January Inflation Turns Negative - Is Deflation Upon Us?

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
March 3, 2015

IN THIS ISSUE:

1. 4Q Gross Domestic Product Revised Lower to 2.2%

2. Inflation Turns Negative in January & Last 12 Months

3. With Prices Falling, Is America Now Headed For Deflation?

4. How Falling Prices Tend to Affect the Stock Markets

5. Fed Chair Speaks to Congress – Nothing Really Important

6. Obama/Netanyahu Showdown Over Iran Nuclear Deal

Overview

Consumer prices fell in January for the third straight month, while inflation over the past 12 months turned negative for the first time since 2009, largely because of cheaper gasoline. In January, the Consumer Price Index sank by a seasonally-adjusted 0.7%, the biggest one-month drop since the end of 2008, the Labor Department reported Thursday.

The pace of inflation over the past 12 months, as measured by the CPI, fell to negative 0.1%, and it’s down sharply from 2.1% last summer shortly before crude prices collapsed. That’s the lowest annual rate since late 2009/early 2010. If this trend continues, we will fall into deflation.

Deflation, not to be confused with disinflation, or a slowing rate of inflation, is dangerous because it reduces the supply of money and credit flowing through the economy, and it can create less demand for big-ticket items from cars to washing machines. At its worst, dwindling demand can lead to global depression. 

Many investors are celebrating the widely-held belief that lower inflation is good for stocks and higher inflation is bad. But, as is often the case, this conventional wisdom is misleading, if not plain wrong.

Consider a study published a decade ago by the National Bureau of Economic Research (NBER). The researchers found that, as a general rule over the past century, earnings and inflation tend to move up and down together. So the idea that lower inflation is good for stocks may be dead wrong, as we’ll see below.

But before we get into that discussion, let’s take a look at last Friday’s report on 4Q Gross Domestic Product, which was a disappointment. At the end of today’s E-Letter, I will comment on Fed Chair Janet Yellen’s testimony before the Senate last week. We will end with some thoughts on President Obama’s quest to reach a nuclear deal with Iran.

4Q Gross Domestic Product Revised Lower to 2.2%                     

On Friday, the Commerce Department reported that 4Q GDP rose only at an annual rate of 2.2%, down from the advance estimate of 2.6% in late January. The pre-report consensus was 2.1%, so the downward revision came as no big surprise. For all of 2014, GDP rose only 2.4% versus 2.2% in 2013 and 2.3% in 2012.

The gain in the 4Q was led by personal consumption expenditures, nonresidential fixed investment, exports, state and local government spending and private inventory investment. The main reason for the downward revision was that companies rebuilt inventories at a slower pace than previously estimated.

Growth Downgrade

On the bright side, consumer spending was quite strong, up 4.2% in the quarter, which was the biggest increase since 2010. American households picked up spending in the 4Q and with continued low gasoline prices, most forecasters expect consumer demand to remain solid for another few months at least.

Another encouraging sign last quarter was that business investment increased 4.8%, more than the 1.9% first estimated. Business capital spending still cooled toward the end of the year as the US dollar strengthened, and the plunge in oil prices dampened energy company investments.

While exports grew 3.2% in the 4Q, more rapidly than initially thought, imports jumped far more dramatically at 10.1%, leaving a slightly wider trade deficit than first estimated and shaving a bit more off growth. The strong dollar bolstered imports by making them cheaper for US consumers.

Despite the downward revision to 2.2% in the 4Q, most economists still believe that the US economy will grow closer to 3% this year, especially if energy prices remain relatively low. Some forecasters believe that cheaper gasoline prices and the improving labor market will push annual GDP above 3% this year for the first time in over a decade.

Economists polled by MarketWatch expect GDP to increase by 2.9% in the current quarter, largely due to continued strong consumer spending and inventory rebuilding. We’ll see.

