Listen to the stock market the past couple of weeks and you’ll hear the hiss of deflation, of air leaking out of the 2013 rally as concerns build about downward pressure on economic growth, prices and corporate profit potential.
While the Standard & Poor’s 500 index ebbed 3.5% from its recent all-time high to Thursday’s close, this represents a sub-surface correction among stocks exposed to global economic momentum finally roiling the market’s surface. The index’s energy and basic-materials sectors are each down more than 5% in the past week.
Gold, suffering from dimming concern about systemic financial risk as well as cooling inflation worry, is down more than 20% from its all-time high and down 10% since April 11. Crude oil is off 15% since February and lumber futures are lower by 10% in a month.
The 10-year Treasury yield is near 1.70%, down steeply from 2.05% five weeks ago. An auction Thursday of Treasury Inflation-Protected Securities, or TIPS, which compensate investors for future inflation, drew the weakest bidding interest in five years, suggesting the markets have little fear that inflation will be a major concern in coming years.
An unexpected decline
The official consumer price index for March showed an unexpected decline of 0.2% this week, dragged lower by sliding gasoline prices, and the core measure of inflation remains handily below the Federal Reserve’s long-term target.
None of this means the economy is at an outright stall, or that true deflation – broad and persistent price declines – is likely to take hold. But it suggests that economic momentum has flagged enough to stir doubts that high corporate profit margins can hold up, while undermining once-urgent worry that the Federal Reserve will quickly reduce its easy-money stimulus efforts.
Vadim Zlotnikov, chief market strategist at Alliance Bernstein, the manager of $400 billion in investment assets, says, “A lot of what’s happening in the market has to do with short-term sentiment with regard to inflation versus deflation. Every three months or so, the world seems to worry about one or the other.”
The pendulum swinging back to a deflationary theme is a reminder that, after a huge debt shock and deep recession in the crisis, the Fed and other central banks have “only partially offset” this drag, says MKM Partners strategist Michael Darda. The Fed has managed to provide ample liquidity and swell the banking system with reserves, but this hasn’t yet turned into strong demand for credit and capital.
The deflationary breeze
The reason the deflationary breeze feels uncomfortable to investors is that it gets directly at the crucial variable for determining whether stocks in general are attractively valued.
“The reason people are so skittish on equities and on inflation is what it means for pricing power,” Zlotnikov says. “The single biggest question is, ‘Will corporate profit margins be sustained?’”
That question depends on whether companies will be able to either raise prices or hold price levels as their input costs decline.
This core worry has essentially separated the winners from the losers in this year’s stock market. Shares of makers of earth-moving equipment and other capital goods have been discarded. Semiconductior stocks have lagged. Even the massive liquidation of Apple Inc. (AAPL) stock derives from fears it won’t retain a price premium for increasingly commoditized iPhones and will offer cheaper phone models, savaging its lush profit margins.
Meantime, the pockets of the market that appear sheltered from pricing pressure, whether due to consolidation or sturdy product demand, have been clear standouts. This includes airlines, rental-car services and biotech firms, all big market winners. Just look at the way the HMO stocks surged – based on a controversial tip from a former healthcare lobbyist – the moment it became clear the government wouldn’t crimp reimbursement rates.
An overwhelming preference
The overwhelming investor preference for consumer staples and other “Grandma stocks” is, first, a flocking instinct to securities with sustainable cash yields and stability.
Yet it is also all about product pricing and whether high profit margins can endure. In this case, it’s all about the producers of cereal, soup and paper towels being able to hold firm on prices while the commodity meltdown pulls their raw material costs down.
Zlotnokov points out that, in general, growth stocks don’t carry much of a valuation premium over the market or value stocks. This is a collective market verdict that most companies will have a hard time achieving organic growth goals and pricing flexibility. If that’s the likely outcome, then investors seem to figure they might just as well own the companies that will at least pay out the greatest portion of those stagnant or slow-growing earnings.
Along with this, though, Zlotnikov cites a select group of “anointed leaders” among hyper-growth concept stocks, which are “more expensive than ever.” These include Lululemon Athletica Inc. (LULU), Netflix Inc. (NFLX), Salesforce.com (CRM), Amazon.com (AMZN), Intuitive Surgical Inc. (ISRG), Priceline.com (PCLN) and Chipotle Mexican Grill Inc. (CMG).
The way all this filters into a market outlook is to reinforce the Fed’s message that it is in no hurry to cut back on its easing efforts to try to spark a quicker credit-creation cycle and hungrier consumer and business demand. As Darda says, deflationary weather fronts “should put a damper on talk of near-term Fed tapering” of its asset-buying program. That should place some support beneath financial markets as they digest the mixed growth signals.
It also means that this present choppy earnings season is likely to usher in a prolonged period in which companies struggle to persuade investors they can grow. Earnings forecasts will likely be trimmed for the second half, which is when a sharp acceleration of profit growth has been expected. The unknown question is how much the under-performance by economically cyclical stocks, which are cheaper than the market, has already priced in downside risk to late-2013 profit forecasts. The likely answer is a lot, but maybe not all.
And those companies that can hold prices – or, those such as Intel Corp. (INTC), which have existed forever in a deflationary market and have already seen its shares cheapen – should continue to win the benefit of the market’s doubt.