By Alistair Barr, MarketWatch
Last update: 3:00 a.m. EST Feb. 13, 2009
SAN FRANCISCO (MarketWatch) -- As 2009 began, U.S. dairy farmers slaughtered more than 70,000 cows in one week to fight slumping prices. Herds are being culled at the fastest rate in almost two decades as the recession withers away consumers' demand for everything from frothy cappuccinos at Starbucks In January alone, milk and cheese prices plunged by at least one-third. The price of milk at wholesale fell significantly in January, leading some dairy farmers to make tough cost-cutting decisions -- like thinning the herds.Similarly painful adjustments are playing out around the world as companies try to slash production and cut jobs in the face of falling demand and waning pricing power.The problem is that, as more companies hunker down, demand may weaken further, spurring another wave of downward pressure on prices that would usher in a prolonged period of deflation.
"The combination of credit-crunch deflation and recession is forcing companies to conserve cash by firing workers and slashing capital spending," said investment strategist Ed Yardeni. "That should work for one company, but when they all do it, it just exacerbates the situation by cutting demand all over again." Many investors believe that a lengthy bout of deflation is unlikely. But if consumer prices do indeed fall for a long time, the result is likely to be a disaster for much of the stock market, investment professionals say.
No global macro hedge funds were bullish on U.S. equities, according to a survey in early February by consulting firm Greenwich Associates. That was down from 46% in January and 62% in December. The lowest level of interest in U.S. stocks before that was 8% in October 2007, just before the Standard & Poor's 500 index began a 45% slump."It's not a question of if. Deflation is upon us," said John Brynjolfsson, chief investment officer at Armored Wolf LLC, a global macro hedge fund in Aliso Viejo, Calif. "It's a question of how bad it will get." Steven Bell, a former Deutsche Bank economist who runs a global macro hedge fund at London-based GLC Ltd., has been betting against, European and Japanese stocks, while buying two-year German government bonds. "Deflation is a serious threat," he said. "You have to say that all companies would lose in such an environment, but some would lose less than others."
When Japan suffered its most severe bout of deflation, from October 2000 through January 2003, only one sector of the nation's stock market -- electric power and gas shares -- posted gains, according to Morgan Stanley. Shares of non-ferrous metals producers, communications, banks and services companies dropped more than 60% during the period.And there's a worrying difference between Japan's experience and the current predicament of the U.S.: The Japanese had lots of savings when the country descended into its deflationary recession, but U.S. consumers are now mired in debt. "The societal effects were not nearly as dramatic as we're experiencing now in the U.S.," said Brian McAuley, chief investment officer at Sitka Pacific Capital Management LLC. "People had much more to fall back on in Japan, while our consumption is falling dramatically."The consumer price index fell 1% in October, the most since the Bureau of Labor Statistics began publishing seasonally adjusted prices in 1947. The CPI slumped 1.7% in November, another record, and 0.7% in December. Morgan Stanley estimates that by July, U.S. consumer prices will have fallen 3% from a year earlier. Merrill Lynch sees the CPI down by the same amount by the third quarter.
Once falling prices form a trend, it's difficult to reverse, partly because consumers are encouraged to save rather than buy. That dents demand and sales, potentially inflating companies' inventories and triggering more discounts. "Potential buyers realize that they can negotiate even lower prices simply by waiting," Brynjolfsson said. Fixed debt payments get larger in real terms, which means any credit problems impacting the financial system only get worse, he added. Sitka's McAuley said Wal-Mart may benefit as shoppers become thriftier. Meanwhile, fast-food giant McDonald's has remained resilient in recent months."Companies that provide consumers with the opportunity to save some money and still get fairly good service and products may do OK," Yardeni said. Even so, Yardeni and McAuley warn, if deflation lingers for a long time, there would be few such examples for investors to consider.
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