Inflation Turns Negative in January & Last 12 Months

Consumer prices fell in January for the third straight month while inflation over the past 12 months turned negative for the first time since 2009, largely because of cheaper gasoline. In January, the Consumer Price Index sank by a seasonally-adjusted 0.7%, the biggest one-month drop since the end of 2008, the Labor Department reported Thursday.

The pace of inflation over the past 12 months, as measured by the CPI, fell to negative 0.1%, and it’s down sharply from 2.1% last summer shortly before crude prices collapsed. That’s the lowest annual rate since late 2009/early 2010.

Excluding food and energy costs, so-called “core” consumer prices rose 0.2% in January. They have also risen 1.6% in the past 12 months, closer to the Fed’s preferred 2% inflation level. In some areas, consumer prices are actually rising quite rapidly. The cost of shelter, for example, jumped 0.3% in January, and it has climbed 2.9% over the past year.

But the point is, overall consumer prices are trending lower, as you can see in the chart below.

Consumer Prices

The turn toward negative inflation has been driven almost entirely by the biggest drop in gasoline prices since the Great Recession. Gas prices slumped by 9.7% in January alone to put the plunge over the past 12 months at over 50% at the low point. As this is written, West Texas Intermediate crude is trading around $50 per barrel.

On the bright side, the combination of higher pay per hour and lower inflation boosted real wages by 1.2% in January, the biggest gain in more than six years. Real or inflation-adjusted wages have risen 2.4% over the past 12 months, the fastest pace since 2009.

With Prices Falling, Is America Now Headed For Deflation?

Ever since the Fed began its massive QE stimulus program in 2008, we’ve been hearing from many pundits about how high inflation was just around the corner – how the Fed’s low interest policy and massive monetary stimulus would inevitably lead prices to spike and inflation to soar, thus undermining the economic recovery.

Instead, the US now appears headed into deflation for the first time since shortly after the Great Recession. As noted above, consumer prices as measured by the Labor Department fell 0.7% from December to January – the largest monthly drop since December 2008 – largely the result of plunging gas prices. And now year-over-year consumer prices are in negative territory at -0.1%. Should we be worried?

Most economists say the negative CPI in January isn’t a cause for added concern, given that it was driven by the unexpected huge drop in gas prices. Most maintain that it isn’t really deflation, since that term really should refer to a general drop in prices, which isn’t what the US economy is experiencing.

The so-called “core” Consumer Price Index, which excludes the more volatile food and energy prices, rose 0.2% in January and 1.6% in the 12 months through January. So by that measure, we are not yet in deflation, they argue. Maybe so. But what if prices continue to decline?

Deflation, not to be confused with disinflation, or a slowing rate of inflation, is dangerous because it reduces the supply of money and credit flowing through the economy, and it can create less demand for big-ticket items from cars to major appliances. At its worst, dwindling demand can lead to global depression. 

It’s a widely-held belief that deflation contributed to the Great Depression’s massive rise in unemployment. Japan suffered from deflation during the mid-1990s/2000s, and the country still hasn’t been able to fully recover, despite its ongoing massive monetary stimulus programs. Now, as Europe teeters on the brink of a triple-dip recession, the fear is that declining oil prices could lead to deflation and spread throughout the global economy.

There is growing evidence that the global economy is heading toward deflation. Some investors and institutions have already begun hedging against it by purchasing vast amounts of US Treasury bonds. The yield on 10-year US Treasury notes dropped below 2% recently, hitting the lowest level since May 2013, signaling deflation fears are heightening investor demand for safe haven assets.

In a deflationary environment, cash also becomes more attractive. It’s also not an accident that the US dollar surged to an 11-year high in February against other major currencies. While one month of the CPI falling into negative territory does not confirm a deflationary trend, investors need to be ever more vigilant.

How Falling Prices Tend to Affect the Stock Markets

Many investors are celebrating the widely-held belief that lower inflation is good for stocks and higher inflation is bad. But, as is often the case, this conventional wisdom is misleading, if not plain wrong.

