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Market Strategy Deflation—The Cycle Isn’t Over Julie Brough O ver the past year the popular outlook on price changes has reversed itself. Media attention has shifted from the dreaded “D” word—yes I do mean deflation—to focus on the inflationary forces stirring beneath the surface of the U.S. economy. But, have we really dodged the bullet, or should we still be worrying about deflation? If deflation is lingering, then as investors we must adjust our thinking to reflect the inevitable economic slowdown that will follow. construction investment has dropped off and coincidentally Chinese steel prices have fallen from their peaks. A rapid decline in Chinese development could lead to an unexpected decline in demand for many of the industrial commodities resulting in softening prices. As commodity prices are the only input to industrial production that have shown inflation, if commodity prices weaken, the inflation threat could evaporate. Inflationary Pressures Easing In order to have inflation, consumers must be both willing and able to pay more for products. Increases in personal disposable income have been meager since the beginning of the year. Wage increases remain nominal, certainly not providing consumers with the ability to spend more on their purchases. Growth in the U.S. economy seems to be slowing from its pace of one year ago. GDP appears to be returning to levels of 3%-4% real growth from the 8% growth rate achieved at the end of 2003. The slowdown is primarily the result of slower growth in consumer spending. If consumer demand weakens, even if manufacturers face higher input costs, it may continue to be difficult to pass those costs along to the consumer. The result is corporations with shrinking profit margins rather than higher prices for consumers. The case for inflation is linked to the strength in commodity prices over the past 18 months. The Commodity Index as tracked by the Bank of Canada has increased 34% (in US$) from the beginning of January 2003 through to the end of June 2004. Although increases in the food, energy and industrial commodities have all been significant, industrial commodities have had the greatest impact, with a price increase of 44% in that period. The strength in commodity prices have had two triggers. The first was a U.S. dollar that tumbled 15% over the same 18-month period. As commodities are priced in U.S. dollars, the declining dollar created an offsetting rise in commodity prices. The second factor is China. Politicians and strategists are still trying to grasp how the opening of the Chinese marketplace to Western capital will affect the global economy. Within a very short period of time the Chinese have established themselves as an important force in the world economy. This is evidenced by their growth from 15% of world steel production to 25% within a mere four years (SG Equity Research, Market Cycles, July 23, 2004). China is expected to shift from being a net importer to a net exporter of steel within two years. The rapid industrialization of China had created a construction boom. But the Chinese authorities put the brakes on. According to a recent report released by SG Equity Research, since its peak in 2003, construction loans issued by Chinese banks have plummeted by 30%. As a result, Slow Growth at Home Asia Continues to Export Deflation For those that remain unconvinced, the final argument against inflation comes from the long-term trend in product prices. Since the end of 1999 prices on U.S. durable goods have declined by 13%, compared to an increase in the broad Consumer Price Index of 12.2%. The trend is not necessarily a new one. The expansion of Asian economies has offered the opportunity to combine a low cost of capital with a low cost workforce. The result has been low cost exports to Western economies. The consequence of this has been a long-term decline in prices of manufactured products for American consumers (see accompanying chart). © Canadian MoneySaver•PO Box 370, Bath ON K0H 1G0 • (613) 352-7448 •http://www.canadianmoneysaver.ca • September 2004 Price Index of Imports from Newly Developed Asian Countries 130 120 110 100 90 Sep-03 Sep-02 Sep-01 Sep-00 Sep-99 Sep-98 Sep-97 Sep-96 Sep-95 Sep-94 Sep-93 80 Sep-92 As the list of products being exported from these countries expands, expect downward pressure on prices to increase. The implications of this are not likely to excite investors. If central banks have misread a short-term upward tick in inflation as the onset of upward price spirals, the interest rate increases to follow could bring economic growth to a halt. Don’t forget, at the end of June, Canadian prices had risen 2.5% over the past year. U.S. prices were up only 3.3%. Hardly numbers that raise a panic, particularly if rather than gearing up, inflation is actually peaking. In this environment, defensive stocks become the choice for investors. Many of these companies are currently out of favour, resulting in attractive valuations. Two of my choices include: BCE Inc. and Emera Inc. Investors have neglected BCE on the basis that its bread and butter business of local and long distance telephone service is in decline. However, they have been ratcheting up double-digit revenue growth in wireless services, high-speed Internet and satellite. These newer business segments are still a small relative portion of the overall revenues, but the rapid growth combined with higher profit margins is beginning to contribute to the overall bottom line. When you add to the equation an aggressive cost cutting program in the traditional business segments, the result is slow earnings growth. However, earnings growth is not the critical factor. The dividend is the attractive feature. The stock is currently trading at $26.86 with a dividend of $1.20. This provides a dividend yield of 4.4%. When compared to a 10-year Canada bond, currently yielding 4.5%, it looks very appealing. In addition, the stock is trading near its five year low, so the downside over the coming months is probably limited. In addition, if the stock rises back to its high of $31 reached less than one year ago, you will have achieved a return of almost 20%. My second choice is Emera Inc. My reasons are not all that different. Emera is a regulated electrical power supplier in Nova Scotia and Maine. The majority of its power sources are from low cost inputs such as coal. Being a regulated power supplier, earnings growth will always be at a modest rate. But, the stock pays a 4.8% dividend. And once again, if the stock moves back to its previous high of $19 (currently at $17.78) you would achieve a total return over one year of 12%. I believe the stability of the revenue source leaves limited downside for this stock. Although we are likely to continue to discuss inflation in the coming months, prudent investors will give equal consideration to the argument that the inflationary pressures have passed. For the dissenters, I will acknowledge that I may be a few months early on my call that inflation is peaking. But remember, when it comes to investing, being fashionably late often means you missed the party. Julie Brough, CFA, CFP, Assistant Vice-President, Morgan Meighen & Associates Limited, 110 Yonge Street, Suite 1601, Toronto, Ontario M5C 1T4 (866) 443-6097 or (416) 366-2931 ex 254 [email protected] © Canadian MoneySaver•PO Box 370, Bath ON K0H 1G0 • (613) 352-7448 •http://www.canadianmoneysaver.ca • September 2004