November 22, 1998
If Deflation Hits, It's a Whole New Game
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• The New York Times: Your Money
By REED ABELSON
<Picture: D>eflation? Don't be ridiculous.
Most investors are quick to dismiss the very notion of deflation, an economic environment defined by widespread declines in the prices of goods and services. Accustomed to the inflation of the last half-century or so, they expect ever higher prices for their cars, their homes and -- perhaps most importantly -- their stocks. They simply cannot imagine a world where most items they buy behave the way that computers do now -- getting cheaper year after year.
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Chris GallDoomsday Scenarios?
A growing chorus of economists and market strategists worries that deflation could pose the biggest threat to Americans' prosperity. But deflation outlooks differ in their likely significance for investors. Here are three:
• Devastating Deflation
• Sustained, Mild Deflation
• A Deflationary Boom
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But the truth is that a lot of smart people are thinking about the possibility -- and not just the Cassandras of the stock market who insist that a crash is coming. After a period in which the U.S. economy could seemingly do no wrong, with inflation low and corporate profits percolating nicely, there is now talk among economists, money managers and strategists about the odds of deflation washing up on these shores.
"We went from the New Paradigm to deflation, from June to August," said Byron Wien, an investment strategist at Morgan Stanley Dean Witter. Even with the recent rally in stocks, he said, "the word 'deflation' is still on everybody's lips."
Like many other people who discuss it, Wien does not think deflation is likely to take hold. So why all the buzz? Because there are just enough signs of deflation -- like the flood of cheap steel into this country or the briefly negative yield on six-month Treasury bills in Japan -- to make people pause.
Even Federal Reserve Chairman Alan Greenspan has mentioned the subject, and his willingness to cut interest rates again last week suggests that he is more concerned about the economy contracting than about inflation.
If the average prognosticator is wrong, and the U.S. economy does slide into deflation, investors are likely to have a hard time adjusting. For all the turns of the business cycle, deflation has been essentially nonexistent in the United States since the 1930s, and few investors have spent much time considering the impact of even a mild decline in prices -- an average of just a percentage point or two a year.
Few money managers are old enough to have had firsthand experience with deflation. "The problem is that nobody, with few exceptions, has ever seen a real deflationary environment," said Timothy Morris, the chief investment officer for Bessemer Trust Co. in New York. "We are not sure what it means."
Like inflation, deflation does not come in a single flavor. Economists are careful to distinguish, for example, between the deflation that wreaked havoc during the Great Depression and the more benign variety seen during the late 1800s.
The former type took a firm hold when demand fell everywhere, driving down prices and putting millions of people out of work. The latter coincided with the arrival of the Industrial Revolution in the United States: Prices fell because both production and productivity soared, and both workers and business could afford to keep demand strong. Some analysts see parallels between that period and today, given the advances occurring in technology.
But no one is sure. "This could be the deflationary abyss that everyone is talking about," said James Paulsen, chief investment officer of Norwest Investment Management in Minneapolis. Or, he said, "this could be the deflationary boom."
Already, portfolio managers are rethinking the kinds of stocks they own as they confront a changing environment: Many companies are finding that they cannot easily raise prices and are facing the deflationary effects of economic turmoil in regions like Southeast Asia.
The debate also provides a chance for investors to examine their own economic assumptions -- and those inherent in the choices made by their money managers.
There is no need to swoon. As noted by Richard Hoey, the chief economist at Dreyfus Corp., investment mistakes tend to be made whenever people work with "giant investment scenarios" -- often in response to scattered current events that they extrapolate into overarching trends. Hoey remembers when people pontificated about triple-digit inflation in the early 1980s -- just as inflation was peaking.
Still, if something new is going on here, it makes sense to think about the implications.
Dangerous Deflation: 'Crash' Is the Word
<Picture: W>hat distinguishes the kind of deflation that destroys nearly everything in its path from the good deflation that marks a productive economy? Demand. As long as falling prices encourage people to keep buying in greater volumes, the overall economy can continue to hum along. When people stop buying, because they start losing their jobs or want to put off their purchases, deflation can spiral into depression.
Such potentially demand-destroying events are unfolding in countries like Indonesia. For now, the country is experiencing high inflation, because it devalued its currency, the rupiah. But Indonesia is awash in people who can no longer afford to consume -- unemployment is rising, with roughly a fifth of workers now unemployed -- and its economy is expected to contract by at least 15 percent this year. High rates of inflation like those in Indonesia, a result of higher prices for imports, can foreshadow deflation as countries sink into depression.
