U.S. Gains From Good Deflation as Europe Faces the Bad and Ugly

JPMorgan Chase & Co CEO Jamie Dimon
Jamie Dimon, Chief Executive Officer of JPMorgan Chase & Co. Photographer: Andrew Harrer/Bloomberg

When it comes to deflation there’s the good -- and there’s the bad and ugly.

Europe faces the risk of the latter as it teeters on the edge of a recession that could trigger a debilitating dive in prices and wages. The U.S., meanwhile, may end up with the more benign version as surging oil and gas supplies push energy costs down and the economy ahead.

“Bad deflation weakens growth,” Nancy Lazar, co-founder and a partner at Cornerstone Macro LP in New York, wrote in a report to clients this month. “Good deflation lifts growth.” Lazar also co-founded International Strategy & Investment Group LLC more than 20 years ago.

That’s welcome news for U.S. investors. Billionaire Paul Tudor Jones, one of the most successful hedge-fund managers, said on Oct. 20 that U.S. stocks will outperform other equity markets for the rest of the year, according to two people who heard him speak at the closed-door Robin Hood Investors conference in New York.

Hedge fund manager David Tepper, who runs the $20 billion Appaloosa Management LP, told the same conference the following day that investors should bet against the euro, two people familiar with his remarks said.

The people asked not to be named because the meetings were private.

The Standard & Poor’s 500 Index has risen 6.3 percent so far this year, while the Stoxx Europe 600 Index has fallen 0.3 percent. The euro is down 7.8 percent against the dollar since the start of 2014.

Bond Gains

Treasuries have returned 5.3 percent this year, compared with 7.6 percent for German bunds and 15 percent for Greek debt, according to Bloomberg World Bond Indexes.

The U.S. has the “best hand” among nations, while Europe is “the sick one,” Jamie Dimon, chief executive officer of JPMorgan Chase & Co. in New York, said at an Oct. 21 event held by the Urban Land Institute in New York.

That dichotomy was reflected in the third quarter results that 3M Co. reported on Oct. 23. The St. Paul, Minnesota-based maker of Scotch tape and Post-it notes said the U.S. outpaced other regions during the period with sales growth of 6 percent, while West Europe suffered a 0.5 percent decline.

It’s also apparent in the actions of the economies’ respective central banks. The Federal Reserve plans to announce this week the end of its asset-buying program, while the European Central Bank is stepping up its purchases to lift inflation from what President Mario Draghi has called an “excessively low level.”

Stress-Test Results

Seeking to reinforce faith in its banking system, the ECB yesterday delivered the results of stress tests on lenders in the region. It concluded that 25, including Banca Monte dei Paschi di Siena SpA, had failed and identified a total shortfall of 25 billion euros ($32 billion), most of which banks have since raised.

Deflation has had a “bad rap,” according to Michael Bordo, a professor of economics at Rutgers University in New Brunswick, New Jersey. It’s been associated with the Great Depression of the 1930s and Japan’s more-recent lost decades of little or no growth.

Nations still can prosper when there’s a widespread drop in prices of goods and services, his research shows. What counts is what’s driving the trend toward deflation, he said. If it’s a deficiency of demand -- as many economists say is the case in the euro area now -- it could be trouble. If it’s a boost in supply -- like the shale-oil and gas boom in the U.S. -- it can prove beneficial.

Below Target

So far, neither the U.S. nor the euro area is experiencing an outright decline in prices, though the latter is close. Inflation was 1.5 percent in the U.S. in August, as measured by the Fed’s favorite gauge: the personal-consumption expenditures price index. In the euro area, it was 0.3 percent in September, the lowest in almost five years and less than a quarter of the ECB’s target of just below 2 percent.

“Deflation is prevailing in parts of Europe, particularly Western Europe,” Laurent Freixe, Nestle SA’s head of operations for that market, said in a Sept. 18 interview. Vevey, Switzerland-based Nestle is the world’s largest food company.

Europe is more susceptible to bad deflation than the U.S. because its growth is weaker, unemployment is higher and its bad debts are more intractable.

The economy stagnated in the second quarter while joblessness in August was 11.5 percent, near the peak of 12 percent seen in 2013. That puts downward pressure on wages.

Labor Costs

Hourly labor costs rose just 1.2 percent in the second quarter of 2014, down from almost 4 percent in the second quarter of 2009. On a nominal basis, costs in Cyprus and Ireland shrank and Italy’s barely budged, while Greece’s dropped 3.6 percent in the first quarter.

Falling prices and wages make it harder for borrowers to pay off their debts. Only the U.S. and Germany among major economies have reduced total public and private debt as a share of gross domestic product since 2007, according to data compiled by the McKinsey Global Institute.

“The euro zone is in a pretty different space than the U.S.,” said Marchel Alexandrovich, senior European economist at Jefferies International Ltd. in London. “The risk is it goes into a spiral of wages being cut and debts, in real terms, going up.”

Salaries in the U.S. may be about to strengthen as unemployment continues to fall, according to Mark Zandi, chief economist at Moody’s Analytics Inc. in West Chester, Pennsylvania. An index compiled by Moody’s using payroll data from the ADP Research Institute shows wages rising 4.1 percent in the past year after adjusting for inflation.

Post-Recession Peak

The jobless rate stood at 5.9 percent in September, down from a post-recession peak of 10 percent in October 2009 and close to the 5.2-percent-to-5.5-percent range most Fed policy makers calculate constitutes full employment.

Households also are profiting from lower energy costs. The average nationwide price of a gallon of gas is down about 17 percent from a high in April, according to data from AAA, the largest U.S. motoring organization.

That’s particularly favorable because increased supply -- from the U.S. and elsewhere -- has been the main driver of lower prices rather than depressed global demand, according to Neil Dutta, head of U.S. economics at Renaissance Macro Research LLC in New York.

“We get the good deflation from the falling oil prices,” Rutgers’ Bordo said.

Regulatory Impediments

While Europe also benefits, it will be held back by regulatory and other impediments that don’t hamper the more-supple U.S. economy, he said.

Fed policy makers have highlighted some risks from a slackening in price increases. James Bullard, president of the Federal Reserve Bank of St. Louis, has voiced worries about the low level of inflation expectations in financial markets and has called on his colleagues to delay the end of the central bank’s bond-buying program.

New York Fed President William C. Dudley said Sept. 22 that a sharply stronger dollar could hamper the central bank’s efforts to spur growth and lift inflation. His remarks were unusually direct about the U.S. currency from the central bank.

“Virtually all major currencies are devaluing against the dollar,” said A. Gary Shilling, a Bloomberg View columnist and head of a New York-based consulting company bearing his name. “That is the prime mechanism by which deflation gets exported to the U.S.”

Still, the world’s biggest economy is better placed than Europe to avoid the drawbacks of deflation, according to Huw Pill, chief European economist in London at Goldman Sachs Group Inc. While arguing that Spain, Ireland and other peripheral economies benefit from falling prices, making them more productive after past excesses, he said the region “is clearly in a weak growth environment.”

“In the euro area, demand is weaker than in the U.S., debt levels are higher and structures are less flexible,” said Pill, a former ECB official. “So deflation has a greater potential to be malign.”

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