Commentary: Don't Cry, It's Only Deflation

Remember the good old days--a month or two ago--when the economic troubles roiling Asia seemed to be only a distant threat, maybe even a timely brake on an overheating economy? Well, it's no time to dwell on the past. Suddenly the prognosis for the immediate future has changed: The deepening Asian crisis now seems far more likely to spread, bringing its deflationary spiral to the U.S. economy.

What does that mean for equity investors? Deflation itself doesn't necessarily sound a death knell for stocks. Indeed, falling commodity prices have helped many corporate bottom lines, headed off inflation, and prevented a rise in interest rates. But if deflation persists and spreads across a wide swath of the economy, the scales could tilt: Profit growth would slow, making today's most pessimistic earnings projections too rosy--and stock market valuations too high. That's part of the reason behind the recent drop in bullish sentiment on the Street (chart).

ATTRACTIVE BONDS. So it's a good time to rethink investment strategies to take into account the possibility of pervasive deflation. In equities, the fallout will vary from industry to industry depending on whether companies export to Asia and how exposed they are to commodity prices. Deflation could, however, make bonds far more attractive than equities over the next year.

Even if the August currency scare subsides, it won't be the end of deflationary pressures. China may devalue its currency in 1999, a move that could spark a string of devaluations and bring Asia's woes to U.S. shores. For Corporate America, the ensuing deflation would mean falling profits and the risk of being stuck with overpriced inventory.

Commodity deflation has become alarming. The Goldman Sachs Commodity Index has fallen about 27% year-to-date and 35% in the past 12 months. A major index component, crude oil, has fallen 26% since Jan. 1 and plunged 7.5% in just two days, on Aug. 10 and Aug. 11. Aluminum is down 14.9% this year.

Now deflation is spreading. Ford Motor Co. announced on Aug. 10 that the average sticker price on 1999-model cars and trucks in the U.S. would be 0.3% lower than on its 1998 models, its first fleet-wide price decrease in more than 30 years. Ford is making major productivity improvements, but not every company will be able to offset price cuts. Says Gerald A. Guild, chief taxable fixed-income strategist for Advest Inc.: "No one focuses on how widespread an effect the Asian deflation could have on our economy."

James W. Paulsen, Norwest Investment Management's chief investment officer, says he still views the low interest rates that deflation brings as a bull market savior. But he concedes that he worries a little about what he calls "depressionary fallout." He believes parallels can be made to the 1920s and 1930s, when the Federal Reserve tightened and foreign trade was closed down. As Asia weakened last fall, he notes, central banks tightened from Hong Kong to Canada. And in the U.S., "the Fed allowed rates to stay put and in real terms tightened." Paulsen says that while specific barriers to trade don't exist today, "trade is being effectively shut down because the only rising currency in the world is the dollar."


INFLATED HOPES. Investors who don't want to figure out how deflation will affect earnings are wisely flocking to bonds. Advest's Guild recommends zero coupon bonds as an equity substitute for investors expecting interest rates to fall. A 20-year zero "will appreciate about 30% in a year if interest rates decline 100 basis points," says Guild. As long as people are willing to hold to maturity, he likes "guaranteed" certificates of deposit that promise no set return, but pass along 100% of whatever a particular stock index returns over the life of the CD.

William H. Gross of Pacific Investment Management Co., who thinks the Fed will lower rates before yearend, recommends intermediate-term bond funds. Prices on intermediate bonds typically rise more than long bonds when the Fed cuts rates, he says. He suggests a government fund, since "its yield won't rely on the confidence of investors in Corporate America."

Deflation doesn't mean the bull market is over. It does mean, however, that equity investors may have to resize their inflated expectations.

Woolley covers the financial


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