The key assumption of this conventional wisdom is that corporate profits don’t fall as inflation recedes. If that were indeed the case, then in inflation-adjusted terms, their profits would rise as inflation falls – which undeniably would be good news.

But that key assumption is not borne out by the data. Consider a study published a decade ago by the National Bureau of Economic Research (NBER), the Massachusetts-based organization which is, among other things, the keeper of the official calendar of when recessions in the US begin and end. The study on how inflation affects corporate profits for NBER was conducted by Harvard economics professors John Campbell and Tuomo Vuolteenaho.

The researchers found that, as a general rule over the past century, earnings and inflation tend to move up and down together. Let’s look at the findings.

Stocks and Inflation

While corporate earnings have been quite volatile over the last 130+ years, you can see in the chart above that there is a strong correlation between the rate of inflation and the growth of corporate earnings. While some aberrations have occurred from time to time, there is a strong pattern that corporate profits go up when inflation goes up, and vice-versa.

So while many investors seem to believe today that low inflation equates to higher corporate profits, history as shown in the chart above simply does not agree. And this should be intuitive.

When inflation is rising, it should be easier for companies to raise prices. When inflation is rising, the costs of the products they have to buy are going up. Thus, it is easier for producers to raise prices. When costs are going down, it is more difficult to justify raising prices.

My point is that while many investors believe that lower inflation is bullish for stock prices, the opposite is true historically speaking. Does this mean that you should liquidate all of your investments in equities? Not necessarily. What it does suggest is that you lower your overall long equity exposure.

This is yet another reason to consider some of the actively-managed equity investment strategies I recommend that can move out of the market – either partially or fully – to the safety of cash (money market) from time to time as market conditions warrant.

Fed Chair Speaks to Congress – Nothing Really Important

Last week, Fed Chair Janet Yellen testified before the Senate Banking Committee, as the Fed chief is required to do twice each year. Her testimony was notable only due to the fact that she said almost nothing of interest, so I’ll keep it short.

Ms. Yellen reiterated that the Fed policy committee will remain “patient” when it comes to deciding when to hike short-term interest rates for the first time since 2007 – no surprise there. The ‘patient’ wording has been the Fed’s stance since late last year.

The Fed is in somewhat of a bind, since it feels like it needs to raise the Fed Funds rate, for reasons that are unclear to many. But nonetheless, the Fed policy committee feels compelled to raise its short-term lending rate sometime soon. The question is, when? With inflation now in negative territory, I suspect it will be later rather than sooner.

Obama/Netanyahu Showdown Over Iran Nuclear Deal

Israeli Prime Minister Benjamin Netanyahu delivered a bold and forceful speech to a joint session of Congress today, arguing against the pending nuclear deal between Iran and the US and several western nations. President Obama seems intent on signing a deal that would end or reduce sanctions on Iran in return for delaying its nuclear capabilities for 10 or more years.

Reports suggest that the prospective agreement may legitimize Iran’s right to enrich uranium, a “right” that doesn’t actually exist in international law – so long as Iran does not pursue nuclear weapons. The agreement reportedly will allow Iran to maintain many thousands of operating centrifuges, and it will lapse after 10 or 15 years, at which point Iran would theoretically be free to go nuclear.

This is a very dangerous moment for Obama and for the world. He has made many promises about our commitment to Israel, which some have questioned as hollow. If he inadvertently sets Iran on a path to the nuclear threshold, he will be forever remembered as the president who sparked a nuclear-arms race in the world’s most volatile region, and for breaking a decades-old promise to Israel that the United States would defend its existence and viability as the nation-state of the Jewish people.

Netanyahu obviously believes that Obama doesn’t have his, or Israel’s, back. Clearly, there is no love lost between these two leaders. The question is whether or not President Obama is so determined to forge a deal with Iran that he is willing to sacrifice Israel’s national security. Let’s hope not!

Very best regards,

Gary D. Halbert

 

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Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.

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