Wither Deflation, Inflation, Interest Rates And The Stock Market?

Looking back over the years it is difficult to remember a time when investors have been buffeted (no pun intended) by so many economic, geo-political and global financial cross currents. And to make matters worse, market volatility persists. Of all the cross currents and related questions, perhaps among the most important are: Are we going into a period of sustained overall deflation? Why does inflation (we use the US CPI as the example in this article) remain so low, when will interest rates rise and to what levels? And finally, what will the impact of rising rates be on North American stock markets? We will try to answer them in this article.

Deflation or Inflation: Actually the answer is "Today we have both and that condition may last for some time". Let us explain that rather contradictory statement. The main point is that we are in a period in which neither deflation or inflation is the over-riding economic condition. It really depends on which sector of the economy one is looking at.

For example, it's no secret that both developing and emerging markets, thanks to incredibly cheap and bountiful amounts of money, have been on a capacity building binge particularly in the commodities areas. However, the current demand is nowhere close to meeting the levels expected. The same is true for many areas of manufacturing both in the US and elsewhere. To put it bluntly, we have created the ability to produce far more stuff, whether goods or commodities, than we can currently use or even want. That has and is putting downward price pressures on a host of manufactured products. While that is good news for consumers, it is not so good for the producers of manufactured goods or commodities. Providing that those price pressures do not decimate cash flow and lead to the inability to pay the interest and principal on debts, which might lead to a credit crisis, then some deflation can be a good thing. i.e the US from about 1875 to 1914 —"The Gilded Age". How long will it take to work off this over-capacity? We don't know but have suggested for some time, as others have, that given the severity of the Great Recession ('07 - '09), it may take as long as a decade for economies to return to anything approaching "normal".

Support for the foregoing can be found from several sources. For example, the October 15th US Bureau of Labor statistics analysis of the US September CPI and its components shows that aside from energy, many categories in the goods manufacturing areas are flat or down year over year. Also, in Ed Yardeni's (Yardeni Research Inc.) monthly inflation analysis, the latest year over year price increase for the Consumer Service sector was 2.3% while for the Consumer Goods sector, it was -3.8%.

To summarize, the current cross currents notwithstanding, we don't think a period of all-inclusive deflation is at hand.

As for the question "Why is the US CPI so low?" It has been partially answered above in the reference to the goods manufacturing areas. But more specifically the energy component, which is 8.00% of the CPI, has been under tremendous downward pressure. For example in August, the overall energy component year over year was down 18.4% with some individual components being down as much as 29.5%.

The overall reported CPI was 0.0%. However, we think that low figure will soon start to rise. For example, excluding energy, the year over year August CPI was 1.9%. With two main components (Housing 42.4% of CPI and overall Medical Commodities and Services 7.7%) showing annualized price increases of 2.2% or more. We think that further price increases in both areas are inevitable. Both will provide upward pressure on the overall CPI figure during the next several years. Also, if oil's price stops going down which we think it will, and starts to rise during the same time period, that will also put upward pressure on the reported CPI. In summary, adjusting for these factors we think that during the next year or so, we can see the US CPI at 2.5% or higher.

When will US interest rates rise and to what levels? Our best guess is that a gradual rise will take place during the same time period as the expected increase in reported CPI. This of course assumes no global economic collapse or no bond market rout if sales of US Treasuries from China and other major holders accelerate. (As reported in the 10/07 Wall Street Journal). As for the question of potential levels, there are some other questions, the answers to which must first be considered. For example, will future lenders, i.e. bond buyers, demand a premium to normal real and nominal rates given the contrived efforts to keep rates excessively low since '08 - '09? History shows that bond buyers will demand and eventually will receive such a real return. We think they will likely receive one again but it will take time.

What then might a level for real rates be and what would the impact on nominal bond yields be? To gain some historical as well as short-term perspective, we contacted Leigh Skene, a consultant for Lombard Street Research in London England. His recent book, Surviving the Debt Storm is a must read for students of fixed income markets. After looking at 200 years of history, he deduces "that in a non-inflationary environment risk free short-term rates fluctuated between 2.0% and 5.0% and long rates between 2.0% and 4.0% with the median in each case below the midpoint". Based on data from 1980 to the present, Federal Reserve charts show that the real return on two-year Treasuries went negative in '09 and has remained so since. The five-year Treasury real return went negative in '11 and currently is slightly above zero. The real return for the 10- and 30-year maturities dipped below 2.0% in '10 and still remain there.

So does all of this indicate where rates might rise to during the next several years? Taking the September 30th closing yields for US Treasuries and adding a 2.0% real return, suggested levels might be: for the two-year maturity: 0.63% + 2.0% = 2.63%, the five-year maturity: 1.36% + 2.0% = 3.36%; the 10-year maturity: 2.04% + 2.0% = 4.04%; the 30-year maturity: 2.86% + 2.0% = 4.86%. However, we estimate that the 2.0% real return for the two- and five-year maturities may not come to pass for some time as the Fed tries to keep short-term rates low so not to negatively impact interest sensitive industries. Nevertheless, we don't think rate increases of that order of magnitude above should spook equity investors. For example, we had 6.0% yields at the start of this century and 4.0% rates in late '06. Also in both cases the yield curve was flat. That is not the case today nor do we think it will be for many years. History shows that a flat yield curve has proven to be the death knell of both the economy and stock markets.

What do rising rates do for the stock market? Assuming the gradual upward trend of rates is accompanied by improving economies and increasing corporate earnings, we don't see any impact of consequence on North American markets. From time to time there will continue to be 5% and possibly 10% corrections but they are a normal part of markets. Therefore, while we currently remain cautious we think the current malaise presents a good potential buying opportunity.

Peter Brieger, HBA, CFA,CEO & Managing Director, GlobeInvest Capital Management Inc, 20 Queen Street West, Suite 3308, Toronto, Ontario M5H 3R3 (800) 387-0784 pbrieger@globe-invest.com