Deflationary winners
By Thomas Easton
<Picture>THINK DEFLATION and you probably think depression. The two, after all, coincided in this country in 1930-33; the two are coming together today in Asia. But the world does not have to work this way. It is quite possible for deflation to coincide with a strong economy. And that means it is quite possible for an investor to prosper during deflation while owning things besides government bonds.
Government bonds, of course, do quite well. Although the Consumer Price Index is still climbing (1.6% over the past 12 months), the prices of commodities from DRAM chips to oil are falling, and that hint of possible future deflation has been enough to send Treasury bond prices upward. Since Jan. 1 the long bond has provided a 13.3% total return.
But do you want a portfolio consisting of nothing but Treasurys? Once yields settle down at a lower level, further returns are limited. Outside a tax-sheltered account, half of that return gets eaten away by taxes. And if the assumption that deflation is coming is not borne out, you could be in real trouble. Rising prices would kill your bonds.
Advice from Maureen Allyn, economist for Scudder Kemper Investments in New York: Buy some Treasurys, but assemble a broadly diversified portfolio of stocks that could also do well in a period of stagnant prices. The table on the following page lists several deflationary themes that she espouses.
"Deflation without growth becomes noxious," says Allyn. But, she emphasizes, it doesn't have to come without growth—in fact, it can feed an enduring expansion.
Evidence? David H. Fischer's monumental history of price movements, The Great Wave (Oxford University Press, 1996), contains a pile of it. Fischer, a professor of history at Brandeis University, harks back to ancient Babylon to construct price charts. Between 1850 B.C. and 1750 B.C. prices collapsed while real wages held up. Fischer came to this conclusion by comparing prices in silver equivalents for wages with prices for slaves, oil, barley, oxen, house rentals and land. It is true now, and it was true then: Those people prospered who were working or invested outside of the areas where prices were falling.
There were three particularly notable stretches when price declines were followed by periods of fluctuating price stability, says Fischer: 1375-1475, 1660-1720 and 1815-96. In each of these there is at least a suggestion of strong underlying technological progress and gains in real wages.
Information is scanty for the two earliest periods. The 1800s, though, are well studied. Among the most interesting spans is the post- Civil War era in the U.S., from 1873 to 1896. It was a period of dynamism, and, says Allyn, very analogous to the present.
Real economic growth averaged 6%, but prosperity was not universal. As commodity prices fell, farmers went bankrupt. But innovation thrived. The economy benefited from the Bessemer steelmaking process invented in the late 1850s. Following on its heels were the internal combustion engine, advanced metal-milling equipment, the acetylene torch and the electric motor. These provided the foundation for skyscrapers, railroads and modern factories.
Today semiconductors take steel's former role in spreading wealth via price declines (see chart). Cheap chips drive down the cost of oil prospecting (see King Faisal and the tide of technology), manufacturing and communications. Open borders push production to low-cost areas; evolving capital markets provide money with increasing dispatch to those that can use it most efficiently. The consequence is a stream of lower prices.
More for Less
Falling prices for crucial products: metals in the 1800s, computers today.
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Sources: Bureau of Economic Analysis; Historical Statistical Abstract of the United States; Scudder Kemper Calculations.
Once inflation is assumed to have been conquered, bonds lose their premium yields. Fischer illustrates this point with yields on Dutch and British perpetual bonds hovering near 3% through most of the 1800s.
Gold, often assumed to be a store of value, usually does not hold its own during deflation. Its strong performance during the 1930s was an artifact of government policy: The U.S. took gold out of circulation and redefined the value of a troy ounce from $20.67 to $35.
So what does work? "We've wracked our minds over this one," says Allyn. "We think everything you learned about during a time of inflation is turned on its head, but not precisely."
Still, begin with companies that did well during the high inflation of the 1970s. The winners were those that made more from price increases than they lost from reduced sales to price-sensitive customers. Petroleum companies are an example. During deflation the opposite will probably prove to be true. The losses from reduced prices are likely to outweigh additional revenues from higher demand. An industry with a radically different structure is telecommunications. Price cuts drive huge gains in volume and revenues.
Other winners during inflation include real estate and capital- intensive manufacturers. Assets purchased today cost far more tomorrow. Book value tends to underestimate the real worth of property, triggering buyouts. Meanwhile, inflation erodes the real value of the loans.
In a deflation the opposite will be true. Debt will maintain its value. Investments you made yesterday will be worth less today and subject to undercutting by new competitors. Companies that do better may be like Dell, an assembler of products produced at the cost of tremendous capital investment by others.
Declines in commodity prices could be devastating to paper and metals producers, especially because they also confront large capital expenditures. But during the inevitable consolidation, the lowest-cost firms will gain power. That is the thinking behind the portfolio of the money manager profiled in Commodity contrarian.
A few capital-intensive operators may avoid the squeeze by having genuinely new products. Pharmaceutical products require huge investment but face little price competition. That was the case in the 1930s for the industry from which drug companies descended, chemicals. This time around big chemical producers will be less equipped to weather deflation because their goods are more like commodities.
Allyn's list of investment angles is coupled with an assortment of specific companies intended more as illustrations than as stock recommendations. One consistent theme: growth. Value investing, with its emphasis on low earnings multiples and hidden assets, may be out of phase with this era.
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