What’s the most important determinant of longterm investment results? I think it’s changes in the price system, relative to what people expected. Like all generalizations, that statement can be understood most easily by looking at extremes. First, when inflation is far higher than anticipated (as was the case during the stagflationary Seventies), commodities outperform stocks, which outperform bonds. Second, when inflation is far lower than anticipated, long-term bonds outperform stocks, which outperform commodities. Third, when outright deflation hits (as in Japan since 1993), long-term bonds are the only attractive asset class.
That deflationary conditions could occur in North America may seem bizarre. The most-used writing program, Microsoft Word, didn’t even admit that “deflationary” was a word until a very recent revision.
Those of us who have for years been warning of the likelihood of deflation have encountered bemusement, disbelief and/or ridicule. Haven’t we always had inflation? Isn’t it the basic disease of democracy? The answer to both questions is no. We have about a thousand years of price records for Europe and, in recent centuries, the United States and Japan. They show that the longest period of sustained inflation began in 1939, peaked in the 1970s, and has been in more or less continuous decline since 1982. During that millennium, inflation was overwhelmingly correlated to wars and preparation for wars. Example: prices in Britain barely budged between 1804 and 1907, except for the late years of the Napoleonic Wars, the Crimean War, the U.S. Civil War, and the Franco-Prussian War. Wars sent prices, particularly for commodities, sharply higher. Each war was followed by postwar deflation, driving prices back down to where the cycle began.
Because the Second World War was followed immediately by the Cold War, we did not experience postwar deflation. Then, during the 1960s and 1970s, we overlaid those war costs with big-government tax-and-spend liberalism that supine central bankers sought to finance by printing money. The result was double-digit inflation. (As Milton Friedman showed, inflation is primarily a monetary phenomenon.)
With the end of the Cold War, we were ready for a sustained drop in inflation. It came after the brief delay of the Gulf War. Central bankers had learned their lessons well, and they practised monetarism. Meanwhile, the civilian economy experienced falling prices because of (1) Moore’s Law, which decreed that the power of a chip doubles in roughly 18 months, giving
To me, the only threat of returning inflation comes from a possible Mideast war. Otherwise, bonds are a buy.
the global economy sustained productivity gains, and (2) the rise of East Asia in world trade. At first, exports from Japan and the so-called Tigers hammered down global prices. Then China, liberated by Deng Xiaoping from its Marxist superstitions, became the most formidable force. In 2000, it dislodged Japan as the biggest contributor to the U.S. trade deficit.
Deflation has shown its muscle in commodity prices. Canadian investors are ruefully familiar with the declines in energy, forest products and metals recendy. The biggest price plunge has beset the pre-eminent commodity of the information economy—the computer memory chip, which was down as much as 88 per cent this year before recovering modesdy.
You’ve noticed the deflation in automobile pricing: not all the price cutting has been in finance charges. For North American-made vehicles, deflationary bargains are the rule. So why does the inflation rate keep going up? Answer: prices for goods and services priced locally, or by governments, keep rising. Cab fares, health care, tolls, tickets, college tuitions, lawyers’ fees, restaurant meals and other items not subject to free trade still hold their own or climb. In a service economy, those transactions outweigh the effects of cost cutting from competition abroad.
Still, those deflationary pressures have a major impact on investments. Shares of manufacturing and commodity companies are obvious examples. Long-term bond yields look low compared to recent history, but their real (inflation-adjusted) yields are once again appealing after that major bond market sell-off in November. The bond bear suddenly returned because investors concluded a strong U.S. recovery was coming, bringing with it, they feared, inflation and higher long-term interest rates. That worry, paradoxically, undermines the attractiveness of stocks. U.S. consumers and corporations need lower long-term rates to manage their towering debt burdens. If bonds are bad, stocks at current prices are worse.
To me, the only threat of returning inflation comes from the Mideast. If a large, lengthy, cosdy war erupts there, inflationary pressures could return. If not, bonds are a buy.
The stock market climbs a wall of worry. Inflation is yesterday’s Big Worry. Today’s are terrorism and recession. If worrywarts worry about the real problems, bonds will rally, stimulating the economy, thereby making stocks once again attractive. Worry usefully. E3
Donald Coxe is chairman of Harris Investment Management in Chicago and Toronto-based Jones Heward Investments.
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