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I scanned a news article I read at the bloomberg.com financial website the
other day and have included it below. It was written by Maggie Mahar (no
idea of her backgroound or credentials) who is a columnist for the
Bloomberg News.
She indicates that deflation is a bigger concern right now than inflation.
Is she right? Or is this just one small part of the problem that is
dragging down markets latley?
On a lighter note: With the recent bombing of the terrorists by the US, I
guess it's true....old Bill still has trouble keeping "his missile in his
silo"
Is Deflation Our Greatest Threat?
By Maggie Mahar
(Maggie Mahar is a columnist for Bloomberg News. The opinions expressed
are her own and don't represent the judgment of Bloomberg LP or Bloomberg
News)
New York, August 21 (Bloomberg) -- As the financial media strive to keep up
with the volatility in equity markets world-wide, prudent journalists
strive for balance "After all, who wants to be accused of causing bad news
by commenting on it (Not to mention the risk of being wrong)
So in the interest of "'balanced reporting" experts on both sides of the
issue are trotted out.
Evenhandedness has its merits, especially when the question at hand is
complex But in this case, the issue is cut-and-dried -- either the bull
market is over, or it's not.
While the debate rages, the numbers pile up And it's not just stock market
indexes that have been declining. In both Europe and the U S, prices -- and
profits -- are sliding. Deflation is replacing inflation as the greatest
threat to economies world-wide.
We always knew that the end of the bull market would come out of left
field. Now it appear" that's exactly what's happening. While everyone was
keeping an eye peeled for inflation, the numbers were running the other way.
Officially, inflation in the US is approaching zero, but "for all practical
purposes it's probably already in negative territory," observes
Jean-Philippe Cremers, a portfolio manager who helps pick stocks for
top-ranked GAM International and GAM Global (Among global and international
funds tracked by Bloomberg, the two GAM funds rank No 1 over five years,
over the past three months, GAM International places 4th among 390 funds
while GAM Global ranks 4th among 191).
Prices of manufactured goods and autos "are already falling," Cremers notes
Moreover, "the official tally doesn't incorporate changes in technology
While the power of the products rises, prices drop."
But it's the numbers coming out of Europe that are startling Cremers calls
them "exceedingly strange for an economy in the first phase of recovery."
In Germany, for instance, June retail sales dropped more than expected
--off 3.1 percent for the month -- and down 2.7 percent from a year
earlier. In July wholesale prices fell 0.9 percent
In Italy, consumer prices were flat in July, and economists expect they'll
remain unchanged in August. It's the height of the tourist season, yet
restaurants and hotels haven't been able to raise their tariffs.
Meanwhile, industrial production fell a greater-than expected 2.1 percent
from May to June. "There is a hesitation on the part of consumers who seem
to lack confidence in the economy," Flavio Rovida, an economist with Caboto
Holdings in Milan told Bloomberg. "Internal demand will likely continue to
decline in coming months." And in Switzerland, producer prices and import
prices remained flat for July, down 1.5 percent for the year. "Deflation is
going to be a threat in many, many industries," Cremers predicts
Greater Threat
None of this means that deflation is a certainty, but it's definitely the
greater threat. Which suggests that investors might want to take a
defensive position by paying more attention to sectors when selecting stocks.
First, though, take the measure of the monster. Deflation didn’t exactly
creep up on us. In the past two years, commodity prices have reached an
historic low in real dollar terms. And in the U.S. the prices of
manufactured goods --which make up 40 percent of the Consumer Price Index
-- have been falling since 1996. We ignored falling prices because
disinflation by and large was good news for consumers. But now it's not
just potato chips and microchips that are cheaper. Inflated assets are
beginning to hiss. That matters because Baby Boomers who watch their
assets drop aren't as likely to shop. Nor are their bosses inclined to be
lavish with raises. (Wage deflation is tricky - while prices slip,
salaries stay sticky. But stagnation is easy.) That said, consumer
confidence is high -- almost as high as their credit lines
But, as David Tice, manager of the Prudent Bear Fund, points out, easy
credit has been masking deflation by pumping up the price of real estate,
restaurants, cigars and other luxury products while the cost of
manufactured goods fell. AS a result, prices looked flat "We probably
should have had 2 percent to 3 percent deflation over the past few years --
thanks to easy money, we've had mild inflation," says Tice "The credit
bubble is another balloon waiting to pop"
Job Creation
But wait a minute, even if consumers give up malls, won't they still buy
stocks? Where else would Boomers put their billions?
