The economy continues to slow down.  While there were some positive reports over the last month, the overall economic outlook is not good.  The Index of Leading Economic Indicators fell for the fourth consecutive month in September, and manufacturing activity declined after eight positive months in a row.  The economy should stay in slightly positive territory through the end of the year, but the odds of falling back into a mild recession have certainly increased.

The Bank Credit Analyst now predicts that the US economy will fall into a mildly deflationary period for the next year or perhaps longer.  The BCA editors caution that the Fed has fallen behind the curve in fighting deflationary forces, and that interest rates must be cut even further in order to keep deflation from becoming more serious.  In this issue, Iexamine BCA’s latest forecast and what it means for your investments.

The stock markets continue under pressure.  The slowing economy, weaker than expected corporate profits and fears about a war with Iraq have sent the broad indexes to four-year lows.  With the markets so severely oversold, a bottom could come at any time.  However, it is also possible that  the downturn will continue.  This is why it is so important to have most of your equity investments in market-timing programs that can go to cash.

Bonds, especially Treasuries, are in a bubble that is ripe for bursting.  However, the flight to safety rush could continue.  Like stocks, the only way I would be in bonds now is in a market-timing program like Capital Growth Management that will go to cash if bond yields should start to spike upward.

This month, I have written a very important issue of Professional Investing .  In this issue, Ishare with you many of our proprietary due diligence procedures that we use when evaluating money managers, mutual funds and investment programs in general.  This is a Special Issue that you will want to keep for your permanent files.

If you are not reading my weekly F&T E-Letters, you are missing out on a lot of great information.  Check them out at www.profutures.com.

BCA’s Latest

For most of this year, BCA has held to a mildly optimistic forecast.  They expected the economy to slowly recover, which has been accurate until lately.  They expected corporate profits to slowly improve, and they expected equity prices to make a bottom and finish the year on a positive note.   Despite their mildly positive outlook, the editors continued to recommend a “below average” weighting in equities all year.  This was a good thing since equities have continued to fall.

Throughout the year BCA has cautioned that their forecast could be rendered too optimistic, due to several possible risk factors.  Most notably, the editors have been increasingly concerned that global deflation could catch hold in the US market.

Based on a combination of economic reports and the increasing threat of deflation in the US, the editors turned to a more negative forecast in their latest report.  They say:

“The economic and equity market picture has deteriorated further in the last month.  Most importantly, the news coming out of the corporate sector has been a litany of disappointing sales and profit numbers, with little promise of an early improvement.  Companies continue to retrench, leaving the economy increasingly dependent on the stretched consumer sector.  Meanwhile, deflation risks are rising, and stock prices are dangerously weak.”

The Index of Leading Economic Indicators (LEI) has now declined for four consecutive months.  This normally reliable indicator has led many analysts, including BCA, to revise their forecasts downward for the rest of the year.  The manufacturing industry turned down in September following eight consecutive up months.

While stopping short of predicting a return to recession, the BCA editors believe the economy will continue to slow down for the rest of the year.  How much remains to be seen.

Deflation Risks On The Rise

While the risk of falling back into a mild recession is not insignificant, BCAbelieves the greater concern now is deflation.  With the economy slowing down again, BCA predicts that the corporate sector will have to cut prices in the months ahead, and possibly resort to more layoffs as well.  This, in turn, will serve to further erode consumer confidence and spending, in which case companies could be forced to lower prices further.  BCA believes this cycle is already playing out in some sectors of the economy.

To many people, the term “deflation” conjures up images of the 1930s Great Depression or, more recently, Japan’s decade-long deflationary slump.  Yet there have also been periods when the economy performed well despite deflation.  Basically, there is good deflation and bad deflation.

An example of good deflation has been computer prices over the last 20 years.  As we all know, prices for smaller, faster and more powerful computers have declined throughout the last 20 years.  Yet computer manufacturers did well, generally speaking, until the tech bubble burst in 2000.

Currently, the US inflation rate is right at +1%.  If prices were to fall, on average, to a rate of -1%, that probably would not be a huge deal.  In this case, the economy could still begin to recover next year.  The problem is, if deflation begins to accelerate in an economy that is this highly indebted, there is the possibility that we could go into a deflationary spiral. 

“The U.S. economy is currently operating at almost 1% below its potential level, according to estimates by the Congressional Budget Office (CBO).  The CBO predicts potential GDP growth of around 2¾% a year in the next couple of years.  We doubt that real GDP will grow much faster than that, implying that there will still be an output gap in mid-2004.  On that basis, the level of the GDPdeflator could well start to decline during the next one or two years.  Even if the overall inflation rate manages to stay in positive territory, there will be deepening deflation in those parts of the economy that are most exposed to competitive pressure.” 

What BCA is saying is that many industries are producing and operating at a growth rate above 2¾% in GDP.  By doing so, they will be outpacing demand for their products which will result, most likely, in falling prices for their goods or services.  That, they believe, will bring the inflation rate down to zero, or more likely that we will fall into mild deflation over the next 1-2 years, and possibly longer as discussed below.

Why Deflation Is Bad For The Economy

Most people would welcome falling prices.  However, there are several reasons why deflation is bad for the economy, especially with public and private debt at such high levels.  First, if consumers expect prices to fall, they will delay spending.  This hasn’t happened yet because consumers still expect inflation to average around 3% in the next year according to surveys.

Second, wages don’t tend to fall as fast as prices.  If so, this means deflation will lead to falling profit margins.  This is already happening in several industries and the trend is expected to increase.

