Download Deflation: Good and Bad

Volume 9, February 2015
Deflation: Good and Bad
There’s an age-old adage that if you ask the opinion of
nine economists, you will get nine different answers. If
two-armed economists are included in the poll, multiply
the result accordingly. That may be overstating the case a
bit, but it’s hard to remember another time when so many
diversely opinionated members of the profession are in
a position to influence policies, both here and abroad. At
the Federal Reserve’s December policy meeting – usually
a model of harmony – three officials dissented from the
majority opinion, only the third time so many no-votes
were cast since 1992. Overseas, the split is even more
dramatic with European policy makers bitterly divided
over how to deal with a wide range of problems, including
a deflation threat, weak growth, currency manipulation
and a prospective Greek exit from the eurozone.
To some extent, philosophical differences underscore
these disagreements, something that would exist
regardless of the facts on the ground. But much of the
disparity among decision makers this time reflects an
economic landscape that is so confusing as to invite headscratching by even the most objective analyst. The Fed,
for example, is overseeing an economy that is generating
a growth rate that is the envy of the developed world.
Against that backdrop, it is prepared to start raising
interest rates this year for the first time since 2006. But
the liftoff date is anything but certain because worker
earnings remain virtually stagnant and inflation is
running far too low to justify higher rates. Hence, the Fed
is torn between moving too early before workers have a
chance to catch up or too late and risk allowing inflation
to gain a toehold.
What distinguishes the dissenting votes on the Fed from
previous votes is they fall on both sides of the policy
issue – from wanting to raise rates sooner on one side to
putting it off until later on the other. Until recently, the
greater risk was being too patient as the growth engine
was heating up and it appeared to be only a matter of
time before inflationary pressures would start to build.
But no sooner had the calendar page turned to 2015
that deflation replaced growth as the biggest headlinegrabbing news story. Prices were actually falling in
Europe and inflation in the U.S. had receded to the lowest
annual pace since the depths of the Great Recession
in 2009. And while the primary catalyst has been the
plunge in oil prices, the disinflationary trend was in
place well before the oil-price break began last summer.
Before running for the hills, however, it’s important to
distinguish between good and bad deflation. What we are
seeing in the U.S. now is more good than bad.
What’s Not to Like?
Ask middle-income Americans what they think of declining
prices and most will respond with a happy face. Who
doesn’t like buying things more cheaply, especially if you
are among the majority of households whose real takehome pay hasn’t increased in decades and are struggling
with tight budgets to meet essential needs? That’s reason
enough to celebrate the $1.50 fall in the price of regular
gasoline since last summer, which translates into a $35
savings with each fill-up at the service station – enough
to purchase a new sweater or more groceries to feed the
family. For low-to middle-income households that devote
twice as much of their incomes to gasoline and heating
oil expenses than wealthier individuals, the extra cash is
indeed a windfall to be savored.
In an era of stagnant wages, declining prices on goods and
services can be the difference between falling behind and
staying even. Simple arithmetic helps define the issue. In
December, average hourly earnings for all private sector
workers unexpectedly fell by 0.2 percent and the previous
month’s increase was revised down from 0.4 percent to 0.2
percent, leaving the year- over-year increase at a paltry 1.9
percent. Since the recession ended, workers have barely
kept ahead of inflation, receiving tepid wage increases that
hovered narrowly – and stubbornly – around 2 percent
over the past five years. But in December consumer prices
fell by 0.4 percent, which exceeded the fall in hourly
earnings. Hence, the purchasing power of workers actually
increased during the month, extending an upward trend
underway since the oil-price break began last summer.
Deflation Boosts Real Pay
12-month % change in average hourly earnings
2.5
2.0
Nominal Dollars
1.5
1.0
0.5
0.0
-0.5
Inflation-Adjusted Dollars
-1.0
-1.5
-2.0
2010
2011
2012
2013
2014
Deflation: Good and Bad
Continued from front page
To be sure, lower energy prices led the decline in headline
inflation late last year, more than offsetting rising costs for
food, shelter and medical expenses. But a broad array of
goods and services came under downward price pressure,
including new and used vehicles, apparel, airline fares and
household furnishings. The so-called core inflation rate
– which strips out volatile energy and food prices – that
presumably represents the underlying inflation trend was
unchanged in December and has not increased by more
than 0.1 percent in six of the past seven months. Simply
put, despite paltry pay raises, households have seen their
dollars go a longer way in recent months, underscoring the
solid consumption gains over the second half of last year.
A Vicious Cycle
Which brings us to the difference between good and bad
deflation. For sure, it would be a stretch to describe what’s
happening in the U.S. as bad deflation. That occurs when
there is a broad based decline in prices that lasts for a
considerable time and has detrimental effects on economic
behavior. Consumers delay spending because they expect
lower prices down the road. Businesses cut back on hiring
and investment outlays, since future profits look less
promising. Borrowers, meanwhile, have a harder time
servicing debt because the dollars used to repay obligations
are worth more than the dollars they borrowed.
These behavioral changes lead to a vicious cycle that
sends the economy on a downward spiral. The cycle is
self-reinforcing and difficult to reverse once it becomes
embedded in the mindset of households and business.
Japan has struggled with this debilitating condition for
the better part of two decades and still remains in its
grip despite aggressive pump-priming efforts by the
government and central bank. Europe may be on the
cusp of suffering the same fate. The inflation rate in the
European Union had been receding towards zero for most
of last year; it finally crossed that threshold in December,
when the year-over-year inflation rate turned negative.
As is the case in the U.S., the downturn in European
inflation is being led by plunging oil prices; core inflation
remains positive, although just barely so. What makes the
low inflation in Europe so ominous is that it is unfolding
against a weak economic backdrop, with virtually no
growth and high unemployment in most of the region.
