While the rest of the pundits and market professionals focus on inflation, I am much more concerned about deflation. That’s right deflation!
Prices are falling and with lower prices corporate profit margins will be smaller. That means stocks as they are priced today may be overly optimistic as the market discounts future cash flows.
Both inflation and deflation can negatively impact earnings, but I’ll take inflation any day as it is easier to price increases into the market than to replace lost revenue due to price decreases.
Oh, I know oil and food prices are rising due to an unprecedented investment boom in commodities, but there is a very good reason the government excludes oil and food when determining the core rate of inflation.
It just doesn’t matter what happens to the price of food and oil. You heard that right, it does not matter.
While I am very empathetic for those now struggling higher fuel, gas, utility and food expenses, those prices tend to be very volatile thus they are excluded from calculating core inflation rates because any changes up or down are likely to be short term.
For exhibit A as to the volatility of commodity prices, take a look at recent action with oil prices. As they shot to near $150 per barrel in early July, they have now fallen back to the low $120’s in a little more than a week of trading.
Of course oil bulls will say that today is a new era of peak oil usage that will forever outpace supply causing oil prices to rise indefinitely. If so, then oil prices should be factored into inflation calculations.
What they don’t tell you is that much of the lesser developed world, those nation’s that are now exploding into the industrial world with fantastic growth and increased demand for commodities, subsidize oil prices.
Those subsidies result in demand that is artificially high. In other words without the subsidies growth would slow dramatically and prices for crude would fall sharply.
Thus it is easy for policy makers and others to be fooled that inflation is of the greater concern here. In the short term that may well be right to be concerned, but over the long haul it is actually more likely that consumption trends will be lower therefore pushing prices lower.
Now let’s get back to my little theory about deflation. At its core is a fundamental confusion as to the inflation argument. Putting aside oil and food prices, how in the world does inflation take hold in other parts of the economy?
If the consumer, which accounts for 75% of economic activity is as weak as the market suggests then there is simply no way for corporations to raise prices in any meaningful way.
In fact, if those companies wish to survive in the current environment they will have no choice but to cut prices. That is what is happening with respect to many consumer retail firms and explains why said firms have seen stock prices drop precipitously.
A good example of this action can be seen in the competition between Walmart (WMT) and Target (TGT). The consumer is voting with their pocketbooks and thus far WMT is winning the battle.
As more customers migrate to the lower price model of WMT, TGT may be forced to lower prices to keep pace. If not they will continue to see revenue declines that will eventually lead to lower margins.
In my opinion we are going to see this drama play out throughout the economy. It will happen with companies big and small and it will happen no matter the industry.
Going further with home prices declining at a pretty fast clip, we are seeing demand destruction for the homebuilding sector and all of the businesses tied to homebuilding. Everything from accessories to appliances are getting whacked.
Now I ask you are such conditions conducive to rising prices?
No way. Inflation today is a temporary phenomenon due to volatility of oil prices that may not be permanent.
Ultimately the goal of the Federal Reserve is to keep prices stable. Neither inflation nor deflation are very good for economic prosperity. At the moment though I would be much more worried about deflation than inflation.
