Stock slaughter
For equities, a sustained period of deflation is widely seen as a disaster
By Alistair Barr, MarketWatch
Last update: 3:00 a.m. EST Feb. 13, 2009Comments: 12SAN FRANCISCO (MarketWatch) -- As 2009 began, U.S. dairy farmers slaughtered more than 70,000 cows in one week to fight slumping prices.
Herds are being culled at the fastest rate in almost two decades as the recession withers away consumers' demand for everything from frothy cappuccinos at Starbucks (SBUX:Starbucks Corp
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Video: Falling milk prices and cow herds
The price of milk at wholesale fell significantly in January, leading some dairy farmers to make tough cost-cutting decisions -- like thinning the herds. MarketWatch's Stacey Delo reports.Similarly painful adjustments are playing out around the world as companies try to slash production and cut jobs in the face of falling demand and waning pricing power.
The problem is that, as more companies hunker down, demand may weaken further, spurring another wave of downward pressure on prices that would usher in a prolonged period of deflation. See feature on deflation and the economy.
"The combination of credit-crunch deflation and recession is forcing companies to conserve cash by firing workers and slashing capital spending," said investment strategist Ed Yardeni. "That should work for one company, but when they all do it, it just exacerbates the situation by cutting demand all over again."
Many investors believe that a lengthy bout of deflation is unlikely. But if consumer prices do indeed fall for a long time, the result is likely to be a disaster for much of the stock market, investment professionals say.
Investors could minimize their losses in stocks -- and maybe even capitalize a little on the situation -- by paring their portfolios of the most vulnerable assets while steering toward sectors that are more resilient to a deflation wave.
Companies that may suffer less include those with costs that fall more than the price of their products, such as Dean Foods (DF:dean foods co new com
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But many sectors including banks, metals companies, retailers and manufacturers would likely be crushed by sustained deflation.
"Sometimes an entire asset class is not a good idea," said Kevin Harrington, chief economist at San Francisco-based Clarium Capital.
Clarium, which runs a $2.24 billion global macro hedge fund, is avoiding stocks, while betting on gains in the U.S. dollar, which Harrington describes as "implicitly a deflationary trade."
'It's not a question of if. Deflation is upon us. It's a question of how bad it will get.'
— John Brynjolfsson, hedge fund investor
No global macro hedge funds were bullish on U.S. equities, according to a survey in early February by consulting firm Greenwich Associates. That was down from 46% in January and 62% in December.
The lowest level of interest in U.S. stocks before that was 8% in October 2007, just before the Standard & Poor's 500 index began a 45% slump.
"It's not a question of if. Deflation is upon us," said John Brynjolfsson, chief investment officer at Armored Wolf LLC, a global macro hedge fund in Aliso Viejo, Calif. "It's a question of how bad it will get."
Steven Bell, a former Deutsche Bank economist who runs a global macro hedge fund at London-based GLC Ltd., has been betting against, European and Japanese stocks, while buying two-year German government bonds.
"Deflation is a serious threat," he said. "You have to say that all companies would lose in such an environment, but some would lose less than others."
In contrast to equities, deflation typically boosts long-term government bonds because their fixed payments become more valuable as the price of goods and services fall. See feature on deflation and the bond market.
Japan
When Japan suffered its most severe bout of deflation, from October 2000 through January 2003, only one sector of the nation's stock market -- electric power and gas shares -- posted gains, according to Morgan Stanley.
Shares of non-ferrous metals producers, communications, banks and services companies dropped more than 60% during the period.
And there's a worrying difference between Japan's experience and the current predicament of the U.S.: The Japanese had lots of savings when the country descended into its deflationary recession, but U.S. consumers are now mired in debt.
"The societal effects were not nearly as dramatic as we're experiencing now in the U.S.," said Brian McAuley, chief investment officer at hedge-fund firm Sitka Pacific Capital Management LLC. "People had much more to fall back on in Japan, while our consumption is falling dramatically."
McAuley is investing in gold and gold mining companies, while keeping his hedge funds' equity exposure at zero.
He's expecting more stock market losses, with the Standard & Poor's 500 index possibly falling to 650 points, more than 20% below current levels.
Deflation scare trades
Morgan Stanley strategist Ronan Carr recently advised investors to keep most of their money in cash and gold.
Gold is usually considered a good hedge against inflation, rather than deflation. However, Carr said the precious metal would likely provide protection in either scenario.
Banks should be avoided, partly because deflation increases borrowers' debt in real terms, making it harder for them to repay loans, Carr explained.
Mining companies carrying lots of debt, such as Xstrata (UK:XTA: news , chart , profile ) , may also be losers because the real value of their interest payments would rise while the prices they can charge for the metals they produce falls, Carr said.
Other so-called cyclical stocks, such as carmakers, should also be avoided, he added.
Relative winners include companies that generate strong cash flow and have little debt. Industries that have pricing power and are protected from new competition could also survive better. Tobacco companies, drug makers and property and casualty insurers fit those criteria, Carr says.
Already declining
While debate swirls over whether deflation or inflation will emerge over the long term, prices are already falling in the U.S.
The consumer price index fell 1% in October, the most since the Bureau of Labor Statistics began publishing seasonally adjusted prices in 1947. The CPI slumped 1.7% in November, another record, and 0.7% in December.
Morgan Stanley estimates that by July, U.S. consumer prices will have fallen 3% from a year earlier. Merrill Lynch sees the CPI down by the same amount by the third quarter.
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