Protecting Your Portfolio from Deflation
The knots in economists' and investors' stomachs tightened on Dec. 17 with the release of consumer price data for November, which showed prices falling for the second straight month—and the fastest rate of decline since the government started tracking these numbers 61 years ago. A 17% drop in energy prices, with gasoline down a staggering 29.5% since October, was the primary driver of the drop in prices.
Food and beverage prices continued to climb, albeit at a a snail's pace of 0.2% in November, their slowest rate of growth this year, and clothing prices rose 0.3%. The core rate of inflation, excluding volatile food and energy prices, was flat for the month and up only 1.1% from a year ago.
It's a dramatic turnaround from less than six months ago, when oil prices peaked at $147.40 a barrel, prompting inflation hawks on the Federal Reserve Board's policy committee to vote against measures intended to minimize, if not entirely stave off, a severe economic downturn. The central bank's decision on Dec. 16 to slash the Fed funds rate to between zero and 0.25%, the lowest rate ever, makes clear that the Fed has shifted its target to preventing widespread deflation.
Deflation is about as dirty a word as you can find in the realm of economics and it's usually associated with the other dreaded "D" word, depression. Indeed, the Great Depression was largely driven by deflation nearly 80 years ago. The consumer is sure to love falling prices at first, but the fear is that if deflation becomes deep and pervasive enough, it will eventually spur employers to cut wages and axe jobs, sending worried consumers deeper into their foxholes. The most pernicious aspect of deflation is how it raises the cost of repaying debt by boosting the value of the dollar,
But concern about a deflation threat to rival the one that afflicted Japan during the 1990s is by no means universal. Barry Boswell, an economist at the Brookings Institution, sees deflation as primarily affecting commodity prices until now and doesn't expect it to become an economy-wide threat.
Along with the Fed's aggressive use of its balance sheet to combat economic contraction, "other lines of defense include the wide dispersion in price changes (which obscure the trend) and some indications that businesses are reluctant to cut prices and wages outright," Goldman Sachs (GS) economist Edward McKelvey said in a research note on Dec. 18.
The extensive destruction of credit is also contributing to deflation, but Joseph Trevisani, chief market analyst at FX Solutions, a currency brokerage firm in Saddle River, N.J., says he doubts "we'll see a textbook case of deflation," the economy-wide version seen in the 1930s and to some extent in Japan 10 years ago, "because the Fed is so diligent in trying to reflate the economy." The effectiveness of the Fed's efforts began to be reflected in the value of the dollar, which fell sharply on Dec. 17 against other major currencies, reaching a 13-year low against the yen.
Still, consecutive monthly declines in consumer and producer prices are enough to make even the most optimistic economy watchers sit up and take notice. For investors, defense against a possible episode of deflation will come down to identifying those sectors of the economy that provide goods and services that consumers and businesses can't afford to do without. Here, BusinessWeek looks at some sectors and stocks best positioned to withstand the scourge of deflation:
Infrastructure will be a key feature of what could be a $1 trillion fiscal stimulus package that the Obama Administration is set to roll out in early 2009. Even without this package, however, the buildout of the electrical grid and road systems in China and other developing economies promise to fuel growth for this industry, even in the midst of a deep global recession.
Analyst Nicholas Heymann at Sterne Agee & Leach recently affirmed buy ratings on a handful of companies, citing a range of company-specific factors. With three low-cost manufacturing centers besides China, Emerson Electric (EMR) has an edge over competitors that have just one low-cost alternative to producing in China. That gives Emerson the flexibility to shift production between China, Southeast Asia, Eastern Europe, and Mexico in order to deal with volatile currency exchange rates.
United Technologies (UTX) can cut costs by 15% to 20% by bringing back a big chunk of production it outsourced to low-cost vendors in recent years, to a new world-class manufacturing plant in Eastern Europe. ABB (ABB) is poised for less anemic growth than some of its peers, thanks to its bigger exposure to emerging markets, where gross domestic product is forecast to grow by 2% to 4% next year, in contrast to a 2% to 3% decline in GDP in developed countries.
With inflation of at least 10% expected to return by early 2010, near-term "deflation will be opportunity for companies to be able to buy assets 10% to 20% below their replacement value" once the economy starts to improve, says Heymann.
Health-care products from prescription drugs to medical devices and surgical equipment are a classic safe bet when the economy hits a rough patch since the costs are largely covered by insurance benefits, whether through federal entitlement programs or private employer plans.
