The End of Disinflation

John Mauldin | Thoughts from the Frontline
May 17, 2002

I must confess I like to work jigsaw puzzles. If you have ever worked on one, you know there are times when the pieces come together, and you can begin to see a major part of the puzzle. There is a certain sense of satisfaction when that happens.

This week has been one of those times for me, and I hope I can transfer that experience to you this week, because we are going to talk about something far more important than a jigsaw puzzle. Today we are going to examine what I believe is the end of an era and the beginning of a new one. It will have profound implications for our investing.

And convenient for me, it fits neatly into my theme of the Muddle Through Economy.

First, we need a little history to set this up. Many of us remember the economic malaise of the 70's. By 1980 stagflation was at its worst. Paul Volker stepped in as chairman of the Fed and decided to crush inflation. To do so he put us into a deep recession, but it worked. Since that time, the Fed has seen its publicly proclaimed main mission as keeping inflation down.

They have done a good job. So good, in fact, that I wrote in 1999 that it was my belief that Greenspan was as privately worried about deflation even as he continued to publicly talk about inflation. Why did I say this? Because even as he was raising interest rates, he was increasing the money supply at a breath-taking pace. On the one hand, he was trying to slow down the economy with a rise in interest rates. But on the other, he was increasing the money supply so that we would avoid outright deflation. If he was really worried about inflation, he would not have allowed the money supply to rise as fast as he did.

(My thesis from several years ago is that over-supply and too much production capacity, along with a strong dollar and increased productivity, the importing of deflation from Japan and Asia, budget surpluses, etc. are taking us into deflationary territory. The Fed, to the extent (and if) they are fighting inflation today, are like generals fighting the last war. The current enemy is deflation.)

I have written since then that I expected to see an annual Consumer Price Index level of below 1%. We have gotten down to 1.1%, and may go below that in a few months, the recent rise in CPI notwithstanding (more on that front next week).

A good deal of the credit for the boom of the 90's has to be given to ever lower interest rates, as companies were able to cut their financing costs, consumers were able to afford more products and higher mortgages, and easy money made expansion much easier. Of course, there were lots of other factors: increased productivity, a strong dollar, government budget surpluses, lower taxes, etc. But lower interest rates were a major factor.

Now, let's look at some of the pieces of the puzzle and see if we can make things come together for you as they did for me.

Puzzle Piece #1: The Fed starts telling us that deflation is an issue

For several months, different Fed governors have been talking about deflation. More and more of them are telling us inflation is not an issue. But this week was a capstone.

"Fed Governor Alfred Broaddus, once known as a hard-core inflation fighter scenting out the slightest whiff of upward price pressure, recently told The Wall Street Journal that it would be "ironic to have fought all this time to bring the inflation rate down ... and then lose price stability on the down side."

"William McDonough, the president of the Federal Reserve Bank of New York, also has lauded the tame inflation environment. With the Consumer Price Index rising only 1.4 percent in the past year, he said: 'If that's not price stability, what is?' "

Then San Francisco Fed President Robert Parry "indicated on Tuesday that the U.S. central bank might be prepared to tolerate a small amount of inflation rather than risk the alternative of declining prices , which have plagued the world's second largest economy, Japan." (Reuters) (emphasis mine.)

"The comments from Parry suggest that the Fed might be prepared to tolerate a little more growth in the economy, and an accompanying small increase in prices, before it starts to tap the monetary brakes.

"Parry's milder comments on inflation followed a similar change of heart from long-time Fed inflation hawk Alfred Broaddus, who said his view on the risks of inflation has changed so much one Fed policymaker now calls him a "leading dove" on the issue.

"Parry said he thought that Broaddus was not the only one who was going through a similar transition in thinking about inflation, noting that he, too, in the past had been described as a "hawk," or extra vigilant, on inflation.

"I always think of myself as pretty resolute when it comes to inflation ... But perhaps a little bit of inflation is a little bit safer than zero," he said. (Reuters)

These two members have been part of the main contingent within the Fed who have been working to hold down inflation. Combined with Greenspan's remarks over recent time and his actions for several years, and I think this signals a major shift in Fed policy.

But so what? What does that mean?

Puzzle piece #2: The End of the Era of Dis-inflation

Rashmi Shukla, formerly with Bank Credit Analyst (for whom I have great respect), and now with Brown Brothers Harriman sent me a research paper by her colleague Myles Zyblock she thought I would enjoy. I read the title and must confess my eyes rolled. "Preparing for the End of Disinflation" it proclaimed, and I thought I was getting ready to read yet another doom and gloom prediction of serious inflation coming soon to an economy near you.

But as I read it, I realized it was far deeper and more thoughtful. In fact, I wish I had thought of this first, but I must give them credit.

