The Fear of Deflation
Is Latest Jitter on Street
By GREG IP
Staff Reporter of THE WALL STREET
Bull markets usually end with inflation. Investors seem to worry this
one will end with deflation.
After several days of calm, foreign turmoil slammed into the U.S.
markets again Friday. A 4.2% drop in Japanese stocks and a 6.4% plunge in
Brazil sent the Dow Jones Industrial Average tumbling Friday as many as
195.48 points before recovering to close down 101.92 points at 7581.32,
though up 139.24 on the week.
The Dow Jones industrials now stand 134.09 points below where they were
before the Bloody Monday plunge of two weeks ago Monday.
Almost ignored in Friday's chaotic trading was a jobs report that on its
own would ordinarily have routed the market: The unemployment rate dropped
to a 24-year low of 4.7% in October, far more jobs than expected were
created, and wage growth jumped. Such a report indicates rising
inflationary pressure and would ordinarily increase the likelihood that the
Federal Reserve would raise interest rates. Yet bond prices, after selling
off initially, were little changed on the day, with the yield finishing at
6.15%. Analysts said such a report would normally have produced a much
bigger rise in yields, but a "flight to quality" from stocks held them
"The fear of deflation is gaining momentum over the fear of inflation,"
says Scott Slayton, equity-derivatives strategist at Morgan Stanley Dean
It's not that people think rising wage growth is good for stocks. It's
just that when you combine that with the Asian currency devaluations and
softer overseas demand, which make it even harder to raise prices,
inflation may be contained but profit margins could be squeezed.
Investors "are trying to factor in the profit impact of more-massive
spreading deflationary pressure," says Jim Paulsen, chief investment
officer of Norwest Investment Management & Trust. The overseas turmoil
will hurt profits by increasing price competition and reducing sales, he
says. While postwar bull markets have typically ended with rising inflation
and interest rates, "this is nothing like the postwar period. In fact, very
little about this decade has been like the postwar period. We couldn't even
get inflation to rise in this recovery."
It's still a minority view that stocks are more at risk from falling
rather than rising prices. Indeed, a central-bank interest-rate increase in
Britain and a jump in oil prices on renewed tensions in Iraq last week show
that inflationary threats can pop up in many places.
But at present, stock investors are reacting more to the threat that
economic and profit growth will be derailed by Asia's troubles.
Instruments, whose prices and sales are perceived as vulnerable to
Asia's troubles, has become a bellwether of this trend, notes Dan
Mathisson, head of stock trading at D.E. Shaw Securities. It tumbled Friday
4 3/4 to 112 3/4 . And other stocks are being clocked because of price and
margin pressure. Computer disk-drive maker
Digital plunged 6 5/8 to 23 5/8 on Friday after it said
second-quarter results would be much less than analysts' estimates because
of "significantly higher-than-normal competitive pricing pressures."
Gerard MacDonell, a financial-markets analyst at the Bank Credit Analyst
Research Group in Montreal, says, "The history of the 1970s and 1980s has
been one huge Fed policy shock followed by another, so we're inclined to
interpret everything as a Fed policy shock." But he says the threats appear
to lie elsewhere this time. BCA research shows that the annual increase in
wages has risen to 3.9% in the three months ended in October from 2.5% at
the beginning of 1994, while the annual increase in consumer prices has
fallen to 1.9% from 2.3% over the same period.
Says Mr. MacDonell: "You have upward pressure on costs from the labor
market, and at the same time the reason we're not getting higher inflation
is there's a ceiling on selling prices set by the strong dollar and Asian
shock. Directionally, this is a no-brainer: This is definitely negative for
margins. The question is the magnitude."
Until recently, what was viewed as good for bonds was good for stocks,
because softer growth implied lower inflation, lower interest rates and
thus higher valuations for stocks. But Mr. MacDonell says with inflation
already so low, the perceived benefits of additional declines ebb away.
