Tuesday, May 28, 2019
Inflation or Deflation - Who Will Win?
Source: Observations from the Executive SuiteBy Jeff Kramer, Managing Director, NRC Realty & Capital Advisors
There are contradictory inflationary and deflationary forces in play right now. Why is this important to me as a convenience store owner/operator? For one, it has a large impact on our main costs, such as fuel, store items, labor, occupancy costs, and interest rates. Also, it can impact our net worth, since it affects land and building valuations and overall business value, often reflected in stock market valuations and what private companies know as ‘Goodwill’. Goodwill values go up in a strong economy and down in a soft economy, as reflected in the price ‘multiple’ companies are willing to pay. A soft economy is often accompanied by tighter lending standards, when combined property and business values converge more with ‘appraised values’, making it more difficult to finance acquisitions or construction with debt.
Governments must monitor inflationary and deflationary trends, because certain policies can impact both and ultimately, the economy. Monetary policy is important and influential over time, but rarely a cure all by itself. Too strong an inflation can often be controlled by raising interest rates. While painful, inflation can usually be more easily controlled than deflation. The reason is that if deflation becomes a mindset of the public and business as prices remain stable or fall, it is often easy to delay purchases. This is true for housing, cars, computers, etc. Reducing interest rates does help spur demand, but once the deflationary mindset is there, it can be slow to reverse. Think of Japan. Were it not for exports, they would have had negative or no growth for over the last 25 years, because they have an aging population that saves rather than spends, and even 0% interest rates cannot encourage them to borrow.
So, where is the World today, and in particular, the U.S? Here are my thoughts on the most impactful inflationary and deflationary trends. Then I’ll tell you my overall feeling, and then you can decide for yourself.
Higher wage costs and worker ‘shortages’ get a lot of Press today. So far, in the U.S. at least, there is labor tightness, but it seems more not having the right workers trained for certain jobs, or having available jobs today’s workforce does not want. In the U.S., manufacturing represents only 11% of our economy, so clearly labor intensive service businesses are more important as labor costs increase, which they are!
Monetary policies are generally quite expansive worldwide, including the U.S. Interest rates are low and funds for lending have been quite plentiful. Luckily, the U.S. banking system is on more solid ground financially than most countries and they can continue to lend to good credits.
Government spending is growing again, increasing many Government budget deficits, yet interest rates have stayed low. Amazing. In the U.S., both political parties are talking about increasing infrastructure expenditures, further increasing the deficit.
China and India have huge populations that have a growing, wealthier Middle Class, that boost demand for resources and goods that are often not made locally. They are continuing to create expansionary policies. Emerging country economies are trying as well, but have been slowed by strength in the U.S. Dollar, since they usually borrow and must repay in Dollars while their local currencies depreciate.
Land is getting harder to find and more expensive, particularly in the cities where millennials want to live and retail wants to follow. Even some internet companies like Amazon see some value in ‘brick and mortar’ investments.
In some cases, these unusually low interest rates reflect slowing economies and a lack of investment opportunities, even in the U.S. Stay tuned.
After 10 years of growth since ‘The Great Recession’, we may be getting closer to the end of this cycle, when it is often more difficult to pass through price increases as competition increases for the consumer’s dollar and company profits fall. Many consumers have already bought their dream house, or dream car, at least until there is a technical breakthrough like on electric or automated cars, or a 5G phone.
Normally, a country’s economic growth over time equals its rise in the work force plus the growth in productivity. The U.S. population growth is limited to about 1% as it is restricted by immigration policies and aging demographics. Interestingly, the U.S. productivity rate has just recently jumped to 2% in Q1 2019. This helps our growth and competitiveness in world markets, although it helps keep a lid on inflation as well. The U.S. business capital spending rate is not growing just now, but maybe the existing spending is now showing up in productivity, or was this productivity increase just a ‘blip’? Stay tuned.
Technology does wonders to keep prices in check. Look at how horizontal drilling and technology have minimized our dependence on foreign oil. So much so, that Russia has even had to attempt to control oil prices by supposedly coordinating with the Saudis and OPEC. They are doomed with these efforts if countries keep finding more oil at today’s prices, or if demand slows from slowing economies, especially in China and India. In fact, overall, commodity prices have been soft, even despite political attempts that normally boost them through import tariffs, like on steel, aluminum, and grains. The internet and it’s incredible innovation and creativity has certainly helped keep inflation in check. Unfortunately, now, huge amounts of money must be spent on critical cybersecurity.
Overall, the U.S. economy remains stronger than most of the World, which keeps the U.S. Dollar strong. This is also in part because our interest rates, while down, are still much higher than other high quality long term rates, as the U.S. Ten Year Treasury rate remains at 2.3%, compared to negative similar rates for Germany and Japan. Indeed, the World currently supposedly has over $10 trillion in mostly Sovereign debt with negative interest rates!! By definition, that is deflationary, as eventually there are limits as to how much can be borrowed, especially at a low rate. In fact, the U.S. Treasury Yield ‘Spread’, which is measured in various ways, recently turned negative supporting a slowing economy and maybe eventually lower rates.
World pollution is a very serious issue, and could have the impact of stifling growth, especially in China and India, two of the major growing World economies still spewing excessive CO2.
Right now, our Government authorities are uncertain about policy, because the measure of ‘core inflation’, which excludes food and energy, has been hanging under the 2% target set as ‘desirable’ by many economists. It has been about 1.6%, but is slowly and steadily dropping. Tariffs are certainly temporarily inflationary IF they can be passed through, but overall tariffs are deflationary because they slow world trade, and increases in World trade have consistently led economic growth since World War II. Profits are uncertain in all this, but important too as our largest companies are International.
Where do you stand on the inflation-deflation question? I am leaning on the deflationary side although we might get an inflationary spurt first. And, of course, what will Governments do to fight the dreaded deflation as long as possible? Politics will play a large role too.
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