The New Watchword-Deflation?

Key Points

  • Stock market volatility has increased after a mixed earnings season and rising concerns over emerging markets. A larger correction than the market's had to endure in the past couple of years remains a possibility, but consolidation and time can also whittle away at sentiment and valuation excesses. We remain optimistic on the longer-term prospect for US equities.
  • Global policymakers have been more vocal in their concerns over low inflation, raising deflation as a possibility. Central banks, including the Federal Reserve, seem committed to fighting that possibility, and we believe fears may be overblown. A more urgent domestic matter involves getting a deal done on the US debt ceiling.
  • The eurozone has fought its way out of recession, for now. But more needs to be done; and deflation is a real threat both there and in Japan, which is dealing with a tax hike in the near future. The emerging market turmoil—largely affecting currency and equity markets—appears to be, so far, largely country-specific and there does not appear to be any imminent and large systemic risk.

Stocks here and globally have experienced a bumpy ride to start the year, with some decent-sized down days, as emerging market concerns have escalated. Worries are high about emerging market currency turmoil leading to an event similar to the failure of Long-Term Capital Management (LTCM) in the late-1990s. For a variety of reasons, we don't believe we're in store for something similar, as the turmoil is more country specific than systemic; but we do want to add some perspective.

Remember, stocks are long-run investments and volatility is to be expected over short term horizons. Specifically, our friend Ed Yardeni points out that in 1997, the S&P was up 31%, with no 10% corrections; while 1998 saw a 19% correction during the height of the aforementioned currency crisis, but the S&P 500 actually closed 1998 with a 27% gain—a roller coaster ride to be sure, but a profitable one. We don’t believe we’re in for that sort of volatility in the near term, but regardless, we remain longer-term optimistic on equities.


The possibility of developed market deflation has been raised by global policymakers, which has likely contributed to the decidedly mediocre start to year for stocks. International Monetary Fund (IMF) Chief Christine Lagarde recently warned, "With inflation running below many central banks' targets, we see rising risks of deflation, which could prove disastrous for the recovery." While the IMF's forecasting track record leaves a bit to be desired, other policymakers around the world have echoed those sentiments, while others have acted in an attempt to forestall the deflationary possibility. For example, the European Central Bank (ECB) surprisingly cut rates late last year, citing low inflation as a concern; Japan continues to aggressively attack what has been persistent deflationary pressures; and Minneapolis Fed President Narayana Kocherlakota recently was quoted by the Financial Times as saying, "We're running the risk of being content with inflation running consistently below our target. That’s inappropriate."

Inflation has been below what many central banks would like to see; and that has certainly been the case in the United States as you can see from the chart below.

Inflation below the Fed's target

Source: FactSet, Bureau of Economimc Analysis. As of Jan. 28, 2014.

We believe concern has risen in part because we have seen global economic growth show signs of improving, which would typically result in at least an uptick in inflation. Interest rates are generally not suggesting any concern of inflation rising in the near future either, as the US 10-year Treasury yield remains below 3% despite signs of improving US growth. A mixed earnings season probably didn't help, as many companies, especially retailers, noted the lack of pricing power they have in a globally competitive economic environment.

Watching but not concerned…yet

Many are surprised that inflation hasn't picked up a bit more over recent months. The unemployment rate has dropped to 6.7%; capacity utilization has risen to its best level since June 2008 at 79.2%; industrial production posted another 0.3% gain in December, taking out its 2007 high; and manufacturing surveys continuing to indicate growth. The latest US gross domestic product (GDP) report confirmed the latest strength in the economy; with a reading of 3.2% real growth for the fourth quarter, which followed an even stronger 4.1% third quarter. With the amount of liquidity still being pumped into the economy by the Federal Reserve, even given the tapering of quantitative easing (QE), there appears to be plenty of fuel to eventually light an inflationary fire.

But there are also offsets. For example, the labor force participation rate is at its lowest point since 1978, capacity utilization remains below its long-term average, while wage growth has been anemic. Perhaps most telling though is that bank loans haven't come close to matching bank deposits, meaning that the liquidity being pumped into the financial system appears to largely just be sitting there—not an inflationary environment.

