Some Fear Inflation Is Ready for a Comeback
by KEN BROWN, Wall Street Journal
Jim Paulsen, the chief investment officer at Wells Capital Management, ticks off the ingredients needed for a mean batch of inflation.
"I would flood the system with money far in excess of economic growth, I would take interest rates to the lowest levels possible, I would have the government spend like a banshee, I would drop the value of the dollar, and finally I would take any capacity growth or additional supply growth and stop it," he says. As a garnish, he'd add rising commodity prices and a growing trade deficit mixed with some rising trade tensions.
Sound familiar? As investors close the books on 2003 and look out into next year, some are worrying that inflation, which had been banished in the past few years, is poised for a comeback. Were that to happen, it would terrify bond investors and shake up the stock market, while giving a boon to some manufacturers, which finally would be able to raise prices.
"Last fall we were all worried about deflation," says Mr. Paulsen. "What could happen by summer is everyone could be panicked about inflation."
That panic may be based more on emotion and expectations than on anything else. There are lots of good reasons why inflation should remain tame, mainly the lack of a strong jobs market. But as investors spend much of their time trying to divine the future, expectations are what will drive stocks and bonds.
If investors collectively agree that inflation is looming, the angst will first show up in bonds, where yields will rise and prices will fall. If the Federal Reserve shares that view, it will push up the federal-funds rate, which is the interest on overnight loans between banks, from its 45-year low of 1%.
That would drive bond prices down, causing pain for bond investors. It could slow or stop the recent economic rebound, which has boosted corporate profits. That means the stock market, particularly stocks that do best in a fast-growing economy, like industrial and big ticket consumer-goods companies, could get hit.
Paul McCulley, a managing director at bond manager Pimco, uses a somewhat different metaphor, but also comes to an inflation conclusion. "The cocktail now pouring into your glass is a 2.5% fed-funds rate by the end of 2005," he says. "The straw in the beverage in 2004 will be fear."
Mr. McCulley, whose firm, Pacific Investment Management Co., oversees $304 billion in assets, predicts a bond bear market next year -- which would come on top of a market that has been largely weak since early this summer. The fed-fund futures market, where investors bet on the direction of short-term interest rates, is saying short-term rates will start their reversal in May when they rise one-quarter of a percentage point. Other markets are predicting inflation; investors in inflation-indexed Treasury bonds are saying inflation will top 2.5% over the next several years. That's well above the 1.5% rate of the past 12 months, but almost inconsequential compared to years past.
To investors who only a few months ago were wringing their hands over deflation, all this inflation talk might seem odd. In a way, it's a predictable part of the cycle, now that the economy has crossed the threshold into a self-sustaining recovery. Powerful economic data over the past few weeks have wiped away fears that the economy might backslide into recession, though a period of weak growth, which would keep inflation in check, is possible.
And there still are a lot of facts economists can muster to make their low-inflation case. First and foremost is that unemployment remains high at 6%, and the jobs situation is worse if you include people who have stopped looking for work. "Inflation is a lot like Elvis," says David Rosenberg, Merrill Lynch's chief North American economist. "Lots of reported sightings, none confirmed."
Whether and how the market reacts to the possibility of inflation depends in part on where it comes from. So far, the market has shrugged off the declining dollar -- though bonds fell Friday as the dollar hit a low against the euro -- rising commodity prices and big budget and trade deficits because the jobs market, until recently, was so weak. "The most important determinant for final goods-and-services inflation does not come from the commodities market, it comes from the labor market," Merrill's Mr. Rosenberg says.
Most experts, the Fed included, believe the economy would need to create hundreds of thousands of jobs -- as many as 150,000 to 200,000 a month for the better part of a year -- for any inflationary pressure to rise. But if coming jobs numbers, including Friday's employment report come in very strong, stocks and bonds could both tumble.
Some economists look to 1993 and 1994 for parallels. The economy and the markets finally gained traction in 1993 after a long slowdown. Commodity prices jumped. At the start of 1994, the Fed started to raise interest rates, ultimately boosting them by three percentage points. The bond market, caught by surprise, had one of its worst years, but the stock market, after an early fall, made up lost ground to finish flat.
As the year ended, economists worried about inflation expected another three percentage points of tightening by the Fed, says John Lipsky, chief economist at J.P. Morgan. Inflation rates never did go up and neither did interest rates.
The lessons from that period provide a possible investor roadmap for next year. First, avoid bonds, particularly long-duration bonds that are the most sensitive to interest rates. "People should learn to appreciate the virtues of cash," says Pimco's Mr. McCulley, a suggestion that is particularly noteworthy considering it comes from the firm that manages the largest bond mutual fund.
Stocks are a harder call. If the Fed starts to jack up rates, or if investors believe a rate move is imminent, they will likely sell stocks. That's because with interest rates higher, stocks will look less attractive. But if the rise in inflation is moderate and the fear factor is low, stocks could do well, particularly if companies are able to raise prices, thereby boosting revenue and profits.
Looking at what's driving inflation could help investors find the most attractive sectors. The biggest beneficiaries of inflation generally are commodity producers such as mining and energy companies. These companies have been earning gobs of cash over the past year, so a boost in their share prices would be justified. In the inflation-riddled 1970s, energy companies led the market.
The biggest winners this time around could be manufacturers that have suffered from declining prices, due in part to rising imports. If the weakening dollar, which makes imports more expensive, gives these companies breathing room to raise prices, their earnings and shares could do well. This group includes auto makers, electrical equipment companies and even some technology companies. "The same thing that pushed those tradable goods prices down is likely to push them up," Mr. Paulsen says.
Inflation also benefits debtors, because the dollars needed to pay back the loans become cheaper. That argues against banks and for companies with lots of debt, usually in industries that require big capital expenditures, such as cable-television companies and manufacturers.
The other big laggards would likely be service companies, which generally don't face foreign competition and have been the only ones able to raise prices. When investors were worried about deflation, they turned to companies that profited through innovation such as the tech and biotech industries, figuring they would be able to buck the trend and raise prices. While they will still be able to boost profits and may still do well, they won't be the standouts they would have been under deflation. |
