Two of the most commonly held beliefs of recent years are:

1. The US has experienced a period of low inflation
   
   
2. The countries of South East Asia have experienced a period of deflation. However, these widely accepted truisms could not be further from the truth.
   
   

Inflation and deflation are monetary phenomena. When the supply of money increases it often results in higher prices for goods and services, but not always. External factors, such as plummeting imported-goods prices and currency exchange-rate changes, can suppress the commonly watched indicators of the general price level. Such has been the case in the US over the past few years, where tame producer and consumer price data have encouraged the Fed to maintain nominal interest rates at unrealistically low levels. In fact, with the money supply growth rate having been greater than the 10-year government bond rate for the past 3 years, the US has enjoyed a long period of negative real interest rates.

It is OK to be bullish on the long-term prospects for stock prices, but let's not kid ourselves into thinking that the driving force behind the highly priced stocks of today has been exceptional earnings growth or low inflation or strong real economic expansion. Let us, instead, recognise that US stocks have been driven to their highest levels in history by a dramatic increase in the supply of money and credit in parallel with consumer/producer price stability due to external factors. Put another way, stocks have been powered by high US inflation, the devaluation of other currencies against the US Dollar, and excess capacity throughout the non-US world.

There is now mounting evidence, however, that the situation is changing. Firstly, continuation of the negative real interest rate environment requires not only a confused and complacent Federal Reserve, but also a contingent of domestic and foreign creditors willing to lend money at rates of interest that are below the true inflation rate. The upward trend in US interest rates since October 1998 and the recent weakness of the Dollar versus the Yen warn that the official US inflation numbers are starting to be treated with the contempt they deserve. Secondly, even the new era types must be grimacing at some of the economic data released over the past few months. For example, we've seen large increases in durable goods orders, we've learnt that the NAPM price index has reached its highest level since 1995, we know that labour costs are increasing and that the labour market continues to tighten, and we've learnt that crude-goods prices are surging. We also know that commodity prices are trending higher. At the same time we see that the core CPI shows minimal increases in the prices of goods and services.

If we assume that the CPI is painting an accurate picture (a stretch, I know, but let's run with it), then companies are absorbing higher labour and materials costs. In other words, increases in costs are not being passed on to consumers, a situation that must put downward pressure on profits.

This is the way it works in the real world – investors pay very high multiples of earnings for companies that have very high earnings growth rates. When profit growth slows, multiples must be adjusted downwards. This is the core problem for the stocks that have driven the major US stock market averages over the past 18 months.

In the short-term the US stock market has two enormous problems. Firstly, even if the Fed is cooperative on the interest rate front and continues to provide adequate liquidity to support the market, market participants are likely to demand higher rates of return to account for the on-going Dollar depreciation. Secondly and more importantly, it looks like we are heading for an earnings growth slowdown late this year and early next year. Although this will probably be a temporary setback prior to strong growth in the second half of next year, no deceleration of earnings momentum has yet been factored into stock prices. An excellent description of the earnings problems lying ahead for technology companies was provided by Fred Hickey in the September 3rd edition of The High Tech Strategist, which can be found at the following site: http://www.siliconinvestor.com/insight/contrarian/link.html

Even though we haven't started seeing any earnings downgrades or disappointments as yet and despite the positive spin placed on some of the recently released economic numbers, the stock market action over the past few weeks has been decidedly negative. Rallies have become weaker and have failed at lower levels. This is a market that currently has major downside risk.

Milhouse
Hong Kong
20 September 1999

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