Is it time to talk about the “D” word?
You know, deflation.
I know that inflation has been and continues to be the big worry. And that’s only logical since you’d figure that with the Federal Reserve, the European Central Bank, the Bank of Japan and other global central banks pouring money into the financial system that we will have to see inflation at some point. And I think that continues to be a real danger: At some point all that monetary stimulus will result in across-the-board asset price inflation (in contrast to the selective asset inflation we’re seeing now in areas such as residential real estate in China) and at some point all that central bank cash will start pushing up priced in general.
But we’re not at that “some point” yet. It looks like first we’ll go through a period where the trend is, surprisingly, towards deflation. Not across-the-board. I don’t think we’re looking at a global equivalent of the Japanese experience of the last 15 years where prices in general fall and then fall. But we are likely to see strong deflationary trends in huge hunks of the global economy and the trends will be strong enough so that stock prices—and investors—will notice.
Another surprise from the global financial crisis and the unprecedented experiments that global central banks are running an attempt to create a sustained recovery? You bet.
Here’s what this period of deflation will look like and why it has made this unexpected appearance.
Just a reminder: by this point in the recovery from the crisis, global economies were supposed to be running toward dangerous inflation. That was certainly the premise behind all those recommendations—mine included—to hedge against inflation by buying gold or gold mining stocks. With global central banks pumping cash into the financial system, inflation seemed a lock. Certainly, it was reasonable to believe that if the Federal Reserve, to take one central bank, expanded its balance sheet by some $3 trillion—the Fed’s balance sheet stood at $3.53 trillion as of July 24—it would have some effect on inflation.
Reasonable, yes. Predictable, no. The recovery from the financial crisis has produced a raft of unintended consequences. And the absence of inflation and the emergence of deflation is quite possibly the biggest.
Certainly inflation is very low in the world’s developed economies. An annual rate of 0.4% in Japan. 1.6% in the United States if you look at the core consumer price index or 1.1% if you use the Federal Reserve’s preferred price index for personal consumption expenditures. 1.6% in the EuroZone. In each of those cases inflation is running below the central bank’s target inflation rate.
It’s higher in such developing economies as Brazil—6.7%–and China—2.7%–but in the context of the historical inflation rates in those economies, inflation isn’t extraordinarily high.
Why this absence of inflation?
A part of the reason is happenstance. For example, the U.S. energy boom has added new supply to the global oil and natural gas market and that has helped keep energy prices low even as the shutdown of Japan’s nuclear power plants has added to demand.
But more important has been the direction of flows of all this global cash. It, by and large, hasn’t produced a spike in consumer demand for reasons that range from the way that this cash has flowed from central banks into the global economy to the timing of programs of economic austerity in the EuroZone and the United States. The increase in U.S. Social Security withholding taxes at the beginning of 2013 took money out of consumer wallets, for example, even as the Federal Reserve was trying to stimulate consumer demand, through the much more circuitous route of making consumers feel richer, and thus able to spend more, because the value of their houses had started to climb again.
The most immediate effect of central bank policies has been to make money cheaper to borrowers. Not all borrowers, mind you. Small and medium sized businesses whether in China or Europe or (less so) the United States have found credit hard to get even as the biggest companies in national economies have found credit easy and cheap. (In the United States many consumers who wanted to take out a mortgage found that banks had tightened their credit standards so that they didn’t qualify for a low-rate mortgage. That has only recently started to change.)
Some of that cheap money for the big guys has flowed into financial assets. The U.S. stock and bond markets—and the U.S dollar–have been major beneficiaries. It is extraordinary that as worries about the Federal Reserve’s balance sheet and U.S. financial governance have mounted, the price of U.S. Treasuries climbed and the yield on U.S. government debt fell. The U.S. gets a credit downgrade from AAA and Washington demonstrates that it will lurch from financial crisis to financial crisis, and the yield on 10-year Treasuries declines?
But that still left a good part of that cheap money available to the CEOs of big companies able to tap the credit markets in China or the European Union or the United States. At some companies that cheap money has been used to refinance more expensive debt and shore up balance sheets. At others it has been used to add new production capacity?
Add more capacity in the midst of a period of very slow economic growth?
Yes, for two reasons.
First, in industries where adding new capacity can take five or more years, companies have to build for projected demand. Waiting until the demand actually materializes is waiting too long. So in industries such as mining or semiconductors or autos, companies looking five years out as the economy stabilized in 2009 and 2010—and as the cost of money fell to near historic lows—decided it made sense to increase capital spending budgets for projects that would come on line in 2014 or 2015 just in time to meet rising demand.
