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  • Writer's pictureJoe Carson

Is Deflation A Risk, Or Are These Prognostications A Spurious Call For A Fed Pivot?

Consumer price inflation is at its highest rate in decades, yet some equity managers are screaming that deflation is the most significant risk. Is deflation a credible risk, or are these prognostications a spurious call for a Fed pivot? It's the latter.

First, the US has never recorded one year of deflation in core consumer prices in the sixty-plus years that the Bureau of Labor Statistics has collected data. Think about that. There have been several years of high unemployment, with the jobless rate exceeding 8% and a few at 10%-plus. Also, the US experienced record wealth losses following sharp drops in equity and real estate prices, abrupt drops in commodity prices, and near-collapse in the banking system in 2008-09, and not one year of a decline in consumer prices. That does not mean the future risk is zero. Still, going from high to negative inflation in months has to be exceptionally low. Also, economic and financial conditions would have to get significantly worse, above and beyond what has happened in the past, for a prolonged period before deflation risks would be the dominant worry.

Second, many equity managers form their opinion on inflation/deflation risks based on changes in commodity prices, especially energy. But, commodity prices are inputs into the production process and have a small weight in the overall cost of operations. Also, the US uses more commodities than it produces, so a fall in commodity prices is usually bullish for growth as it frees up cash flow and increases demand (and prices) in other areas.

Third, it is surprising that some equity managers view deflation as bullish for equities. Price is what companies get for their goods and services. A broad decline in final goods and service prices equates to less revenue and slimmer margins for many companies as firms can't cover or offset the cost of labor and other things. Some of the lowest operating profit margins on record occurred during low consumer price readings. Those periods happened against relatively high unemployment, which is not the case nowadays. So it's hard to see how deflation is bullish for equities, especially in the current environment of job openings exceeding the number of jobless by a factor of two, pushing up the cost of labor.

Fourth, the primary motivation of portfolio managers' deflation calls appears to be a campaign to pressure the fed to stop and eventually reverse the rise in official and market interest rates. Higher interest rates are a double whammy for equities as they hit growth and earnings and reduce the market multiple, or what people will be willing to pay for future profits.

Suppose the Fed keeps on the current path of raising official rates to get consumer price inflation back to 2%. In that case, equity PMs might eventually get the policy reversal they are presenting with their spurious calls about deflation risks. But that path will be rocky, with sharp declines in operating earnings, corporate bankruptcies, and a rise in credit default rates. The risk of the latter occurring is much higher than the risk of deflation, which is not a friendly environment for risk assets.

Deflation is not the magic wand to turn the equity market fortunes around, but that doesn't mean some PMs won't stop talking about it.

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