Bank loans continue to be weak

Source: FactSet, Federal Reserve. As of Jan. 28, 2014.

Additionally, we appear to be in at least a temporary new paradigm regarding many of the goods we purchase. With the increase in globalization, consumers are gaining greater power. Prices can now be compared around the world in a matter of seconds, with many items able to be inexpensively shipped directly to the consumer. This makes it quite difficult for many retailers to meaningfully raise prices. And technological innovation is increasingly allowing companies to do more with fewer employees, resulting in workers in some industries unable to command higher wages. This is where true inflation would likely begin (the classic "wage-price spiral"). In fact, despite the drop in the unemployment rate, real average hourly earnings only ticked up 0.6% year-over-year as of December 2013.

But we don't believe deflation in the United States is a large concern. First, US consumers have traditionally been much more oriented to spending than saving; in contrast to some other cultures, helping to ensure demand stays intact. Also, the Federal Reserve, first with Chairman Bernanke and now with incoming Chairman Yellen, appears committed to doing whatever they can to avoid deflation and its consequences. And finally, there is quite a distance between a low level of inflation, and broader deflation. We believe it would take another near-term severe recession to see that come to fruition, which we don't see as likely.

The good news is that, absent widespread deflation, low levels of inflation tend to be supportive of stock prices. However, we continue to believe the possibility of a decent (10%+) price correction has grown. Stocks could also "grind" within a range for an extended period, which is referred to as a "correction in time." This would allow valuations to decline, as earnings continue to rise while prices stay steady, and the froth to come off sentiment. Either way, our view has been that the early part of 2014 could be a bit rough for investors.

Fed maintains pace…debt ceiling needs action

While some members of the Fed, as noted earlier, have expressed concern over the low levels of inflation, the consensus remains that a modest tapering at each of this year's FOMC meetings is appropriate. Bond purchases have dropped from $85 billion per month to $65 billion as the slow process toward normalization continues. As always, the Fed's decisions remain dependent on economic developments, but we believe a steady drawdown in asset purchases while keeping short-term interest rates pegged near zero is the most likely course throughout 2014.

The most likely course for the Federal government, however, is less predictable. We do believe an agreement to extend the debt ceiling will be reached without much pain before the end of February deadline given by the Treasury secretary. We don't expect much else out of Congress in this mid-term election year, but we'll note that the fiscal drag we've seen over the past few years is set to be reduced this year. This should help to contribute to better overall growth.

Europe – the case of too slow

The eurozone crisis shifted in August 2012 when European Central Bank (ECB) President Mario Draghi said the ECB would do "whatever it takes," including conditional government bond purchases. However, the eurozone's banking system has remained hobbled due to painstakingly slow progress on common bank regulations; and measures to resolve failing banks, which have resulted in banks hoarding capital rather than lending. Borrowers have also been uncertain and hesitant, due to threats to global growth, rising eurozone unemployment and resultant pressure on wages.

Too little lending in the eurozone

Source: FactSet, European Central Bank. As of Jan. 28, 2014.

Global growth threats and fiscal drag in Europe eased in 2013, resulting in the eurozone emerging from recession. However, the eurozone recovery remains "fragile;" yet to become self-reinforcing and there remains talk of the potential for deflation. The reason is that the longer economic growth remains sluggish, the bigger the risk that prices fall, which can become self-reinforcing on the downside.

Growth in the eurozone and globally will likely continue to recover, and eurozone lending is likely to follow; but parts of Europe could mimic Japan and suffer a "lost decade" in our view. We believe significant reforms are still needed in France and Italy, and that the ECB needs to provide more stimulus to thwart potential deflation. Unfortunately, meaningful action by the ECB in the near term may require a worsening of financial conditions. While not a new idea, Draghi recently renewed the prospect of ECB bank loan purchases. It is possible that the upcoming asset quality review and bank stress tests could make bank loan purchases viable in the view of our friends at ISI Research, but this is not a near-term option, as the details need time to be worked out.

