period has deservedly given serious pause to central bankers and portfolio managers worldwide.  With the recent stock market meltdown and implosion of the housing bubble, one cannot deny the massive destruction of wealth and asset price decline that is symptomatic of deflation.  Precisely because deflation presented such a dire and immediate threat, the Federal Reserve has embarked on the most aggressive easing of monetary policy, expansion of its balance sheet and expansion of the money supply in history.

Jim Grant of Grant’s Interest Rate Observer defines deflation as “too much debt chasing too little income”.  This definition helps to better illustrate the potential downward spiral of deflation.  If one does not have enough income to service their debt, they must either increase their income or reduce their debt.  In a recession such as the one we are muddling through now, the prospects for significant increases in income are low, thereby increasing the need to sell assets in order to pay down debt.  This process of paying down debt is what has now become commonly known as “deleveraging”.  Of course, the other option is to foreclose or file bankruptcy and effectively walk away from one’s debt.  The combination of selling assets during a period of already declining asset prices begets a vicious cycle of balance sheet destruction.  This is why you may hear economists refer to the current recession as the first “balance sheet recession” since the Great Depression.

Another characteristic of deflation is the need to increase savings in order to restore one’s balance sheet.  In just one year, the U.S. national savings rate has jumped from 0% to 7%.  This is a dramatic increase in a very short period of time and indicates that consumers may have already reached a comfortable level of spending/saving equilibrium.  The current 7% savings rate compares to 5% during the 1990s and a 9% savings rate during the 1980s.  A higher savings rate implies that less money is being spent on consumption, which further implies a lower level of economic activity since consumer spending accounts for approximately 70% of overall GDP.   

While we have witnessed spectacular declines in housing and in the stock market, we have yet to experience a year-over-year outright period of decline in the most commonly used measures of inflation, CPI and core CPI.  Grant explains that “in a proper deflation, prices fall broadly, not narrowly.  Seventeen months into the Great Depression, the CPI had fallen by a cumulative 8.1%.  This time around, from December 2000 to date, the CPI has risen 1.8%.” The Labor Department recently reported that core CPI, excluding food and energy prices and accounting for 75% of consumer expenditures, rose .1% from April to May and is now 1.8% higher than a year earlier.  Meanwhile, headline CPI was down 1.3% during the same period as a result of the collapse in energy prices and pricking of the oil bubble.  And the just reported Producer Price Index (PPI) unexpectedly rose 1.8% in June while core PPI “enjoyed” its biggest one-month increase since last October.  The evidence suggests that prices have not fallen broadly as is typical during a “proper deflation”.   

Our hypothesis is that deleveraging and a higher savings rate/lower spending will reduce overall economic growth (“the new normal”) for an extended period, but an extended period of deflation is not a necessary outcome.  With core CPI and PPI rising even during the worst of the financial crisis, the worst-case scenario for a broad deflation carries a low probability, especially when we consider the highly inflationary potential of the various government stimulus initiatives.     

Many pundits will point to the rising unemployment rate as a further potential sign of deflation risk.  As more people lose their jobs, so goes the argument, there is less collective income to pay debts and an increased need to sell assets.  However, this argument ignores the fact that the inverse of the unemployment rate implies that 90% of the employable population is working.  And inflation-adjusted average hourly earnings actually rose by 3.3% in June, implying that the vast majority of us that are employed actually have more income available to service debt.  We have always been cautious to make too much of the long-term impact of temporary asset price declines.  While we agree with the immediate impact of the so-called “wealth effect” where declining prices influence lower spending, lower asset prices do not require the vast majority of homeowners and investors to sell their home or liquidate their portfolios.  Further, the stock market recovery is well underway and there are ample signs of stabilization in the housing market.  A sustained recovery in asset prices would provide a much-needed short-term boost to consumers and go a long way towards restoring the collective health of the U.S. balance sheet.  

While we do not expect a broad and sustained period of deflation, there is no doubt that there remains considerable slack in our economy.  Not only is unemployment at 10% and rising, capacity utilization at 68.3% is now 12.6% below its long-term average and below the previous low reading of 70.9% registered in December 1982.  Until unemployment and capacity utilization end their decline, it is unlikely that inflation will become a real problem.  The slack or “output gap” that presently exists is keeping a lid on wage demands and pricing pressure, acting like a giant sponge and soaking up the otherwise inflationary forces unleashed by the Federal Reserve and Obama administration.  The Fed recently telegraphed that “substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time”.  However, with trillions of dollars of fiscal and monetary stimulus now flooding the system and with an expected $1.85 trillion annual budget deficit, the odds favor an eventual rising tide of inflationary pressure.

There are some that fear “unintended consequences” of the recent government intervention, referring to the potential for hyperinflation as the most likely outcome.  We would argue that this invitation for inflation is hardly “unintended” as Bernanke and the Fed do whatever is necessary to prevent a deflation meltdown.  The U.S. monetary base (all money in circulation plus bank deposits at the Fed) has climbed by 114% over the past year through the end of May.  To put this in perspective, as illustrated by the chart on the prior page, the previous largest increase was 16% and occurred in 1999 to avert the potential “Y2K” crisis.   

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If deflation is “too much debt chasing too little income”, inflation (as coined by the late economist Milton Friedman) can be understood as “too much money chasing too few goods”.  It was Friedman that also wrote in 1963 “inflation is always and everywhere a monetary phenomenon”.  Through it’s zero percent Fed Funds rate and quantitative easing campaign, the Fed has created an unprecedented explosion of the money supply (“too much money”) designed as an all-out front against deflation.  The substantial rise in the commodity and stock market from their recent low is a tell-tale sign of the “too few goods” syndrome as investors with excess liquidity seek out higher returns.       

While the so-called “Taylor Rule” for forecasting monetary policy indicates that the Fed Funds rate ought to be negative right now, Taylor Rule inventor and Stanford economist John Taylor believes that “we will soon see a resurgence of inflation and an increase in mortgage rates unless the Fed presents a clear and credible exit strategy from the unprecedented explosion of its balance sheet.”  The fact that such well-regarded economists such as Taylor are now worried more about inflation suggests that the Fed has already won the battle against deflation.  Increasing the odds that Taylor’s fears may be realized, the Fed is unlikely to alter its easy monetary policy in the intermediate term or risk halting the still-fragile economic recovery in its tracks.  To that end, the Fed is likely to tolerate higher inflation until it is assured that consumers and the economy can withstand higher interest rates.   

Our base-case hypothesis is that deflation has been successfully averted and inflationary pressures will become more evident over the coming year to eighteen months.  Recently reported better-than-expected durable goods orders and ISM reports (both ISM services and ISM manufacturing) signal that the economic recovery continues to pick up steam.  Meanwhile, a drop in new home sales and decline in consumer confidence remind us that the recovery is far from robust.  In addition to these economic data points, we will be closely watching the dollar, the price of gold and other commodities, and potential “vigilante spikes” in interest rates to help confirm our thesis.  Given the fragility of the economic recovery now underway, we will also watch out for signs of stagflation, a condition where rising inflation is accompanied by stagnant economic growth.

While it is far from abundantly clear what the ultimate economic outcome will be, our focus on high-quality growth companies with long records of consistent earnings growth and dividend hikes, and that garner substantial growth from foreign operations will serve our clients well, regardless of the prevailing flavor of “flation”.

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