up and Down Wall Street Daily - The Deflation (Almost) Nobody Saw Coming

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The Deflation (Almost) Nobody Saw Coming
By RANDALL W. FORSYTH, Barrons, AUGUST 27, 2009

The same seers who fretted about inflation last year are the ones now declaring the recession to be over.

IT SEEMS LIKE A LIFETIME AGO, but inflation that was driving the financial markets nuts in August 2008. Producer prices had their biggest year-on-year leap since the peak of the Great Inflation in 1981 while consumer prices saw their biggest jump since 1991.

Only a few weeks later in September, the markets would be facing the worst crisis in two generations with the collapse of Lehman Brothers, which sent the economy into a tailspin. Or so goes the popular recollection.

As the economy tumbled into the worst post-World War II recession, prices inevitably receded in tandem. On the anniversary of the worst inflation numbers in years, the latest readings show the most severe deflation in ages.

The consumer price index fell 2.1% in the year to July, the sharpest drop in prices at the retail level since the 12 months ended January 1950, according to Bureau of Labor Statistics data charted by Bianco Research.

The current deflation followed a rise in the CPI of 5.6% in the year to July 2008, a pace of inflation that was the norm through much of the late 1960s and the trough of the 1970s. Only with the defeat of inflation by the mid-1980s would a "5 handle" inflation number seem high.

Meanwhile, the producer price index for finished goods shot up 9.8% in the 12 months to July 2008, the biggest increase the year to June 1981 and uncomfortably close to the double-digit inflation of that era. In the latest 12 months, the PPI plunged a record 6.8%.

But to ascribe the collapse of inflation entirely to the after-effects of last year's near-meltdown in the financial markets is to engage in some revisionist history.

While there were calls in the summer of 2008 for central banks to tighten policy, the signs pointed not only to a peak in inflation, but that deflation posed the clear and present danger.

Indeed, that's what I wrote in this space almost exactly a year ago: "The Inflationary Fever is About to Break; While producer prices rise the most in 27 years, deflation poses the danger ahead," Aug. 20, 2008.

I mention this column mainly because it elicited more vitriol than perhaps anything I've written in Up & Down Wall Street Daily in the past three-plus years.

I wasn't alone in making that call. In that column, I cited Dow Theory Letters' Richard Russell, who wrote at the time: "From what I see, the markets are telling us to prepare for hard times, and a global spate of the worst deflation to be seen in generations. That is why gold has been sinking, this is why stocks have been falling—big money, sophisticated money, is cashing out, raising cash, preparing for world deflation."

Similarly, Albert Edwards, the chief strategist of Societe Generale, was also looking for deflation. Indeed, he insisted a sharp contraction was inevitable -- weeks before Lehman's collapse and maelstrom that ensued.

Back in the summer of 2008, mainstream economists weren't sure we were in a recession -- even though it had begun in December 2007. Now, the same crowd that didn't see the recession a year ago confidently declares it has ended.

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THE STUNNING COLLAPSE IN INFLATION has produced losers and winners. Among the former are Social Security recipients, which are unlikely to receive a cost-of-living adjustment next year and possibly none in 2011. At least they won't get a cut as a result of the negative CPI.

For consumers, the swing in inflation from 5.6% to minus 2.1% in the past 12 months is equivalent to tax cut that benefits them more than any other sector of the economy, according to the Portfolio Strategy team at ISI Group led by Francois Trahan.

As a result, consumer discretionary stocks have been the leaders in the market's rally. "Intuitively, this makes sense since the space is considered to be the classic 'early cycle' place of the market place," they write in a note to clients.

But, they add, that's about to change as the global economic recovery takes root. "This spells the end of the 'sweet spot' for the Consumer Discretionary sector as opportunities will develop in other segments," according to Trahan and his associates, Stephen G. Gregory, Brian J. Herlihy and Michael J. Kantrowitz.

They think the best performance is past for consumer durables, services and retailing stocks "as they would be classified as interest-rate sensitive, defensive and early-cyclical by our definitions."

That's the glass half-full reason to move out of consumer discretionary stocks.

With unemployment continuing to rise with one-sixth of the workforce either jobless, working part-time because they can't find full-time jobs, or "discouraged" and not find work; weekly earnings falling; house prices still down sharply from a year earlier, and credit conditions still tightening for consumers, it's hard to see how consumer discretionary spending will lead the economy.

After all those folks who traded in their clunkers for shiny, new cars, they won't be in the market for autos. And with their new car-loan payments, there will be less discretionary cash left over for stuff they might have bought if they still were driving that clunker.

Comments: randall.forsyth@barrons.com

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