British inflation figures came in higher than expected yesterday. As usual.
The consumer price index rose at an annual rate of 2.2% in May, compared to 2.3% in April. Economists had expected it to come in at 2%. Meanwhile, retail price index inflation (which includes mortgage costs, and so is in deflationary territory) actually edged higher, from -1.2% to -1.1%, as home loan costs started to pick up.
So is deflation a fear that we can now simply dismiss? Not so fast…
This bounce is exactly what was expected
As global stock markets have soared, so pundits have gradually become more optimistic. Britain is starting to go from being the sick man of the world, to flavour of the month, while elsewhere, more and more people are declaring the start of a new bull market.
It’s another fascinating lesson in how short our memories are. The truth is that, after the markets had collapsed at the end of last year, most people expected a bear market rally to appear from just around the corner. And they had perfectly sensible reasons for doing so. After all, the harder you fall, the higher you bounce.
That doesn’t just go for the stock market – it goes for the economy too. At our Roundtable meeting in March, for example – just after the current rally started – almost everyone agreed that we were still heading for deflation. Everyone agreed we were in a bear market rally. They believed that we’d probably see a bounce in economic activity at some point in 2009, as businesses were forced to restock after cutting back sharply – but a bounce is all it would be, in reaction to the severe drop off seen last year.
And this is exactly what seems to be happening. But as the bounce has continued, people have started to question those bearish assumptions, and wonder if the recovery is genuine. This is exactly what bear market rallies do of course. They suck in investors as stocks continue to rise, until eventually there aren’t any buyers left, and the stage is set for another leg down.
Why investors are right to be concerned
And once again, it’s the stock market that seems to be ahead of the crowd. Despite relatively upbeat economic data yesterday, most markets closed lower, suggesting that fear for the future is starting to over-ride any ‘irrational exuberance’ investors had been feeling.
Investors are right to be concerned. This downturn isn’t just something that can be shrugged off. “Business as usual” is not going to be an option for quite some time.
As Michael E. Lewitt points out in The HCM Market Letter, any recovery in company earnings will be short-lived, because “it is based on corporations cutting costs and governments spending money that the rest of us don’t have. At some point, the economy must generate growth without huge infusions of government money, and companies must generate revenue growth again because cost-cutting can only get them so far.” As it stands, it’s very hard to see “the source of future sustainable profits once government stimulus ends.”
Enjoying this article? Sign up for our free daily email, Money Morning, to receive intelligent investment advice every weekday. Sign up to Money Morning.
And hedge fund manager Hugh Hendry from Eclectica points out that all this cost-cutting is going to make life harder for companies in the long run. By firing people, they are decimating their own customer base. “American unemployment is at a 26-year high of 9.4% and total nominal wage payments have fallen for the first time in at least 50 years… in their quest to contain costs (by firing the economy’s consumers), [companies] are suffering from a loss of revenue in future quarters.”
Another worrying trend is that it’s not just consumers who are desperately paying off debts – companies are doing exactly the same. A report on Bloomberg this morning points out that “almost two years into the worst financial calamity since the 1930s, companies are doing everything they can to reduce their indebtedness, selling record amounts of equity to pay back bonds and loans.”
They’ve been taking advantage of the big rally to dilute existing shareholders in order to repay their creditors. But if companies are focusing on paying debts, it means that money isn’t being invested in growth.
This is among the reasons, according to Japan expert Richard Koo, that Japan suffered its ‘lost decade’ (or decades, now) – it suffered a ‘balance sheet recession’, whereby companies “devote most of their resources to paying off their debts, even when interest rates are near zero”. That sounds worryingly familiar.
So what does all this mean? We suspect that in the long run, strong inflation is the most likely outcome. When it can get away with it, the Federal Reserve seems hell-bent on avoiding a Japan scenario, even if that involves putting the dollar at risk.
But in the nearer term, recessionary forces remain very strong. Home loan rates in both the US and the UK are rising, which makes life tougher for consumers, as do rising oil and petrol prices. These might bump up the inflation statistics, but at the same time they take money out of consumers’ pockets and set us up for a harder fall in the future.
Why types of stocks should you buy now?
In short, the economy and the markets are likely to have a relapse before too long. We’d still avoid government bonds, as we just don’t think they’re worth the risk – the market is too easily disrupted by whatever the central bank has to say that day. What we do like is big defensive blue-chips, that already have solid balance sheets and don’t have to fret too much about paying off debt or issuing new shares, and pay sustainable dividends. You can read more about decent defensive stocks in my colleague David Stevenson’s recent Money Morning on the topic: Six recession-beating stocks that still look good.
Our recommended article for today
Is transparent fund management possible?
If flat fees for fund management can’t – or won’t – be made to work, then the industry should operate on the basis of absolute transparency, says Merryn Somerset Webb.