More stuff on deflation -- note percentages of businesses with falling prices.
August 26, 1998
Deflation Becomes a Concern
As Prices of Commodities Fall
By GREG IP
Staff Reporter of THE WALL STREET JOURNAL
For months, stock market bulls have taken comfort in an important historic
observation: Postwar bear markets have almost all begun with rising inflation
and the Federal Reserve raising interest rates, and neither is on the horizon.
The signs are growing that this time could be different.
With the Bridge Commodity Research Bureau index of commodity prices
closing below the widely watched 200 level Tuesday, deflation is once again
supplanting inflation on investors' list of concerns.
While deflation -- an environment of steadily
falling prices -- doesn't appear to be a risk yet
for the overall economy, where consumer prices
are still up 1.7% from a year earlier, it is
becoming a more pressing reality for companies and their shareholders.
A survey taken by Prudential Securities economists in June found that 40% of
the industries covered by the firm's analysts are experiencing declining prices,
compared with 26.4% a year earlier, while just 26% are experiencing rising
prices, compared with 51% a year earlier.
Those expecting the bull market to end with inflation "have got the wrong
paradigm," says Ed Yardeni, chief economist at Deutsche Bank Securities.
"That's the old paradigm that did work quite well in the past, but my strong
suspicion is we're entering a deflationary period," he says. "In many parts of
our economy, especially ones in the S&P 500, we're in a price recession. It's
very difficult to raise prices in a lot of industries -- especially commodities, and
now some capital goods like farm equipment."
For example, two weeks ago Pep Boys-Manny, Moe & Jack, an automobile
aftermarket retail and service chain, reported that lower selling prices played a
part in a 38% drop in per-share earnings for the 13 weeks ended Aug. 1.
'Competitive Environment'
"The lower selling prices we're instituting have ... to do with the competitive
environment in stores in certain parts of the country," says Nancy Kyle, Pep
Boys' director of investor relations. "We said we'd examine all our pricing in all
cities around the country and where we were high compared to the
competition we'd lower prices."
Deflation is nothing new to technology stocks, but it's certainly not getting
better. Monday, Intel Corp. unveiled its new low-cost microprocessor chip in
response to the public's demand for cheaper personal computers. But citing
this downward pressure on computer and semiconductor prices, a Merrill
Lynch analyst downgraded the stock last week, predicting that Intel's average
selling prices will decline 33% over the next five years.
Stephen Poloz, managing editor of the International Bank Credit Analyst, a
Montreal-based financial forecast journal, thinks stocks are in a bear market,
just as they normally would be when the economy slows sharply or enters a
recession. It is just that this slowdown is starting differently, with a drag from
overseas economies which has hit profits on two fronts: slowing demand and
falling selling prices.
Mr. Poloz argues that real interest rates have actually been rising, but in
contrast to the usual pattern it has happened with the Fed keeping interest rates
steady while inflation falls. But the result is the same: "I don't see how share
prices can hold up." Now, long-term bond yields are barely above short-term
rates, which usually has been a good sign of a coming recession, says Mr.
Poloz.
That said, Mr. Poloz also notes that price stability historically is excellent for
stock prices and after the current bear market is over, the long-term bull
market should resume. But he worries that the Fed may remain worried about
inflation for too long. The more long-term bond yields slip below shorter-term
rates, "the more I'll be worried the Fed is waiting too long to follow this trend
[in rates] downward. And that enhances the risk of deflation and a major
decline in stock prices."
Commodity Producers
The damaging impacts of deflation are showing up in the stock market sectors
suffering the most. The greatest pain has been suffered by commodity
producers, as displayed by the poor performance of energy and basic materials
company stocks in the U.S., and foreign markets such as Russia, Mexico,
Canada and Australia, which are relatively more dependent on commodity
exports. Those markets have received an additional kick from a fall in their
currencies, and the corresponding increase in the U.S. dollar only amplifies the
disinflationary impact in America as imports become cheaper. But all
manufacturers are grappling with an inability to raise prices. Even airlines,
where capacity is tight, can't seem to make leisure-fare increases stick.
Philip Laverson, an economist at Prudential Securities, says the firm is now
compiling its third-quarter analyst survey and so far, the trend of declining
pricing power appears to be intact. He has found areas where analysts don't
see the price increases that official government figures have identified, such as
in prescription drugs. He cautions that technology's large representation in the
survey skews upward the number of industries with declining prices.
Still, it's not a foregone conclusion that flat to falling prices will deflate
earnings and spark a bear market. For example, if costs fall in line with, or
further than, prices, then profit margins can remain stable or expand.
"Margin pressures alone have not been the cause of U.S. bear markets,"
Christine Callies, chief investment strategist at Credit Suisse First Boston,
asserts in a recent report. And she finds the current picture encouraging: At
present, productivity growth hasn't deteriorated as it has late in previous
business expansions, and labor-cost growth remains remarkably subdued, she
says. Indeed, she notes that in the second quarter, operating margins actually
increased or were unchanged in seven of 11 Standard & Poor's 500-stock
index sectors from the first quarter.
"Margin compressions under these circumstances tend to be minor in scope
and industry-specific rather than broad based," Ms. Callies says. "We continue
to believe that the spring-summer correction was essentially complete at the
1054 level in the S&P 500." The S&P 500 closed Tuesday at 1092.85, up
4.71.
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