October 2010 - Commentary: The Haunting Specter of Deflation and the Reflation Trade

The global stock and bond markets rebounded strongly in the aftermath of the European sovereign debt crisis and the summer fears over a double-dip recession, largely reversing the losses suffered in the second quarter. Although the summer was volatile as investors oscillated between confidence in a slow and steady improvement in global growth on the one hand - and fears of a deflationary, double-dip recession on the other- markets rallied in September as investors embraced a rosier, if not entirely clear, global economic picture.

The broad S&P500 stock index rose 11.3% during the quarter. Despite this material gain, there is still a sense that the stock market is essentially running in place, posting an anemic 3.9% return year-to-date and lagging all components of the bond market. Ironically, the third quarter rebound in stocks was fueled by one of the factors that led to the second quarter selloff: the struggling U.S. economy. Although investors did grow more comfortable that the worst of the slowdown was over, it was the Federal Reserve’s subsequent concern over our subpar recovery and the expectation of a second “quantitative easing” program that jolted the markets out of their pessimistic funk.

Quantitative easing is the process whereby the Federal Reserve injects money into the financial markets through purchases of U.S. Treasury Bonds. The simple purpose of this exercise is to “reflate” the U.S. economy through the power of their electronic printing press. By doing so, they are hoping to accomplish two important goals. The first is to weaken the U.S. dollar relative to other currencies, improving our competitiveness in trade and boosting our exports as a result. This “competitive devaluation” of our currency helps to redistribute global growth back to the United States and supports our recovery. The second critical goal is to effectively allow the Federal Reserve to take out an “insurance policy” against the threat of “deflation,” or falling prices.

Deflation is a scary, and fortunately rare, phenomenon that is typically associated with a depression-like plunge in demand throughout the economy. The problem with deflation is that not only do prices fall during deflationary periods but typically so do asset prices and incomes. As a result, deflation halts every variety of activity as consumers, businesses and investors go into postponement mode due to the expectation that prices will be lower in the future. That is why deflation, or even the expectation of it, is so potentially toxic to economic growth.

The threat of a deflationary, double-dip recession over the summer helps to explain the market’s bouts with indigestion, as well as valuations that are not keeping pace with stellar earnings growth. As the chart above depicts, the level of inflation or deflation plays a significant role in stock market valuation. Moving the market’s expectation away from the threat of deflation and towards a modest, positive inflationary environment leads to higher valuations for stocks. Stock market earnings and stock market returns are also closely correlated to this chart. We believe the Federal Reserve is likely to formally raise their inflation target to a 2-3% range - as depicted on this chart. Such a move would result in a waning of deflationary risk, and is the likely driver of the quarter-end rally in the stock market.

The Federal Reserve’s decision to reengage its quantitative easing program is the equivalent of adding fuel to the embers of our subpar recovery. It was the first round of quantitative easing that resulted in the dramatic reflation of stock, bond and commodity prices in 2009 and not surprisingly, some investors are now betting on a similar rally. We suspect the ultimate impact of a second round of easing would be to add approximately a half percent to economic growth in 2011 and 2012 and for inflationary expectations to rise. The stock market would react accordingly.

The offset to forcing a more robust inflationary environment is that the risk of a serious policy error increases over time, and of course, ultimately all of this activity must be reversed and normalized. Quantitative easing is by no means a panacea. It lowers financing costs and historically boosts asset prices and household wealth. It also weakens our dollar and therefore helps our exports. However, it escalates the long-term risks to our economic stability should the reflation program prove unsuccessful.

Many are expecting the stock market to be facing a low-return environment for some time as the legacy of the Great Recession is felt through higher tax rates, increased regulation, government and household deleveraging and a protracted recovery in the labor and housing markets. This so-called “new normal” environment is now a consensus belief. We continue to believe that the consensus view of growth and market returns is too dour.

Strong corporate earnings, accommodative interest rates, benign inflation and an inexpensive valuation backdrop for the stock market remain supportive despite the dislocation between sentiment and reality that opened up over the summer. That disconnect and the consensus expectation for “new normal” outcomes set up the potential for economic growth to surprise on the upside, particularly in the housing and employment market, as the recovery reaccelerates.

From our vantage point, economic activity appears to be accelerating as we move into 2011. We are constructive on global growth and continue to believe this cyclical recovery has more staying power than market participants feared over the summer. Although we have remained disciplined in that view all year, Sand Hill Global Advisors remains vigilant and impartial in assessing this real-time and continually changing environment.

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