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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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