Liz Ann Sonders
Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
August 2, 2010

Although the fears about inflation have unquestionably subsided, I'm still surprised how often I get questions about its perceived inevitability … regardless of any actual evidence that it's here or near.

Deflation, a scarier prospect, frankly, than even hyper-inflation, has emerged as a key worry. It may help to explain the market's bouts with indigestion this year, as well as valuations that are not keeping pace with stellar earnings growth.

Fortunately, deflation is fairly rare, and is typically associated with a Depression-like plunge in demand of all stripes. Prices not only fall during deflationary periods but, typically, so do asset prices and incomes. In response, interest rates tend to fall to rock-bottom levels, which on the surface may seem like a good thing.

But here's the rub: Even though the Federal Reserve has typically lowered rates aggressively, the cost of servicing debt for many remains elevated given that the plunge in asset prices disallows refinancings. Does this all sound familiar?

Inflation fears plummet
As you can see in the chart below, inflation expectations, as measured by the yield on five-year Treasury Inflation-Protected Securities (TIPS), have plummeted from the peak in late-2008 when inflation fears were full-blown thanks to the Fed's stimulus.

Low inflation expectations
 
Click to enlarge
Source: FactSet and Federal Reserve, as of July 29, 2010.

TIPS' yields are clearly not negative, but for some they're too close for comfort.

Why buy/invest now?
Deflation halts every variety of activity as consumers, business and investors go into postpone mode due to the expectation that prices/costs will be lower in the future—that's why it's so toxic to economic growth. Add to that rates typically already at rock-bottom levels, and the Fed is left in a bind without its traditional policy lever to pull.

Before I go further, let me note that we do not think we're entering a deflationary period that will at all resemble the Great Depression era. In 1932, US consumer prices fell 10%, and between 1929 and 1933, they fell a whopping 27% overall. The bigger risk (albeit still small in our opinion) is that we encroach on a Japanese scenario. Consumer prices in Japan have been falling for more than 15 years, but never more than 2% a year.

Double-dip recession fears subsiding
I think deflation fears will begin to subside as double-dip recession fears also subside. The latest readings on the economy were largely better than expectations, with some good news even found in the latest gross domestic product (GDP) report for the second quarter.

Although revisions showed that the recession was deeper than originally thought, the income and savings numbers were both revised higher. Given low inflation, consumers can manage to maintain their consumption and use the inflation-adjusted difference to increase their savings rate, which includes much-needed debt reduction.

In addition, this week's readings on US manufacturing and construction spending were also ahead of expectations, while initial unemployment claims have restarted their descent after a flat period that had some negative census-related biases.

When Fed heads speak …
Deflation fears were stoked recently when James Bullard, the president of the Federal Reserve Bank of St. Louis, warned that the Fed's current policies were putting the US economy at risk of becoming "enmeshed in a Japanese-style deflationary outcome within the next several years." For those of you who are inflation hawks, you can no longer count Bullard in your camp.

Bullard appears to have joined the ranks of three other influential regional Fed heads: Eric Rosengren of Boston, Janet Yellen of San Francisco (nominated by President Obama to be vice chair of the Fed) and William Dudley of New York. All three are sympathetic to the view that the damage from long-term unemployment and the threat of deflation are among the greatest challenges facing the economy.

But two additional Fed heads probably said it best (OK, I say that because their comments support our case). Charles Plosser, president of the Philadelphia Fed said recently in an interview: "I think the fear of deflation in and of itself is probably overblown." He said that inflation expectations were "well-anchored" and noted that $1 trillion in bank reserves was sitting at the Fed. "It's hard to imagine with that much money sitting around you would have a prolonged period of deflation."

Richard Fisher, president of the Dallas Fed also said in a recent interview: "Reasonable people can argue that there's a risk of deflation, but we haven't seen it in the numbers yet."

Weak money multiplier = low inflation risk
The bottom line is that the Fed has pumped $2 trillion into the financial system via its purchases of government debt and mortgage bonds, while lowering interest rates to the floor.

To make those purchases, the Fed essentially printed money (the $1 trillion in reserves). If—and it's a big if—those reserves were lent out quickly, the money supply would increase rapidly and generate inflation. But as we've noted incessantly, bank lending has continued to contract and the velocity of money (or the money multiplier) remains extremely low.