Second, in economies structured around incentives other than profit—such as, say job creation or market share or production volumes—companies raised cheap capital to add capacity since that guaranteed the ability to raise more capital in the future and covered up a current lack of profits. Borrowing money to expand—so that the company could make government officials happy—was a critical survival technique even if by any reasonable profit and loss calculation, the extra capacity would not be profitable and would indeed increase losses. (Of course, these companies could “pay” for these losses by borrowing more from lenders who wanted to keep these companies in business.) China’s economy, the world’s second largest, saw many of its big state-owned companies follow this path.
The end result of adding so much global capacity in industry after industry wouldn’t have been a river of profits even if the world economy had staged a robust recovery. But in a modest recovery that actually looks to be slowing currently, the result has been a glut of capacity that has hit profits hard as supply outpaced demand.
In China those effects were obvious in profit numbers announced on July 27. Net income at China’s industrial companies rose 6.3% in June from June 2012, according to the National Bureau of Statistics. That was a huge drop from the 15.5% year over year growth rate in May. That number overstates the profitability of Chinese companies too since it includes income from ancillary, often speculative, activities such as investing or real estate. Looking just at profit from main business operations, net income fell 2.3% in June, year over year from an 8.8% year over year gain in May.
What does all this mean to you as an investor?
- In industrial sectors with big overcapacity problems—but where market-based profit and loss incentives are largely in force—look for a period in which companies slash capital spending, write down assets, and delay or postpone projects. For example, according to a June report from PriceWaterhouseCoopers, the 40 largest mining companies will cut capital spending by more than 20% in 2013. That’s in response to a drop in net profits of 49% in 2012. The return on invested capital for these companies fell in 2012 to 8%. That’s the lowest in a decade. This kind of painful response is what you, as an investor, want to see because cuts in plans to add capacity will lead to higher prices in the future. I think you can see this process working its way through those big parts of the commodity sector that are dominated by giants from developed economies. In the case of gold, iron ore, and copper, for example, I think that another quarter or two of pain could lead to enough capacity cuts to end price deflation for these commodities. (Depending, of course, on how much more the global economy—by which I mean China—slows in the next few quarters) In other words, I could see getting back into these sectors in late 2013 (if U.S. economic policy doesn’t blow up) or early 2014 (if it does.)
- In industrial sectors dominated by Chinese overcapacity, the question of when significant excess capacity will be eliminated is much more difficult to answer. On July 24 China’s government ordered 1,400 companies in 19 industries to cut excess production capacity this year. Excess capacity must be idled by September and eliminated by the end of the year the Ministry of Industry and Information Technology said in a statement on its website. We’ve been down this road before so pardon me if I doubt that what the central government wants will have much immediate effect on local officials and well-connected big companies. China’s aluminum sector is, for example, still adding new capacity despite a global surplus of supply. And I even have to question whether everyone in Beijing is on the same page. The recent deal with the European Union to settle dumping charges against China’s solar companies set prices so low—at 74 cents a watt—that few in China’s solar sector will make a profit. (It may, however, wash out those smaller Chinese companies, many already bankrupt, that are selling at prices as low as 40 cents a watt because sales at those prices will be banned by the deal. As an investor I think you’ve got a longer wait on capacity reductions in any industry dominated by Chinese suppliers. An end to deflation in these sectors my wait on increased demand since reductions in supply may simply not be forthcoming.
- I can see only a few global sectors where this industry-by-industry deflation isn’t a danger. The biggest and most promising is in food. Not food-related sectors, mind you, such as fertilizers where Middle Eastern countries with a policy of moving up the oil and gas product chain are building fertilizer capacity despite a global surplus. I mean food growers themselves and, even better, food processors. The current projection for a record grain harvest this year suggests that food processors could see falling costs this year. You can find picks in this sector in my June 14 post http://jubakpicks.com/2013/06/14/10-food-stock-picks-for-a-post-smithfield-world/ I’m at work on a special report that you’ll be able to download from the JubakPicks.com site sometime in the next week that will look at a few more food picks from developing markets.
I think that general price deflation is certainly possible but unlikely. But I do think we’re looking at a period where many—indeed maybe most—sectors of the global economy experience falling prices thanks to over capacity and increasing competition from companies willing to sell their products at prices so low they lose money on every sale.
If you’re looking for places to put your money that will escape this squeeze on margins and profits, I think the safe havens will be few and far between. I can think of only one sector, food, that is a good bet to escape this deflationary tendency. In most sectors the goal will be to find companies with temporary advantages that let the owner reap—for the moment—excess profits.
We’re not looking at an impossible environment for investors—a replay of the last fifteen years of deflation in Japan on a global basis is unlikely. But this isn’t going to be an easy period for investors to find a way to escape the consequences of this industry-by-industry deflation.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , I liquidated all my individual stock holdings and put the money into the fund. The fund did not own shares of any company mentioned in this post as of the end of March. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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