The short, ugly answer is that paper profits burn quite easily. If the Dow
continues to slither south, boomers will have less money to worry about
--fewer dollars will be chasing the same number of stocks.
The Asian crisis is the trigger, not the root cause of the problem. Global
deflation had a head start -- add low-priced imports, and more and more
blue-chip companies will announce lower earnings.
Just in the past week, for instance, Veba A G. Germany's largest utility
announced earnings fell 3.6 percent for the first half of '98 (the price of
silicon wafers is falling)
Up 'til now, U S manufacturers could make up for their lack of pricing
power by restructuring and increasing productivity. Much of that
cost-cutting has now been done. As for Europe, restructuring is much more
difficult, says Cremers. "Social legislation stands in the way, and
meanwhile, unemployment remains high -- we just don't see much job creation"
In theory, shrinking inflation in Europe is a sign of economic strength.
In fact the hot air balloon is plunging toward ground faster than anyone
expected.
In France, Bloomberg News reports, "consumer prices fell faster in July
than in more than 40 years -- down 0.4 percent after rising only 0.1
percent in May and June. Meanwhile German inflation has hit 0 9 percent --
the lowest level in 10 years.
Deutsche Banks's chief economist, Norbert Walter, sounded the warning last
week, forecasting "only limited chances for growth in Germany's economy
this year," adding that "Asia's financial crisis could trigger a "worldwide
period of economic weakening"
Different Strategy
That's why Cremers is avoiding cyclical stocks "retail, chemical, steel,
focusing instead on banks, insurers, and drug companies.
Roughly 40 percent of GAM International's assets are invested in financial
companies because in a deflationary environment, it's always better to be a
lender. When inflation reigns, borrowed money is cheap -- you repay in
dollars with less purchasing power. Yet when inflation swings into reverse,
and prices drop 1 percent, a 7 percent loan winds up costing 8 percent.
This sounds like good news for bondholders -- and it can be. But the health
of corporate debt depends on corporate profits, when earnings slide, so do
credit ratings.
Cremers' sees better prospects elsewhere.
"We prefer to play the bond market through the financial sector (since) we
expect interest rates will favor earnings," he explains.
Insurance companies are attractive not only because they invest in bonds,
but "with low inflation, they'll be paying claims in currency that is worth
less," Cremers points out. Three insurers rank among Gam International's
top 10 holdings, accounting for over 9 percent of the portfolio. AXA-UAP in
France, Fortis Amev NV in the Netherlands and Zurich Allied AG in Switzerland.
Four banks account for another 15 percent of the fund's holdings Barclays,
Bank of Scotland, Credit Lyonnais and, in the Netherlands, ABM-Amro Holdings
'Inflation Is Zero' But what about the banking industry's exposure to Asian
and Russian debt? The recent bank sell-off, like most mass movements, has
been indiscriminate. As Cremers points out, "not all banks carry Asian
debt Fortis has some exposure," he acknowledges, "but it's small and
indirect - through merchants in the Netherlands" "We don't own any German
banks he adds. Not only are they vulnerable to emerging markets, they're
exposed to the cyclicals in Europe that he's trying to avoid . "When you
buy Deutsche Bank, you buy many companies in Germany. We prefer Dutch and
Belgian banks -- they're much cleaner banking plays."
GAM also counts on mergers to spur earnings in the financial sector. When
banks consolidate they don't have to make difficult personnel decisions,
they just shut down branches. "Fortis, for example, just bought, Generale
de Banque, Belgium's largest bank, and they'll be closing 700 branches out
of 1700," says Gremers.
There's just one other sector which offers broad immunity to deflation
--pharmaceuticals, he says "Drug companies can still increase prices - in
the U S they've gone up three percent in the last few months," Cremers
observes. Even in Italy, where the cost of housing, utilities, food and
hotels dropped in July, prescription drugs climbed 0.7 percent
Novartis ranks among the top 10 in both GAM Global and GAM International. "
We also own Merck, Schering-Plough, Johnson & Johnson, Amerisoft, and
Zeneca, the second-largest pharmaceutical in the U.K.," says Cremers.
"Recently, we added Warner-Lambert Co -- they have a new cardio-vascular
drug, and we don't see any competition for many years"
By assuming deflation, GAM is taking a cautious approach. But as Cremers
describes it, the upside is hardly conservative: "We're investing in
sectors where we expect earnings to grow 15 to 18 percent -- in a world
where inflation is zero".
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