Japan also continues to wrestle with deflation. Wholesale prices have been flat or have fallen there for more than a year as the government has struggled to re-ignite the economy. Last week, yet another recovery package was announced -- a plan to inject nearly $200 billion in tax cuts and government spending into the economy.
The United States last saw devastating deflation during the Depression, when unemployment soared and many people lucky enough to have jobs saw their wages fall faster than prices. But only the most alarmist thinkers paint a picture in which 1930s-style deflation would be unleashed on America today, when stocks and real estate are not nearly as overvalued as they were in the 1920s, the banking system is healthier and the Federal Reserve is likely to act more decisively.
"Monetary policy can prevent depressions," said Charles Calomiris, an economics and finance professor at Columbia University, "and we have a Fed that is extremely attuned to those kinds of threats."
One has to hope so. In a vicious deflation, assets like real estate and stocks go into free fall. Very little is spared, and the wreckage is magnified by the borrowing that companies and individuals undertook to buy those assets, as collateral collapses in value and margin calls on stocks mount.
"If it's ugly deflation, you'll want to get out of stocks," said David Tice, who runs his own money management firm in Dallas. He sees the United States facing sharp deflation -- a result of the popping of a credit-induced bubble -- that could wipe out about half the current value of the stock market, sending share prices to levels last seen in 1995.
Among the biggest losers, he said, would be shares of credit-card companies and home-equity lenders, because people would be unable to pay their bills.
Investors seeking an escape from the carnage would have little recourse other than to squirrel away cash or invest in Treasury bonds. As the world witnessed earlier this year, when investors embrace quality, they hug Treasuries the hardest. "This is an asset class that would go up in price -- and up substantially," said William Gross, a managing director at the Pacific Investment Management Co. in Newport Beach, Calif.
Other types of bonds, like corporates and municipals, would be riskier during steep deflation, Gross said. Though those, too, would benefit as interest rates fell, there would be more defaults as struggling companies or small municipalities could no longer make their interest payments. Less liquid than Treasuries, and without the backing of the federal government, these bonds might be shunned by investors.
Friendly Deflation: Time of Opportunity
<Picture: F>ortunately, bad deflation is less common than good, according to A. Gary Shilling, an economist and investment strategist in Springfield, N.J., who recently wrote a book on the subject, "Deflation" (Lakeview Publishing, 1998).
The United States has not seen benevolent deflation since the 1920s, when the country was roaring as automobiles became commonplace and many homes and factories received electrical service for the first time. But there are modern examples like Switzerland, where the stock market has posted average annual gains of 19 percent over the last five years despite a bout with falling prices prompted by the strength of the national currency.
This sort of deflation, like that seen during the Industrial Revolution, is marked by strong demand. Even when wages fall in such an environment, prices fall faster. From 1870 to 1894, for example, the real pay for nonfarm workers increased 29 percent, Shilling said, though in dollars not adjusted for deflation, pay fell 14 percent.
Like the rise of modern manufacturing in the last century, the technological gains of today show signs of bringing the kind of rapid increases in productivity that can lead to good deflation. Advances in computing, telecommunications, biotechnology and other fields have led to lower costs and improved productivity.
And there are productivity gains in other sectors, too, Shilling said, pointing to the efficiencies of mass-market retailers like Wal-Mart and Home Depot. These companies have harnessed technology to cut prices -- thereby exerting pressure on competitors to lower their prices as well.
Like Shilling, Paulsen of Norwest describes a world where more and more products are like computers, steadily falling in price, and where every business is forced to compete in the way technology companies already do. Technology -- which Paulsen describes as this country's leading industry -- "was birthed under and lives under massive deflation every year," he said.
Shilling said companies like Microsoft, Intel and Cisco Systems have learned to thrive by figuring out how to drive demand, making rapid improvements to their technology and developing new markets.
And just as companies were forced to innovate during the late 1800s, any innovator of today, like Pfizer in pharmaceuticals, would be likely to prosper in deflationary times, according to Gross of Pacific Investment Management. He says companies that dominate their industries, like Microsoft in computer operating systems, would also have an advantage.
Can Stocks Move Up If Other Prices Fall?
<Picture: T>he effects on investors from even mild deflation are the subject of sharp disagreement. While strategists and economists agree that a sudden swing from today's low inflation rates to deflation -- a move of several percentage points -- would rattle everyone, they are divided over how painful any transition would be.