Basically, their thesis is that we have seen inflation and interest rates drop for 20 years. We have come about as far as we can go in fighting inflation without actually getting into deflation. They agree with me that the Fed has been more concerned about reflating demand than fighting inflation.

This research paper says: "While the ultimate low point for inflation this cycle might be several months away, the powerful shift in policy settings in the past few years probably marks the beginning of the end of the trend towards lower and lower inflation levels. At this stage we are not arguing that inflation will accelerate, but rather that the authorities have and will most likely continue to act forcefully to arrest long-term disinflationary trends before they become deflationary trends. This alone carries important strategy implications."

Let me make my main point here, that I draw as a corollary implication of their analysis: one of the main sources or engines of growth in the 90's was a result of the Fed policy of disinflation, which led to lower interest rates. That engine is coming to a halt. There is no more room on the downside to slow inflation without risking deflation. We can only look at Japan and 1930's America to see that this is not something to take lightly.

This means that to the extent that ever lower rates added to the growth of the economy, that boost will no longer be there. The best we can hope for is stability. Bluntly, it means a period of lower growth in the future, unless some new engine can be brought in to replace it. I cannot think of a NEW engine as powerful as lower rates.

Puzzle Piece #3: Stock Prices have seen their highs for a long time

Zyblock provides us with several great graphs. The first shows the very tight correlation since 1952 between P/E (price to Earnings) multiples and long-term inflation trends. As inflation drops, P/E multiples rise. When inflation is flat, P/E multiples are flat as well, trending around profit expectations. When inflation rises, P/E multiples fall.

What is the Fed telling us? Inflation has fallen about as far as it is going to. They are prepared to tolerate a little inflation rather than risk deflation. That means whatever boost stock prices (multiples) have gotten from falling inflation, that boost is just about over. The BEST we can hope for is a sideways market and a continuation of the current era of mild inflation. Either an increase in inflation or a fall into deflation is very bad for stocks.

I think we Muddle Through, at least for the next few quarters. However, there are those I respect who disagree. If Eric Fry of Apogee Research is right, we might actually have some increased inflation in our future. We are at a cusp, and the factors affecting the future are numerous and complex. It could go either way. Making precise predictions in a period of a major sea change for more than a few quarters out is dangerous. Not that I don't make them, of course (proof that my mother did not beat all the foolishness out of me as a kid), but things can change rapidly and predictions are much more likely to be wrong.

The second graph I find of interest is one which shows the tight correlation between P/E ratios and the rise in price of growth stocks. Quote: "The chart shows that growth stocks outperform the market when P/Es rise and underperform when multiples contract. If our story plays out and the era of multiple expansion is coming to an end, then growth's secular advantage is also likely to fade. The initial adjustment to this new environment might be that growth stocks underperform value stocks for longer than cyclical timing indicators would normally predict."

My translation: We have seen a run-up in value stocks as compared to growth stocks that has been quite pronounced. Normally, it would be time for growth stocks to begin to catch up. But as P/E ratios come down, value stocks will continue to outperform growth. This means all those techs and high-powered NASDAQ issues (with some exceptions) are unlikely to surprise to the upside on any sustained basis. The best you can hope for is the NASDAQ stays in its sideways trend. I wouldn't bet on that with my money.

Puzzle Piece #4: Profit Growth, and Thus Stocks, Are Likely to Disappoint

Last year, I wrote about an important book by Michael Alexander called Stock Cycles. It is now in Barnes and Noble. Get it, or order from Amazon.com.

In this book, one of the things he showed was how periods of high profit growth and thus bull markets are followed, for a variety of reasons, by low profit growth and secular bear markets.

One of my themes since late 2000 is that we are in a Long-Term Secular Bear Market. We have seen the highs for the stock indexes, probably for the decade. I have detailed over 6 major studies, each coming from a different angle, which point to this fact. (I hope to combine them all in one large white paper soon. I just need a few extra days in the week.)

This paper is one more nail in the coffin. If disinflation is over, and thus the boost to profits from disinflation is over, then profits are going to grow slower. If profits grow slower, then stocks are unlikely to rise, and the risk is to the downside. The best you can hope for is sideways. It is tough to make money in a sideways market.

Remember what I wrote about "Investors Behaving Badly" a few weeks ago? In sideways markets, most mutual fund investors lose, as they chase the latest hot performing fund, buying high and selling after it drops.

Puzzle Piece #5: Jobless Prosperity

Then today, Stephen Roach posts another brilliant essay. I am simply going to quote him, rather than butcher his eloquence in summary.

"The early stage of the recovery of the 1990s has been widely labeled a 'jobless prosperity.' And with good reason. The unemployment rate kept rising fully 15 months into that recovery -- going from 6.8% in March 1991 to a peak of 7.8% in June 1992. I think there's every reason to believe that another jobless recovery could be in the offing in the years immediately ahead -- one that would take a comparable toll on consumer demand.

