Connexions

Connexions, Volume 5 – November 1997

A prices crisis?

Changing prices for goods and services both reflect and direct a functioning economic system. Over-supply of a product will bring lower prices, and less will be produced. Excess demand brings higher prices and greater production. During the 1990s, as world economies have moved toward greater freedom, faster information transfer and flexible production processes, overall price levels have become more stable.

To talk more generally about changing price levels, we have coined the term "'flation". In a chart at the end of this article we delineate five different "'flation regimes" and their financial market effects. The largest swings in markets have occurred during the periods of transition from one regime to another.

Since 1981, prices have been rising, but at declining rates -- a process economists call Disinflation. The most widely accepted measure of Canadian prices -- the Consumer Price Index (CPI) -- advanced by 14% in 1981, but in 1997 will rise roughly 2%. Financial markets exulted in this process -- interest rates fell from record highs to generation lows, while stocks climbed skyward. Recently, concerns that benevolent Disinflation might turn into ugly Deflation have surfaced.

A Deflation scenario?

As usual, statistics hide more than they reveal, and the calm deceleration in the rate of advancing prices does not show the dispersion around that average. Many entities have experienced falling prices, which cause great anguish. Consider those whose skills became obsolete and whose price (their wages) fell to zero. Remember the fate of companies unable to adapt to changing market requirements. Inflexibility and immobility bring sharp reductions in "cash flow" -- the fundamental support under financial assets.

Only in select instances, when the demand for a product increases faster than the decline in prices is the process of declining prices happy for providers. As an example, computer technology prices have fallen continuously, but increases in speed and power have kept demand expanding, providing great rewards to the successful. The corollary is bankruptcy for the unsuccessful.

If prices on average were to fall with some persistence, economists would call this Deflation, and cash flows would begin to wither. Companies would earn less and pay less; governments would receive less in taxes and pay more in social support. As investors perceive and adjust to the new deflation regime, stocks and fixed income investments without solid cash flow underpinnings would certainly fall – perhaps a lot. Investors in high quality fixed assets like Government of Canada bonds would benefit from assured cash flows, although there would be anxious moments as government deficits would certainly rise.

Why have Deflation fears arisen?

1. Japan continues to experience the Deflation that began in 1990. The charts below portray the course the Japanese have followed over 15 years – from euphoria to depression. The value of assets with uncertain cash flow, such as stocks and real estate, has plummeted. Several bank, insurance and construction companies, which bet heavily on real estate, have gone bankrupt. Unemployment is sharply higher, and the burden of social security payments has brought the public sector deficit to an extremely high 7% of GDP, forcing cutbacks in other areas. Recent data indicate that the hoped-for recovery of Japan remains elusive.
2. In 1997, several economies of Southeast Asia may have entered a deflationary cycle. Years of aggressive capital investment have significantly added to global productive capacity in autos, chemicals, clothing, pulp and technology. With diminishing Asian growth prospects, the spectre of "beggar-thy-neighbour" trade practices rises. To shore up their sagging economies, they have joined Japan in competitive currency devaluation.
3. Businesses in North America, Europe, Japan and China have been counting on Southeast Asia for the growth of their export markets. With the evident slowdown in Asian prospects, many businesses may be forced to reduce their plans for expansion. In the inter-connected world we inhabit, economic weakness could spread as rapidly as did the democratic-capitalist model of Mrs. Thatcher and Mr. Reagan.

A low probability scenario

While the rhetoric sometimes becomes impassioned, the likelihood of a generalized deflation affecting global financial assets is low. Central bankers have provided ample liquidity to promote activity since the devaluation of the Mexican peso in 1995. Governments of most countries have redressed prior fiscal excesses, and now have the flexibility to provide support should it become necessary.

Probably of greatest significance, the persistent increase in entrepreneurial flexibility means that as relative prices of productive factors shift, and technologies become ever more accessible, businesses can quickly adapt and respond. Macro-economic crises are less likely in a micro world.

Portfolio implications

1. If we became convinced that Deflation in the major economies was the likely scenario, we would take the following action in our clients' portfolios:
   (a) Sell stocks, especially of companies with cyclical or commodity price-sensitive products and services.
   (b) Buy the bonds of the soundest sovereign governments, avoiding those where the underpinning cash flows might be inadequate to service the debt.
   (c) Consider obtaining exposure to gold if a flight to the traditional ultimate store of value were in prospect.
2. Fortunately, Deflation is only one of several realistic possibilities, and the most likely outcome remains a persistent stable 'flation regime. Our analysis indicates that stock market participants have now fully discounted its continuation, although bond analysts continue to be mesmerized by the potential for higher inflation. This suggests that safer value may currently be found in the bond market.

However, in this environment, companies will continue to make good use of new technologies and effective resource management techniques to expand their revenues and to maintain their profit margins. Stocks should, therefore, provide returns that match the growth of the economy. On balance, investors should enjoy returns similar to the long-run average – less than those of recent years.

To manage the portfolios of our clients, we always seek to understand the possible sets of developments that will come to bear on capital markets, since evaluating the risks of loss against the potential for gain is the way we provide our clients the greatest service. Since Deflation is today a low probability outcome, we should only take strong defensive action if the evidence increases in intensity. We remain vigilant.

Deflation in Japan

There has been virtually no economic growth in Japan since 1991, in spite of aggressive monetary and fiscal stimulation. The chart below shows that prices have changed very little over that period. This is very close to outright deflation and depression. Financial markets have followed the deflation model: the stock market is below its level of 1987, short-term interest rates have been almost zero for two years and long-term interest rates on government bonds recently fell below 2%.

The Deflation resulted from unthinking optimism regarding the Japanese miracle of the 1980s, which led to wild excesses in asset prices and financial leverage, coincident with the peak in stock prices in 1990. Seven years after the peak in exuberance, the excesses have still not been fully unwound. The banking system has not fully acknowledged massive problems with over-valued real estate, and the economy remains quite inefficient due to an excessive and unsustainable regulatory burden.

Historically, 'flation regime shifts such as this have profoundly altered the outlook of citizens, and the returns to financial markets, for at least a generation.

Canada Trust Private Investment Counsel

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