Hyper-Inflation or Deflation … or Something Else?

The mood on Wall Street has brightened considerably over the last couple of weeks. With only one down day in the last 12 (not counting Tuesday’s decline of .06%) the S&P has rallied 7.5% so far this September, following the worst August since 2001 losing 4.7%. September is traditionally a bad month for stocks as companies begin warning of earnings disappointments for the third quarter and mutual fund managers return to stir their pots as they return from summer vacations.

The week’s rally began with the banks on news released by regulators in Basel, Switzerland over the weekend that new restraints on lenders would be phased in over more than eight years; a longer period than earlier expected. Bank earnings and lending shouldn’t be immediately impacted, according to the Wall Street Journal. Materials and industrial stocks strengthened on unexpected news of China’s major economic indicators rising in August.

The good news continued on Wednesday with retail sales coming in strongly for the second month in a row. Sales rose a better-than-expected .4% in August spurred by back-to-school specials and tax-free promotions in 13 states. The increase follows a .3% rise in July. A separate report showed that inventories at companies rose 1% in July with results evenly spread among industries. The report indicates that businesses are gaining confidence, but they could become a liability if growth fizzles. However, the sales data for August supports businesses’ confidence so far.

Data from the regional Feds was more mixed. The New York Fed supported the rebound story as it reported a rise of 4.14 in its growth index which followed a reading of 7.10 in August (readings above zero indicate monthly growth). The Philadelphia Fed report alternatively reported a -0.7 headline dip. The data beneath suggested a continuing negative trend.

Industrial production for the nation grew .2% in August, which followed a robust July increase of .6%. Without the auto sector which reduced output after a July surge, the number would have been stronger. Manufacturing has been a key factor in the support of the economic rebound.

As stocks rebounded significantly over the past two weeks, Treasuries declined, but orderly. In fact, over the past 12 trading sessions both the 7-10 year index and the 20+ year index had five up days. The 20+ Year index is down 6% in September while the 7-10 year index is down 1.75%. Relative to the movement of stocks Treasury declines are tame given all the talk bubbles bursting.

There are two more doom camps competing for attention in your worry register; the hyper-inflationists and the deflationists. The mere fact that they are equally and contemporaneously discussed as possibilities should give one cause to question the likelihood of either.

First let’s look at hyper-inflation. If it’s right around the corner, some very smart investors, bond buyers, don’t see it; the yield on the 30-year Treasury is 3.9% while the 10-year is at 2.75%. Yields should be rising precipitously commensurate with bond prices plummeting if investors thought hyper-inflation was just around the corner, yet that is not happening. Some might argue that the Fed’s massive purchases of Treasuries and housing bonds have forced yields uncharacteristically lower as they have bought bonds to inject liquidity into the system. Total US bond debt is at roughly $31 trillion with Treasuries representing $13.5 trillion and housing totaling just over $14 trillion. The Fed’s balance sheet now stands at $2.3 trillion in Treasuries and mortgage bonds, or 8% of the total.

Current inflation remains exceptionally tame. Yesterday, the government reported that the core rate of inflation at the producer level slowed to .1% from a gain of .3% in July. The headline consumer price index, reported today, increased a bit more than expected at .3%, but the core rate which removes volatile food and energy, showed no change.

Harvard University’s James Stock and Princeton’s Mark Watson, who presented findings at the economic summit in Jackson Hold Wyoming, said that inflation could fall much further next year, because of the enormous slack built into the US economy during the recession. They point out that some measures of inflation are already below the Fed’s unofficial target of 1.5% to 2%. They say that a decline to near zero, if it materialized, would likely be greeted with alarm at the Fed and would give officials added incentive to take new steps to forestall such a move.

Economists have long held the view that inflation falls as unemployment rises.  But during the 1970’s inflation hit double digits three times (1974, 1979, 1980) while unemployment rose from 5% to 8.2%. To refine their study, Stock and Watson analyzed what happened only during recessions. They used the seven recessionary episodes from 1960 to present when unemployment shot higher. Their findings suggest that “a sharp rise in unemployment causes what they call an ‘unemployment recession gap’ which pushes down inflation.

What about the very opposite side of the economic spectrum – deflation? While not currently the case, long term government bond yields have recently been lower than they were during the Great Depression. This implies that bond investors fall more on the side of deflation than inflation. But as Stephen Lewis, chief economist at Monument Securities points out that stocks are “far from discounting a 1930s-style deflation. It is as if investors think there could be a deflationary process that would leave corporate earnings unscathed.”

Lewis notes that equity valuations are low compared to averages of the past 25 years, but as recently as 1980, “US equities were trading on an average historic P/E ratio below 7. That was certainly a worrying time, but the long-term threats to global economic stability were arguably less serious than they are today.” He also notes that bonds at that time were not priced for deflation, but rather for inflation. Inflation during 1980 reached 13.5%.

Lewis suggests that if bond yields seem too low today relative to 1930 levels when deflation was real, it can be equally plausible that bond yields during the 1930’s were too high. “The way the economy behaved at the time, with sharp multi-year falls in prices and activity, suggests they were” he says.

He adds that “in Japan, where expectations of annual price falls are now well entrenched, the 10-year yield has been hovering around 1.00%.” That being the case, a 2.94% yield on the US 10 year with an inflation expectation of say, 1%, looks quite reasonable by comparison.

Lewis observes that the world’s advanced economies suffered their most dramatic contraction in over seventy years between the end of 2007 and early 2009. During this process, their GDPs fell, in real terms, by 5%, 6% and even 7%. Yet only in Japan, where deflation is endemic, did core inflation rates turn negative. In the US, the weakest rate of CPI inflation, excluding oil and food, was 0.9%, in the euro zone 0.8%, and in the UK 1.7%. He says that Central Banks’ efforts to sustain inflation worked “so well when demand was falling so precipitously, they must have been aided by underlying inflationary forces.” He concludes by saying these observations “leave out of account inflation in the food sector, which will surely help the central banks’ pro-inflation strategy in the years ahead. Bond yields are ultra-low despite the outlook for CPI, rather than because of it.

If we knew with perfect foresight what forces would grip our economy in the coming next few years, advisors (focused on their clients, not their money) would not issue blanket financial advice. It would be tailored to their client’s needs. For their younger clients they would be considerably more concerned if deflation was in their future as it would pose the greater threat to their employment and growth investments. For their retired clients, they would welcome deflation as falling prices would virtually increase their relatively fixed income. On the other hand, an inflationary environment would be worse as their fixed incomes would likely not keep pace with rising prices of essentials.

While we cannot predict what the economy will look like next year, we can stress test our clients’ plans for the extremes. In fact we do just that. On a continual basis with the latest pertinent information we provide our clients with confidence that all of their important goals will be met, when they need to be met. We call it Wealthcare.®