Within that industry, however, certain products, such as orthopedic implants, benefit from support by an important demographic—aging baby boomers who want to maintain their active lifestyles, says Bruce McCain, chief investment strategist at Key Private Bank (KEY) in Cleveland, Ohio. Demand for orthopedic products like joint implants is consistent enough "that we're less likely to see price erosion there than in PCs or iPods, where people don't have as much discretionary income," he says.
Stryker (SYK) and Zimmer Holdings (ZMH) both produce knee and hip replacements, as well as spinal and trauma-related products to help re-attach and stabilize damaged bone and tissue. Stryker also offers skull and facial implants, while Zimmer makes dental implants.
Pharmaceuticals are another group that hold up well during periods of economic stress. They are one of themes that lead portfolio manager Lee Schultheis incorporates in the long/short strategy he applies to the $375 million Alpha Hedged Strategies Fund (ALPHX), in order to protect investors against economic downturns, if not specifically deflation. His picks include Wyeth (WYE), which makes nutritional supplements and over-the-counter cold and asthma remedies and animal vaccines in addition to cancer and other prescription drugs. He likes Pfizer (PFE) for the same reason, because demand for prescribed medications is much less flexible than for discretionary products.
Generic drugmakers will have an advantage if Barack Obama's Administration implements some form of price controls on drugs as part of a broader effort to make health coverage more broadly available, says Phil Orlando, chief equity market strategist at Federated Investors (FII). Teva Pharmaceuticals Industries (TEVA) and Barr Pharmaceuticals (BRL) are two companies that sell only generic drugs.
Another group that Schultheis favors: discount retailers like Wal-Mart (WMT) that will probably experience less of a pullback by consumers, who will be hard-pressed to find the household products they need at comparable prices anywhere else. Walgreens (WAG), the drugstore chain, benefits from selling both prescription drugs and a smaller selection of the sort of general merchandise that Wal-Mart carries, he says. Walgreens customers may be inclined to spend some of discretionary income they're saving from discounted drugs on other merchandise because it's a little cheaper than what they can buy in other stores. In that respect, Walgreens may suffer some dropoff in demand, but not as much what most mall retailers will face, he predicts.
Cheaper gasoline prices are good news for Casey's General Stores (CASY), whose convenience stores will continue to pull in customers, who are more likely to use money they're saving on gas to buy products in Casey's stores that have higher margins than at the pump, says Schultheis.
For-Profit Education Providers
Companies that provide vocational training and advanced academic degrees also tend to do well during economic downturns. Corinthian Colleges (COCO) offer a 10-month allied health program that trains students to be dental or medical assistants, jobs that pays $14 an hour instead of minimum wage. Those programs are seeing a surge in enrollment, says Trace Urdan, an analyst at Signal Hill Capital Markets in San Francisco. When there are jobs available at the mall, not many people are willing to borrow $13,500 to go back to school, "but when the mall jobs go away, the value proposition becomes much more compelling," he says.
The same sort of thinking applies to students looking at bachelor's and business masters programs at Strayer University, which is owned by Strayer Education (STRA). When it comes to the general desire to strengthen your résumé, "there's nothing like the prospect of having to look for a job to sharpen your focus in that direction," he says.
The big question of course is whether students can get private student loans as long as the credit markets remain frozen. With loans from third-party private lenders drying up, Corinthian and some of its peers have had to pick up the slack by providing the gap funding that students require to stay in school—and many can't afford it, says Urdan. That's where Strayer, Capella Education (CPLA) and American Public Education (APEI) have an advantage, since they get the portion of their tuition not covered by federal Title IV programs from the corporate tuition reimbursement benefit that Fortune 2000 companies offer their employees as an extra perk.
Even companies that are laying off workers and cutting other costs, including Wachovia, Legg Mason (LM) and Black & Decker (BDK), have told Urdan that they aren't considering eliminating or reducing tuition reimbursement. That would be the last perk to be cut, someone in Black & Decker's Human Resources department told him, since it would kill morale among remaining employees.
Even amid the grim warnings to brace for the longest and deepest recession since World War II, there's at least one stock poised to buck the trend toward cutting all discretionary expenses, says Schultheis of the Alpha Hedged Strategies Fund. Scientific Games Corp. (SGMS) makes gaming machines ranging from lottery ticket dispensers to amusement-type games like video poker often found in bars. The company also manufactures, maintains, and services Lotto machines, which will continue to attract customers despite the fact that lottery tickets may be seen as a bit of a luxury.
"In tough times, people may be more enamored of winning Lotto and getting themselves out of their [financial] predicament once and for all," says Schultheis.