But Rosanne Cahn, chief equity economist at Credit Suisse First Boston,
is more sanguine about profits. Quarterly surveys of her firm's analysts
have found that for the past year a minority of industries they follow are
able to raise prices but a majority face rising wages. "Yet profitability
is terrific. The answer that squares that is the productivity element:
[Companies] are hiring less rapidly than their output is going up. And
that's all still in place. If anything, those efforts will now be
Ms. Cahn says as inflation drops, it's natural that more and more
individual items will actually have price drops. But that doesn't
necessarily bring deflation. The 1950s were marked by stable producer
prices, two big steel strikes, two serious recessions, the Korean War and
routine drops in individual prices, "yet it never tipped into deflation or
depression." Stocks performed "fabulously," with an average annual 13%
capital gain for 10 years.
Christine Callies, stock strategist at CSFB, also doubts that the
historic pattern of bull markets ending with rising inflation and interest
rates is about to change. "The stock market usually runs into difficulty on
the shoals of data that can move quickly or dramatically," such as interest
rates. "Profit margins change slowly over time, particularly in an extended
Still, with pricing pressure in abundance, Mr. Slayton says investors
should go after companies that can raise prices. There aren't many; Mr.
Slayton counts just seven of 50 sectors with the ability to raise prices
materially. Among his favorites are oil-field service stocks, airlines and
upscale hotels. Indeed, while the Dow Jones industrials are 9.2% below
their Aug. 6 high, the Philadelphia Stock Exchange's oil-service index has
since risen 22% while the American Stock Exchange's airline index is up
12%. "You want to be exposed to domestic, not foreign, situations," he
adds, such as
Airways Group, rather than
Airlines, which have a greater reliance on Asian business.
Friday's Market Activity
The Dow Jones Industrial Average tumbled 101.92, shedding 1.33%, to
close at 7581.32. It marked the fourth time in the past two weeks the
average posted a three-digit loss for a session, and the 11th time since
the market reached its current high of 8259.31 on Aug. 6.
gained 3 15/16 to 77 7/16 on Nasdaq. The company conducted its semiannual
meeting with analysts, at which it stuck to its previous outlook for
Digital's tumble hurt stocks in the disk-drive sector, with
falling 1 15/16 to 19 3/16 on Nasdaq,
Technology losing 7/16 to 26,
Magnetics falling 2 1/4 to 21 3/8, and
shedding 2 5/32 to 25 7/8 on Nasdaq.
The broader technology sector suffered its own slowdown, with
Technology surrendering 1 9/16 to 26 1/4 on the Big Board.
dropped 5 3/8 to 30 3/16, while
tumbled 2 13/16 to 38 1/8, hurt by a downgrade by Robertson Stephens, and
Systems declined 1 1/8 to 83 9/16, all on Nasdaq.
Broadcasting moved ahead 1 7/8 to 75 1/8 on Nasdaq, extending the
rise that began Thursday when the company reported third-quarter earnings
and declared a 2-for-1 stock split.
International added 1 3/16 to 65 7/8 . The company, which makes
drilling equipment, said late Thursday it would split its stock on a
Parking climbed 5 1/4 to 60 3/4 . The parking services concern
agreed to acquire Kinney System, a parking facilities operator, for about
$206 million in cash and stock.
added 11/16 to 80 5/16.
Lodging Trust confirmed that it sweetened its bid for the hotel
and gaming concern, the latest move in the takeover battle.
Hotels, a bidder for ITT, slipped 1/8 to 31 1/2, while Starwood
lost 1 to 57 13/16.
Fred Meyer rose 1 3/16 to 32 3/16. The supermarket chain said it will
Food Centers, paying $1.7 billion, and closely held Ralphs Grocery
for $3.1 billion. Quality Food shot up 6 7/8 to 58 1/2 .
West Group fell 2 3/16 to 33 1/2 . Merrill Lynch lowered its
rating on the footwear maker.
-- Robert O'Brien
Copyright © 1997 Dow Jones & Company, Inc. All Rights Reserved.