Third, deflation leads to a wealth transfer from debtors to creditors via a rise in the real value of the outstanding debt.  Deflation can cause declines in incomes and asset values, while the outstanding debt remains the same.  This could also lead to a decline in consumer spending.

Fourth, the Fed may run out of monetary policy options to head-off a deflationary cycle.  With interest rates already at such low levels, the Fed funds rate could go to zero if deflationary winds continue to blow. 

Fifth, once a deflationary cycle begins, it can accelerate very quickly, especially when consumers fully understand that it pays to delay spending as long as possible.  One has to look no further than the experience in Japan over the last decade.

BCAbelieves that the Fed is not taking the deflation threat seriously enough.  The BCA editors were very disappointed when the Fed did not move to lower rates at the recent FOMC meeting.  As a result, the BCAeditors called on the Fed to lower rates by a full 50 basis-points (½%) at its next meeting in November.   That remains to be seen.  Currently, the markets are expecting only a 25 basis-point cut next month.

Not Falling Behind In Fighting Deflation

The Fed released a major study in 1997 which warned, among other things, that the key to fighting deflation is not falling behind the curve in terms of monetary policy and liquidity.  In recent weeks, the Fed released another study on fighting deflation.  That study concluded that “when inflation and interest rates  have fallen close to zero, and the risk of deflation is high, stimulus - both monetary and fiscal - should go beyond the levels conventionally implied by baseline forecasts of future inflation and economic activity.”

Simply put, the Fed’s own studies caution that  both monetary and fiscal policies should be considerably more stimulative during periods when the deflation risks are high, as they are today.  As BCA says, “A key message from these two studies and others is that it is vital to prevent deflation from getting a hold.  Once deflation takes root in a heavily-indebted economy, it can be extremely difficult to reverse, as Japan found out.”

Are We Doomed To A Deflationary Cycle?

No.  While the BCA editors are concerned about the increasing risk of deflation, they are NOT predicting that the US will experience a Japan-style debt deflation.  Instead, their most likely scenario is that we will experience mild deflation for the next 1-2 years, after which time their long-term optimistic scenario will resume.  This assumes, of course, that the Fed acts aggressively in fighting growing deflationary pressures.

While BCA’s latest issue will appear to be very strident to some of their subscribers, I have seen BCA issue numerous serious warnings such as this over the years.  When they get concerned that US policymakers are about to make a serious mistake, they do not hesitate to voice a stern warning such as this.  I remember a similarly stern warning in 1980 regarding the potential for a banking crisis.  Another such warning came in 1997 when the Asian economies went into a crisis.  While the latest warning about deflation will almost certainly unnerve some of BCA’s subscribers, those of us who have read them for 20 years or more know that they are simply sending a message to the Fed that it needs to turn policy up a notch or two now, before deflation gains more momentum.

Home Prices May Be The Key

Home prices will play a key role in determining the deflation risk.  Home mortgages account for 70% of household debt.  One of the main reasons the economy has been positive this year is that home prices have continued to increase.  Home prices are up over 6% from year-ago levels.  This has contributed to consumer confidence and spending.

There are those, however, who believe the housing market is the next bubble to burst.  In the September  issue of Forecasts &Trends , I presented the findings of the most recent Harvard study on housing prices.   That study concluded that while prices might drop slightly in the next year or so, the demographics are such that housing prices should continue to rise for at least the next 20 years.  The Harvard study revealed that the number of US households will increase by over 22% in the next 20 years.  Based on these figures, the study concluded that while home prices might decline somewhat in the near-term, they will continue to rise over the long-term.

Conclusions

BCA’s latest forecast of deflation over the next 1-2 years could well prove to be correct.  However, this is no reason to assume a worst-case scenario.  There is currently no evidence that prices will fall into a downward spiral.   The Fed has made it very clear that it will  aggressively fight a deflationary trend.  If need be, I could even see Greenspan going to Congress and arguing for more stimulative fiscal policy.  Imagine the Fed chairman asking Congress to spend more money!

The reason that Japan has been mired in a deflationary spiral over the last decade is that its leadership did not stimulate their economy with monetary policy, lower rates and increased fiscal spending.  In fact, they did just the opposite.  Our leaders have learned much from the Japanese, in terms of how NOT to react to a deflationary threat.

Investment Implications

The textbook answer is that deflation will be bullish for bonds and bearish for stocks.  However, as of the end of September, the S&P 500 Index is down 46% from its peak.  Meanwhile, bonds are in a huge bull market, with long-term interest rates at 40-year lows.   All of this has occurred in the absence of deflation.  Should the economy slip into mild deflation, does this mean that stocks have much further to fall and bonds have much further to rise?  This is certainly the scenario that many deflationists are now arguing.

Does this mean we should sell (and/or short) stocks and load-up on bonds now?  I say no.  There is no certainty that we are headed for deflation.  As discussed above, the Fed will work aggressively to avoid deflation.  If for any reason deflation does not unfold, or if the economy happens to perk-up early next year, then both stocks and bonds could experience huge reversals.  It could happen.

With this much uncertainty, I continue to recommend that you use market-timing services for most of your investments in stocks and bonds.

A “Must Read” Newsletter

This month’s issue of Professional Investing is one of the most important and useful newsletters I have ever written.  Entitled “What Money Managers Won’t Tell You,” I share with you how to evaluate money managers, mutual funds and other investment programs.  I give you some “due diligence” tips that I have never made public before.  Be sure to read it!