In such a low-growth environment, deflation has a much
greater chance of gaining traction as it reinforces the
growth- dampening behavioral changes that are already
in motion. More than anything, the heightened deflation
prospect is nudging policy makers away from the stringent
Legacy’s Core Equity Portfolio
The core equity portfolio is designed to ensure broad
participation in the equity market, with less than average
market volatility, while effectively producing a meaningful
performance edge for our clients.
We use an active valuation strategy that employs quantitative
and fundamental analysis, focusing on individual stock
selection in conjunction with economic sector discipline.
Securities are selected through a process incorporating
quantitative and fundamental analysis with the qualitative
judgment of our senior investment professionals. This rigorous
investment process strives to look beyond mainstream
consensus opinion to construct portfolios designed to achieve
your investment goals and weather varying market conditions.
The graphic below shows the sector weightings in the Core
Portfolio as of February 2015.
Financials
20%
Energy
4% Utilities
4%
Information
Technology
16%
Industrials
8%
Consumer
Discretionary
16%
Health Care
20%
Consumer Staples
12%
austerity measures championed by Germany, which
many consider responsible for Europe’s stop-and- go
tepid recovery from the 2007-2009 global crisis and deep
recession.
Good Deflation
Still, Europe, like the U.S., has not experienced a long enough
period of broadly falling prices for it to be classified as bad
deflation. If households and businesses are holding back,
it’s because of weak economic conditions not in response
to falling inflation expectations. No doubt, if conditions
weaken further, the deflation threat would become more of a
reality and impact behavior. But the European Central Bank
is applying more muscle to prevent that from happening,
embarking on an aggressive bond buying program that has
helped rev up the U.S. growth engine. The purchasing power
boost from lower oil prices will help, not hinder that effort.
Likewise, the oil-price plunge that is dragging down the
Continued next page
Deflation: Good and Bad
Continued from page two
price indexes in the U.S. is more emblematic of good rather
than bad deflation. Instead of inducing a delayed spending
response that would accompany a downshift in inflation
expectations, American consumers are buoyed by the extra
cash that cheaper oil is putting in their wallets. Household
sentiment surged to an 10-year high in early January and
while short-term inflation expectations have fallen a notch
in response to lower energy prices, long-term expectations
have not; the expected inflation rate over the next five to ten
years remains virtually the same as a year ago.
Hence, instead of a vicious deflationary cycle, lower energy
costs are helping to set the stage for a virtuous cycle. The
improved mood and added purchasing power of households
portends stronger consumption in 2015. Businesses, in
turn, are feeding off of more optimistic sales expectations,
particularly smaller firms, which account for the bulk of job
growth. The National Federation of Independent Businesses
reported that its small firm optimism index surged to the
highest level since October 2006 in December and plans
to expand capital spending rose to a seven-year high.
Significantly, more small firms plan to increase prices this
year, hardly a deflationary omen.
Waiting For Confirmation
That said, the persistence of low inflation in the U.S. is
understandably a source of concern to the Federal Reserve,
as it highlights the slack that still exists in the product
and labor markets. The growth pick-up over the last year
has winnowed down that slack, but not enough to give
businesses more pricing power or labor more bargaining
power to obtain higher wages. It’s doubtful the Fed would
want to stifle growth before the economy moves closer to its
full potential and reverses the downward pull on inflation.
Small Firms More Optimistic
105
100
95
90
85
80
75
The chart to the right shows the GTG asset allocation mix across
the four major asset classes (domestic equity, foreign equity, fixed
income, and alternatives) over the past six months. Investment
performance in each asset class can vary substantially over time. By
systematically over-weighting those asset class categories that offer
superior value at a given point in time, risk-adjusted returns can be
significantly enhanced.
’90 ’92 ’94 ’96 ’98 ’00 ’02 ’04 ’06 ’08 ’10 ’12 ’14
Happily, economic fundamentals in the U.S. are moving in
the right direction. As noted above, more small firms believe
that they can raise prices this year, reflecting increased
confidence in sales prospects. Just as important, key labor
market indicators – job growth, new openings and voluntary
quits – strongly suggest that bigger pay raises are on the
way. The Fed has stated that it does not have to wait until
inflation hits its 2 percent target to start hiking rates,
only that it must be trending towards that goal; when the
growth pickup is confirmed by heftier wage increases, that
condition will be met. Not only will the path be cleared for
the first rate hike to take place, the decision will spark less
dissension among policy makers than has recently been the
case. n
Legacy’s Global Tactical Growth Portfolio
The Global Tactical Growth (GTG) Portfolio is a disciplined,
proprietary investment solution designed to maximize long-term
investment returns while taking a moderate amount of risk. With
GTG, Legacy complements the traditional asset classes of domestic
equity and fixed income with foreign equity and fixed income,
foreign and domestic real estate, commodities and currencies with
a “go anywhere” approach to asset allocation. Legacy’s goal is to
position the GTG Portfolio in the best performing asset class using all
Exchange Traded Products.
Based on 10 Survey Indicators, 1986 = 100
110
Global Tactical Growth Portfolio Composition
100%
80%
60%
40%
20%
0%
Aug ’14
Domestic Equity
Sep ’14
Oct ’14
Foreign Equity
Nov ’14
Fixed Income
Dec ’14
Jan ’15
Alternatives
(Real Estate, Commodities, Foreign Currency)
Past performance does not predict future results. Current and future results may
be lower or higher than those referenced in this newsletter. Investments are not
FDIC-insured, nor are they deposits of or guaranteed by a bank or any other entity.
Investment return and principal value will fluctuate and investments may lose value.
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