Last week, the official recession dating committee, the National Bureau of Economic Research, announced that the recession was officially over in June 2009. This was not surprising to most market participants. In fact, the LPL Financial Current Conditions Index reflected at that time a move from contraction to growth. However, the question today that most investors want to see addressed is: will the economy slip back into recession? On that note, the Federal Reserve's message last week implied the Fed was preparing to take action to help ensure the economy avoids a return to recession.
In a surprisingly transparent statement made last week, the Fed told us that inflation is so low they are not doing enough to promote growth. Specifically, the Fed stated, "Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability."
The Fed balances employment and prices by seeking growth that generates the highest level of employment without causing too much price inflation. The Fed has spent much of the past 30 years determining when to attempt to slow down an economy that is growing too rapidly in order to avoid the destructive effects of high inflation. However, when inflation gets too low, as the Fed has noted it currently is, with inflation at less than 1% over the past year, it is a sign that growth needs a boost.
The Fed typically acts as a counterweight to Congress' inflationary spending impulses, but the Fed has communicated its view that inflation is too low. With Congress unlikely to pass another substantial spending package, the Fed is likely to take action.
Deflation Defined
If inflation is a bad thing, then how can inflation be too low? Inflation results when too much money is chasing too few goods and
services. This results in higher prices and usually happens when demand is strong but output is constrained in the form of shortages of materials or capacity. Deflation, or falling prices, is the opposite of inflation and generally occurs when the supply of goods rises faster than the supply of money. he problem with deflation is that when prices fall as output exceeds emand it can become self-perpetuating as consumers and businesses ostpone spending because they believe prices will fall further. Consumers and businesses delay buying expensive items like homes or cars because they believe these things will be cheaper in the future. As a result, spending and economic growth slows, but it does not stop there. Businesses' profits weaken, straining their ability to pay their debts and leading them to cut production and workers. This, in turn, results in lower demand for goods which leads to even lower prices as a destructive downward spiral takes root.
From Deflation To Reflation
To combat fears of a downward spiral of deflation the Fed is preparing a reflation strategy. Typically, the Fed lowers the cost of money, or interest rates, when they want to promote growth. But with the Fed having already lowered rates effectively to zero, they intend to increase the supply of money by buying bonds in the market.
The Fed will likely be engaging in quantitative easing which means they will expand the supply of money in the financial system in an effort to encourage lending and economic growth. This can counter deflationary fears by directly inflating the money supply. All else equal, this means that with more dollars in the system, the value of the dollar goes down and prices in dollar terms go up, resulting in a faster pace of inflation.
The Fed took a small step in the direction of providing more stimulus at their August 10 meeting when they committed to increasing the quantity of money in the financial system by purchasing Treasuries as the housing debt they hold matures. Last week, at their September 21 meeting, the Fed paved the way for another much larger quantitative easing at an upcoming meeting later this year. The Fed may introduce a $1 trillion Treasury purchase program at their next meeting, on November 3.
Investing For Reflation
Incorporating the theme of reflation into your portfolio may be beneficial. Key positive effects of reflation are likely to be seen in precious metals, commodities, commodity-sensitive stocks, Emerging Markets, real estate, and Treasuries. The dollar and the Financial sector may be negatively impacted.
Precious metals: Gold may be the most obvious beneficiary of the Fed's intentions. Inflation and a falling dollar tend to lift gold investment demand as a way to preserve value. Gold prices made new all time highs last week. This trend can continue as the dollar falls and inflation picks up.
Commodities: Commodity prices-including, cotton, copper, and corn, just to name a few-may also benefit from the outlook for reflation and dollar depreciation. Industrial and agricultural commodities posted gains on the week. The potency of the reflation theme as it related to commodities can be seen in crude oil. Crude prices were up on the week despite the report of near record-breaking U.S. inventories.
Commodity-Sensitive Stocks: The Fed's intention to avoid a return to recession and the potential for another liquidity-fueled rally like that of 2009 argue in favor of stock market performance. On the other hand, investment banks may benefit from the additional credit to fuel profitable merger and acquisition deals and more bond underwriting as businesses look to refinance at lower rates. Nevertheless, since the Fed announcement, Financials have been the worst performing sector - the only sector to suffer losses.
Longer-Term Impact
While the near-term impacts of Operation Reflation are reasonably clear, the longer-term effects are not. Unlike during the financial crisis when liquidity was scarce, the benefits of adding more cash into the financial system on growth and employment may be very limited in the current environment given the already high cash balances at banks and corporations. In addition, U.S. stimulus cash may wind up fueling Emerging Market growth as U.S. companies deploy the cheap cash to fuel growth in markets with lower labor costs and stronger demand. The Fed also risks undermining the lower interest rates that are essential to growth by devaluing the dollar making U.S. Treasury bonds less attractive to the foreign investors that we are increasingly dependent upon to fund our national debt.
We are cautious on the longer-term economic growth impact of another round of stimulus. However, we do not believe a return to recession is the most likely outcome and believe that the economy will muddle through with below-average growth in the coming quarters. In the near-term, Operation Reflation provides us with an investment theme. And finally, though we expect near-term weakness in the stock market, the timing of the mid-term elections on November 2 and the Fed's next meeting on November 3 could help to fuel a year-end rally for stocks.
This week is light on data until Friday when the closely-watched ISM index, a barometer of the manufacturing sector of the U.S. economy, is released. But it is not until the following week that the market-moving U.S. monthly job report is released and start of the third quarter earnings season gets underway. The absence of much new news this week that would refute the pending Fed action leaves the reflation theme that was established last week to continue to unfold.
Jeffrey Kleintop, CFA, is chief market strategist for LPL Financial.