This is a story I read more than 20 years ago but is still interesting
Looking down: Some economists say deflation - yes, deflation - is around the corner
Nov 18,1997
Many good shopper loves a sale. And if some top economists are right, consumers are about to see a lot more reductions soon. A constellation of trends is coming together to push prices down, they say.
Yes, you read right: They're talking about deflation.
Sound too good to be true? Well, listen up: While declining prices may be good for shoppers, they can be downright harmful for companies and the economy, not to mention your investments. Luckily, if deflation does occur, there are steps you can take to protect yourself.
What will cause deflation
Economists in the deflation - or disinflation -- camp marshall several convincing cultural and economic trends to build their case. They include:
Demographics In the 1980s, baby boomers were in their peak spending years. Now they are spending less on cars, clothes and houses -- saving more, in other words, rather than adding to demand and driving up prices.
GlobalizationSince the Berlin Wall fell, economies are much more open. Before, inefficient producers could hide behind trade barriers. "Production now moves to the lowest-cost area of the globe," says James Paulsen, the chief investment officer at Norwest Investment Management. "Nearly overnight, the world economy was transformed from a collection of protected monopolies to a truly competitive environment." Obviously there are still lots of exceptions. But often excess demand is now simply met by excess capacity some where else in the world, rather than causing inflation by overheating a domestic economy.
Technology This does more than just raise efficiency and productivity. In the field of technology, prices tend to come down all the time. That's a big change from the industry that used to dominate the economy -- automobiles, which increased prices every year.
Cultural factors Compared to the 1980s, there is much less focus on consumption and debt today and more emphasis on saving, says Paulsen. In short, for better or worse, "the material girl" has been replaced by the mutual fund investor. The new lust for saving is strong in the business world, too. Part of nearly every business strategy is price competition and cost-cutting. Firms are using technology to boost productivity rather than expanding capacity to produce more. And they are using stock options rather than wage increases to reward workers, or cutting debt to bring down interest costs.
Fiscal policy In Washington, the government is working on getting the deficit under control, which helps relieve inflationary pressures caused by excessive spending. The Fed, meanwhile is focused on controlling inflation, as opposed to creating jobs, which is the other half of its brief, strictly speaking.
Problems in AsiaOvercapacity in Asia is putting downward pressure on prices. "Overinvestment is the basic engine of deflation," points out Merrill Lynch economist Charles Clough." And the 1990s saw a surge in Asian capacity building, as high domestic savings rates coincided with strong foreign direct investment to massively inflate Asia's capital stock." This trend is directly linked to the current round of worldwide currency devaluations, which themselves put downward pressure on prices elsewhere. "Countries in Asia are trying to export their way out of deflation by devaluing," says Clough. The U.S. and Europe will "import" some of this deflation, he says.
Put together, all these factors point to downward pressure on prices ahead. What's different this time is that many of the trends can't be changed by politicians or economic cycles. In other words, they will have an impact on prices regardless of economic shifts that normally might cause inflation to kick in. "So the old cyclical indicators of inflation no longer play the role they once did, even though the Fed, market strategists and the press continue to focus on them," says Paulsen.
Keep in mind that as good as the case for lower prices sounds, not everyone is convinced. "I don't really see a strong deflationary trend materializing," says Carl Wiese, a portfolio manager at Hokanson Capital Management in Encinitas, Calif. "People are arguing that there is overcapacity in Asia. But I believe the market has a way of adjusting itself and that capacity will be taken out."
Other detractors point out that Asia is not big enough to drive global disinflation by itself, even if the Japanese economy sinks even lower because of problems there. What's more, money supply is growing in most of the world, and that's not usually a condition for deflation, points out David Shulman, the market strategist at Salomon Brothers. Other naysayers point out that the evidence of rising productivity, a key part of the deflation argument, is spotty at best.
The dark side of declining prices
Deflation is something for investors to fear, but there are steps you can take to protect yourself
Second in a two-part special report. Click here for part one.
Yesterday we discussed the notion of deflation - downward movement of prices - and the factors some economists cite as evidence that it could occur now.
Let's say they're right, and we enter a deflationary period. What will it mean for your investments?
It depends how far things go. If disinflation brings interest rates down, as it probably would since less inflation would be built into long-term interest rates, that will be good for stocks. And it may even be even good enough to offset any losses companies incur from lower prices.
Lower interest rates help stocks by reducing the "discount rate" used to value a stock's performance over time. When a lower discount rate is used to figure out the present value of future cash flows, you get a larger value -- meaning that companies are worth more and stock prices go up. So declining interest rates increase current stock valuations. For example, between 1979 and 1987, notes Norwest Investment Management's James Paulsen, earnings did not change much but stock prices tripled -- in part because interest rates came down sharply.
So far, so good. But if disinflation - downward pressure on prices -- turns into deflation, or actual declines in prices, then company earnings start to get crushed. And that means trouble. "As inflation goes from one percent to zero, it is incredibly bullish for both stocks and bonds," says Paulsen. "But if it goes right through zero, it destroys the stock market."
Assuming sustained disinflation - or out and out deflation - is on the way, what should you do with your investments? The specific response depends on the makeup of your portfolio. But here are some general tips to consider.
Buy bonds. The simplest advice is to reduce your exposure to stocks and shift your money into fixed-income instruments. Bonds do well when inflation goes down, whereas companies may be hurt by declining prices.
Buy stocks that will weather deflation. Getting out of stocks altogether, of course, would mean you'd lose out on potential gains there from companies that are more immune to disinflation. So you should stay in stocks but minimize your exposure to damage, says Paulsen. That means several things. First, you might want to tilt your portfolio towards large caps instead of small caps, because signs of deflation would cause a flight to the perceived stability of a larger company. But don't buy just any large cap stock. Look for companies with multinational franchises and economies of scale. These will be better able to deal with disinflation.
Look for companies that have pricing power, or the ability to set prices for their goods or service. Software companies come to mind. But any company that makes products which other firms need to stay competitive is a safe bet.
Look for companies that have stable -- as opposed to cyclical - earnings: You want to be in companies whose products will be in demand no matter what the economic climate. This means drug companies, food producers, companies that make consumer nondurable goods like cosmetics and household products, and utilities.
Buy bond-like stocks. What does this mean? First, of course, it means look for companies with big dividends, like financials, utilities, Real Estate Investment Trusts and some of the oil stocks. Insurance companies fit the bill too, since a big part of their portfolios is invested in bonds. But you can also consider companies whose future cash flows make them look and act a little like bonds, points out Paulsen. This means firms with predictable long-term unit sales growth. These include drug companies and many of the "nifty fifty" firms that have consistent unit sales growth, like Coca-Cola or Kellogg.
Avoid cash. Ironically, the safest of safe havens may provide little protection at all when prices fall. If declining prices bring down interest rates, then the returns on money market funds can slip. So your money market fund will offer little protection. For safety, you have to turn to bonds, which benefit when prices decline or inflation slows down.
Yesterday: Looking down: Some economists say deflation - yes, deflation
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