Investors are worried about deflation, a debilitating curse that has dogged Japan for years and savaged the U.S. during the Great Depression. But they shouldn’t be. Today’s falling prices are far more likely to set the stage for inflation ahead, likely gentle.
As the Consumer Price Index dipped 0.1% in January, the first slide in prices since the recession, people are rightfully concerned about what future price slippage might do to their investments. The University of Michigan median expected price change over the next 12 months is currently declining.
Although the U.S. economy is expanding, the labor market is nearing full employment and manufacturing capacity utilization is almost back to historical norms, the CPI and commodity prices show no hint of inflationary pressures that such developments typically bring.
Shown below are charts of inflation expectations and capacity utilization. Capacity utilization has climbed substantially from recession lows even as oil production in the U.S. ratchets back due to plunging prices.
Signs of deflation are pervasive. The U.S. 10-year Treasury yield, at around 1.95%, is not trending higher. German 10-year government rates have declined from about 1.7% to 0.19% in the past year. Commodity prices have depreciated since 2011. Copper declined from $4.40 per pound to about $2.62. Gold is down roughly 15% to some $1,168 per ounce. Oil has fallen from about $100 per barrel ($146 in July 2008) to about $45.
The chart below shows year-over-year percent changes in commodity prices and inflation from 1996 through 2014. Commodity prices have trended lower since 2011 helping to lower inflation rates.
Normally, an expanding economy creates higher inflation as demand pressures on the margin exceed supply capacity. For example, a significant decline in unemployment – absorption of slack in the labor market – often precedes wage escalation.
For the past six years, though, we have seen little evidence of this. One reason is monetary policy, both in the U.S. and around the world. On a global macro level, central banks are keeping interest rates low and monetary policy accommodative, in an attempt to stimulate growth and inflation and ward off possible deflation.
Why worry about deflation? We have experienced negative price action in commodities and falling inflation expectations for four straight years and stocks, bonds and home prices have all traded higher. So far, price deflation (especially in commodities) has not been a negative for many investors. As we look back at the history of commodity price deflation over the past 20 years, we do not see periods of longer than four years of falling prices.
Rather than worry about what has already taken place, what may happen going forward? With commodity prices down, supply will be curtailed over time placing upward pressure on commodity prices.
For example, it is likely the U.S. will produce less oil at $50 per barrel than it did at $100 per barrel. In a tightening labor market, job seekers will eventually become more selective which may drive wage inflation. A rising feeling of wealth based on higher stock and home values, increased employment certainty and higher disposable income from lower gas prices may accelerate consumption (demand driven inflation) just as commodity supply declines on the margin (supply-side inflation).
The demand/supply equilibrium is how free markets set price. Rising demand versus falling supply usually leads to higher prices.
What happens to stocks during an inflationary environment? As long as inflation rates remain below 4% and the 10-year Treasury below about 5%, rising inflation and interest rates have been a positive for stock valuations.
Once inflation and the 10-year exceed 4% and 5% respectively, further rate increases have a negative correlation with changes in stock valuation. At about 1.6% core inflation (not counting food and energy) and 2% 10-year Treasury yields, we have a ways to go before rising rates become in equity investment concern.
During times of high inflation, both stocks and bonds didn’t go well. Consider 1958 to 1981, a time of high rates. Average annual inflation was about 5% and 10-year Treasury notes saw yields climb from about 4.8% to 15.84%. Impact on investments: The annual real return (nominal return less inflation) in corporate bonds was minus 2% and the Standard & Poor’s 500 logged 3.5%. From 1965 to 1981, stocks essentially offered no nominal return and negative real returns.
From 1982 to 2013 interest and inflation rates declined and stayed low for a long time. Average annual inflation has been about 3% since 1981 and 10-year Treasury yields declined from 14.6% to roughly 2% now. The average annual return on corporate bonds was 6.5% and S&P 500 real returns were 8.4%.
There may be a day in the future when interest rates move well above 5%. When this day comes, consider shifting your asset mix more toward fixed income and away from stocks. But that day is not here yet.
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Nicholas Atkeson and Andrew Houghton are the founding partners of Delta Investment Management, a registered investment advisory firm in San Francisco, and authors of the new book, Win by Not Losing: A Disciplined Approach To Building And Protecting Your Wealth In The Stock Market By Managing Your Risk. Additional market commentary and investment advice is available via their websites at www.deltaim.com and www.deltawealthaccelerator.com.
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