"There are three reasons behind this conclusion -- the first being that corporate earnings remain under unrelenting pressure ...Second, with earnings-constrained businesses unwilling to bet on a solid recovery in final demand, they have little choice other than to keep cutting costs. After having slashed capital spending budgets, a likely pruning of labor compensation expenses is now at the top of the list.

"The third reason is possibly the 'smoking gun.' Corporate America is currently saddled with another excess of white-collar workers, especially managers. In 2001 -- a recession year -- total managerial headcount in the US economy increased by an astonishing 2.9%. (while unemployment increased! - JFM.)

"I remain confident that this is now about to change. Earnings-constrained Corporate America has no choice other than to face the painful reality of pruning the excesses of managerial bloat." (MorganStanley.com)

Business spending is in full scale retreat. If Roach is right, and his argument is very compelling, then consumer spending is in trouble. And consumer spending depends upon income growth. Roach further notes that "My case is premised on the single most important driver of consumer demand -- income generation, and the job creation that lies behind it. Much of the recent hand-wringing over the prognosis of personal consumption has focused on wealth effects -- equities and, more recently, homes. Far be it for me to dismiss the impact of wealth effects. Yet the econometrics are quite clear in assessing the relative importance of these two determinants of consumer spending. On average, about 90 cents of each dollar of personal income is spent, whereas only about five cents of each dollar of equity wealth creation eventually shows up in the form of consumption. In that context, the stresses and strains of household balance sheets hardly matter if personal income growth remains solid."

This is a prescription for slow growth, although Roach argues it will presage a second, or double dip recession. To me, it screams of a Muddle Through Economy.

Yes, we can point to a number of good statistics. Capacity utilization is slowly going up, although it is still well into recession territory. Sales are up. Inventories are down. Productivity is up. All these things are good.

But there is too much drag from economic forces of the type I describe above for the economy to really take off and for the 90's boom to return

We will go into this more in later letters, but this is just one more reason that you need to seriously look at your goals for retirement. If you need to make 10% on your portfolio to retire, then you are in trouble.

As we saw last week, dividends accounted for 80% of stock growth over the past century. Stocks grew at 6-7% annually. Dividends averaged 4-5% over that period. Now they average 1.5% or so. If dividends remain as 80% of stock growth, then annual growth of 2% is more likely in this cycle, which could last for another ten years or more. That means projecting 8-10% growth from your stock portfolio, especially in a Secular Bear Market, is not realistic.

You have to start looking for Absolute Returns.

Compound Effort Over Time

Moving on to more important matters: one of my daily rituals is to read Bill Bonner. I read him primarily for the sheer pleasure of his writing style and thought. I simply must share a few paragraphs. He has a son, Jules, who is struggling in a tough Parisian school. He gave him this advice, which I am sending to all my kids:

"Jules, I'm going to let you in on the secret to success," I began. And why not? A father has not only the right, but the duty, to pretend that he knows what he's talking about. "Normally, I would wait until you were older... but you may need this now. So here goes...

"There are two principles that almost no one understands...but they are critical to success. First, everything happens at the margin. Take some kid who's just as smart as you are...and one of you will do very well, while the other one might do not-so-well. What's the difference? One makes just a little bit more effort. Of course, just a little bit more effort doesn't make any big difference the first day...but that's where my second principle comes into play - 'compounded effort over time.' You know how compound interest works. You put money in the bank. Depending on the interest rate, it builds up.

"At first, you barely notice the increase. But after a while, it grows at an incredible pace. Well, effort is the same. At first, the results are barely perceptible. But over time, the guy who puts in just a little more effort...who listens just a little more carefully...who tries to work just a little harder...and just a little longer...and who cares just a little bit more about the way things turn out...after a few years, this guy's extra efforts compound until he is far ahead of the other guy."

*** "Uhh...thanks, Dad..." said Jules.

That struck me as remarkably profound, and as true in life as anything I've experienced.

It reminds me of the framed quote my Less-Than-Sainted Dad gave me when I was young: "Nothing in the world can take the place of persistence. Talent will not; nothing is more common than unsuccessful men with talent. Genius will not; unrewarded genius is almost a proverb. Education will not; the world is full of educated derelicts. Persistence and determination alone are omnipotent." (Calvin Coolidge)

I am off for a quick trip to La Jolla looking at yet another fund on behalf of clients. I will get in at least a round of golf, to give me some solace for yet another airplane and a weekend without my bride. I will be in New York City June 3-5, speaking at the annual Hedge Fund Forum on "Issues Facing the Hedge Fund Industry." I will have some time to meet with clients and prospective clients.

Next week we will look at further implications of the End of Disinflation, and see if we can find a few ways to profit. Have a great week, and take your kids or grandkids to see Spiderman if you already haven't. It is great fun.

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Your ever persistent and determined analyst,

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