Many strategists believe that stocks would suffer as corporate profits weakened, at least initially, in a recession inspired by incipient deflation. Even now, Southeast Asia's economic collapse is hurting American companies that must compete with a flood of inexpensive imports.
But if the United States skirted a recession, stocks of corporations that were trimmed to fighting form by the restructuring of the last two decades might escape essentially unscathed.
"The companies in the U.S. have been training for deflation for almost 20 years," Paulsen said.
One thing looks certain in this picture: As interest rates make their way lower, Treasury bonds will be attractive. They may also benefit from investor uncertainty.
Jonathan Francis, the head of global strategy for Putnam Investments, said that if deflation became an issue, "for better or worse there will be a reflexive move into fixed-income, until investors work through the calculus."
Depending on the severity of the deflation, and how calmly investors reacted, other types of bonds might also be worth considering.
Anyone worried about taxes would think about owning high-quality municipal bonds. High-quality corporates would also benefit from lower interest rates.
But for stocks and relatively risky bonds, like high-yield and most corporate issues, there could be casualties even during relatively mild deflation. The pain would be most notable among companies that are used to being able to raise prices to cover their mistakes, like taking on too much debt or holding too much inventory. "Inflation covers a multitude of sins," Shilling said.
Investors who want to prepare for deflation might want to avoid companies with high labor or capital costs -- which become more burdensome if there is pressure to reduce prices -- or companies that have loaded up on debt.
To protect profits in deflationary times, companies must either cut costs or generate more sales. The primary goal for the majority of businesses confronting deflation would be to gain market share, whether by wresting it away from competitors or by acquiring weaker companies. "Top-line growth will be a huge issue," Paulsen said.
The high-stress environment of deflation could favor large companies, he added. Big companies have more leeway than small ones to reduce their costs, he said, because they can invest in technology to increase their productivity and can take better advantage of economies of scale. Small companies have fared better in times of inflation, he said.
Moreover, some pockets of the economy are likely to remain somewhat immune to deflation.
Investors who think deflation may be coming, whether devastating or benevolent, should focus on industries "where demand is very stable and not terribly price-sensitive," said George Jacobsen, chief investment officer at Trevor Stewart Burton & Jacobsen, a money management firm in New York.
He pointed to areas that investors have traditionally considered safe from economic upheaval, like certain food and entertainment businesses. Even so, he said, companies that depend on the strength of their brands to let them charge higher prices than the competition could be vulnerable. For example, Kellogg Co. is already seeing its profits hurt because rivals are luring away customers with lower-cost breakfast foods.
Other areas that might withstand deflation include utilities, though deregulation is making them face more competition; military suppliers, which build profits into their contracts with the government, and small companies that concentrate on narrow niches where competition is limited, according to Diego Espinosa, a portfolio manager at Scudder Kemper Investments.
The outlook for real estate, which has traditionally been crushed by deflation, would be mixed if the United States fell into a mild deflation sometime soon. Prices for commercial real estate do not look as high now as in past economic upswings, according to managers and strategists. Shopping malls and hotels could be hurt if people felt more like saving their money than sprucing up their wardrobes or going on vacations, but rental apartments could be in greater demand if falling values made houses no longer look like good investments, Shilling said.
Economic History Isn't Always a Guide
<Picture: M>ild deflationary breezes, at least, are already wafting across the U.S. economy, and some portfolio managers have their fingers to the wind. At Bessemer Trust, for example, managers have shifted money toward companies whose main market is the United States, because they believe that consumers here will keep buying no matter what. They have trimmed holdings in companies that sell many goods or services in Southeast Asia, where the drought in demand is likely to drag on.
Money managers have also distinguished between companies that benefit from cheaper raw materials, like apparel makers, and those, including oil companies and steel makers, that continue to be hurt by a fall in commodity prices and could be damaged further by a potential rush of imports from foreign producers.
And despite another interest-rate cut last week, intended to loosen credit and keep the economy jumping, some professional investors are pondering the prospect of an economic slowdown, whether prompted by deflation or by increases in labor costs.
But a lot of thinking -- including the thinking about just how serious a threat deflation is -- remains to be done. The past, of course, is not necessarily prologue: What was seen in the United States more than a century ago -- or in Japan or Switzerland today -- may bear very little resemblance to what happens here in the future. Confronting the unknown, acknowledged Wien of Morgan Stanley, money managers "really don't know what to buy." |