Where does that leave us on European stocks? We still remain positive on European stocks, due to the prospects for economic, lending and profit margin improvement. However, future gains for European stocks may be slower and more volatile.

Japan in a wait-and-see mode

In the developed world, the Bank of Japan (BoJ) is the central bank most likely to increase, rather than decrease, policy accommodation. The reason is that Japan's recovery is under threat because wages have yet to increase to offset a sales tax hike that begins in April. And, inflation is rising due to the weak yen pressuring import prices for food and energy. As a result, the upcoming spring Shunto wage negotiations will be closely scrutinized.

While inflation has increased, consumer prices excluding food are still rising just 0.9% in December, well below the BoJ's 2% target. Given the headwinds to the economy, we believe the BoJ needs to increase stimulus. The BoJ could come under pressure to increase stimulus if wage increases fail to show up, or if the sales tax hike damages demand too much.

Meanwhile, emerging market turmoil has resulted in the yen strengthening, as investors have unwound risky trades funded by the weak yen. This has hurt Japanese stocks; which have tended to take their cue from the yen in an inverse relationship over the past year, rising when the yen falls and losing ground when the yen strengthens. We believe investors are likely to adopt a "wait-and-see" attitude toward Japanese stocks until there is clarity on emerging market risk and further BoJ action.

Emerging market turmoil – will it ripple globally?

Unlike the retrenchment of lending in the developed world in the wake of the global financial crisis, emerging markets (EM) had the capacity to increase lending, and benefitted from easy developed country monetary policy. In fact, some EM countries have been living beyond their means. China, in particular, is a case of too much lending in recent years.

Too much lending in China

Source; FactSet, Bloomberg. As of Jan. 28, 2014.

Chinese policymakers recognize the risks and have been cracking down on speculative lending. Growth has slowed and borrowing costs have risen as a result. However, this is a tricky balancing act. Too quick a pullback could cause a negative feedback loop of reduced access to credit and increased default risks, further slowing growth.

As a result, a perfect storm of soft Chinese economic data and threat of a Chinese trust default; along with sharp declines in the Argentina peso and Turkish lira; resulted in turmoil in emerging markets so far this year. Memories of past emerging market (EM) crises, such as the Asian financial crisis in 1997-98, have traders worried about a repeat. With the Fed pulling back on tapering and the US economy accelerating, US Treasury yields are expected to rise and boost the attractiveness of the US dollar relative to other currencies. Countries dependent on foreign investment, due to current account deficits and/or high amounts of short-term debt denominated in US dollars, could be vulnerable to the self-feeding negative feedback loop of currency declines, inflation threats, monetary tightening and slowing growth.

The short-term will likely remain difficult for emerging market stocks, but it's probably not a great time to sell. We believe emerging market stocks still deserve a position in portfolios in line with your long-term strategic asset allocation. Within the emerging market allocation, we believe Chinese stocks could outperform as reforms begin to take hold. We discuss these issues in Emerging Markets: Stay or Go?

Investors are also questioning whether the emerging market problems will spill over to the global economy. The Asian financial crisis had little impact on developed economies, but EMs have increased in importance since that time; rising from 20% of global GDP to 38% in 2012; and equating to 15% of sales for companies in the S&P 500, according to Deutsche Bank. While do not believe we are on the verge of a systemic financial crisis in EMs, as they are stronger than in 1997, changes in sentiment can be infectious. Investor flight out of EMs could build on itself, with selling begetting selling. If the slowdown in EM economies becomes long-lasting or pervasive, it could be a threat to global growth; but for now we are viewing this as a small, albeit unwelcome, headwind.

Read more international perspective at

So what?

Equity markets have been shaky to start the year but we don't believe it's time to abandon ship. The fundamentals in the United States continue to look appealing and the recent pullback has helped to correct some sentiment and valuation concerns. We are watching the fight against deflation carefully in Europe and Japan, and believe both countries may need to do more via monetary policy stimulus. Meanwhile, some emerging economies are dealing with inflation, but we don't believe the recent problems will morph into a widespread crisis at this point.

© Charles Schwab

© Charles Schwab

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