As Rosengren of the Boston Fed notes, "… The creation of reserves, in and of themselves, isn't going to become inflationary and shouldn't affect inflation expectations, unless you see a banking system that is growing rapidly and starting to increase lending." Lending remains key to watch to see if deflation risk (now) becomes inflation risk (later)—a view that many share.

I will be on vacation next week when the Fed meets (Brad Sorensen will write our Fed commentary in my stead); but a top agenda item is likely to be whether the Fed should consider more new and untested actions to support the economy. The "extended period" phrase attached to the Fed's 0% interest rate policy is unlikely to change, but we will be looking for other more subtle indications of the Fed's plans.

For what it's worth, I continue to have a more optimistic view on the economy than the consensus and if that translates to improving jobs numbers—especially if deflation risks subside and inflation concerns kick back in, that could mean we face the prospect of the Fed easing off the gas pedal sooner than is presently anticipated. We remain in the camp that believes an environment that justifies a zero interest rate policy in perpetuity is not good!

Which "flation" is it?
What is unique today, and stoking the debate, is the bifurcation globally in terms of inflation/deflation.

Rapid economic growth has driven up price and asset inflation in China, India, Brazil and other emerging economies. These are regions with relatively low incomes and high and rising rates of inflation.

Then there's the other side of the story—places like the United States, Western Europe, Japan and Australia, which have slower economic growth, higher incomes and lower inflation rates.

Inflation/deflation and markets
The threat of deflation here in the United States has had important implications for stock market action and I'll highlight a few of my most tried-and-true charts supporting the relationship between inflation/deflation and the market.

The second bar in the chart, "Stocks hate severe deflation, but love mild deflation," shows that the zone of "flation" the stock market most favors is actually mild deflation. But the zone that stocks detest is just to its left—the "severe" deflation zone.

As you can see by the numbers in parentheses above/below each bar, which show how many periods we were in each zone, most of history (since 1926) has been spent in the low inflation zones, where we sit presently. But, it's fear of the toxic form of deflation that characterized the Great Depression that has caused some hiccups for the market this year.

Stocks hate severe deflation, but love mild deflation

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Source: The Leuthold Group, as of June 30, 2010. Dotted line shows average total return.

Inflation, or lack thereof, can also impact valuation. For the same reason a dollar of earnings you and I make is worth more to us when inflation is low, corporate earnings are worth more when inflation is low. But when inflation gets too low or disappears altogether, valuations also suffer as you can see in the table below that I've highlighted many times.

Valuations love low inflation

Inflation vs. valuation
Inflation	Average P/E	Peak P/E	Trough P/E
< 0%	12.6	17.1	9.3
0 - 1%	14.5	22.5	9.2
1 - 2%	19.8	32.6	9.2
2 - 3%	20.5	35.1	9.7
3 - 4%	18.7	34.4	9.7
4 - 5%	16.8	22.4	9.6
5 - 6%	15.9	19.8	7.4
6 - 7%	12.2	18.1	7.7
> 7%	11.9	19.1	7.9

Source: Department of Labor, FactSet and The Leuthold Group, as of June 30, 2010.

Although we are presently in one of the sweet spots for valuation, it's probably fear of deflation that has kept current P/Es generally quite low relative to history.

Finally, deflation fears have wrought another unique market phenomenon. We're taught the traditional relationship between bond yields and stock prices: when bond yields are rising, stock prices are typically falling and vice versa. Today, however, the correlation between the two has risen to lofty heights. In other words, lately, falling yields have been met with falling stock prices and vice versa.

Correlation between bond yields and stocks way up

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Source: FactSet and The Leuthold Group, as of July 30, 2010.

As you can see in the chart, "Correlation between bond yields and stocks way up," this high correlation has only two historical precedents—both periods during which deflation was either a reality or at least a fear. In these environments, like today, falling yields send a deflationary message, a message distasteful to stocks.

However, when yields are rising (typically from a low level), it sends a message that deflation is less a risk, a message more tasteful to stocks. In this environment, rising yields can also signal economic growth traction, also tasteful to stocks.

Today's reality is low inflation but perceptions about deflation have wreaked some havoc on markets. The latest rally may be based on a combination of waning deflation risk and decreased likelihood of a double-dip recession.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative (or "informational") purposes only and not intended to be reflective of results you can expect to achieve.