Stocks fell yesterday on bad economic news mounting in China. Troubles in China’s real estate sector weighed on global economic fears and a report that Chinese consumer prices were actually falling, amplified concerns.
What is wrong with paying less? Have you ever wondered why the Fed has a +2% inflation target? Think about it. Go on. The Fed WANTS inflation to be +2%; it wants the prices you and I pay for… stuff to get more expensive every year by +2%. That’s not very fair, is it? Why doesn’t the Fed set its target for 0%? Or better yet, why doesn’t the Fed try to get prices to go down?
There is a lot of confusion about all this stuff lately. I recently wrote a piece about disinflation, reminding you that prices were not going lower, but hopefully, due to the Fed’s good work, prices will stop growing so fast. Remember, disinflation is when price growth slows. Contrary to popular belief, disinflation is not the opposite of inflation. Deflation is the opposite of inflation and many economists fear deflation, and I will get to that in about 30 seconds (depending on how fast you read ).
First, I want to define another somewhat related term: stagflation. Stagflation is when there exists high inflation during a time of declining economic growth. That is considered by economists to be a worst-case scenario, and the US suffered from a few bouts of stagflation in the 1970s and early 1980s. Though that was a long time ago, the turbulent economic period is still quite fresh in the minds of economists and central bankers. That institutional memory certainly has had an impact on the current kettle of Fed hawks who are eager to avoid a recurrence of those Volcker and Greenspan days (both famous/infamous Fed chiefs who battled inflation). Now back to deflation.
When prices go down, companies make… um, less revenue. When companies make less revenue, Gross Domestic Product / GDP shrinks. Let’s not get into all the math, but let’s DO ponder the negative impacts of deflation. We are all, presumably, investors, so we can start from the perspective of companies. If the companies we invest in are suddenly forced to charge less for each unit sold, revenues will decrease and so will the value of our investment (not good ☹). I am sure that you are thinking that lower prices would cause consumers to buy more units which should make up for the lower price. However, consumers are smart, and if they perceive that prices will be lower (deflating), they are likely to put off purchases which would only confound companies’ lower price point problems. These corporate challenges are the starting point for a broader-reaching problem. When companies are making less revenues, they must cut costs in order to maintain margins. They do this by first, reducing employment, and then by reducing investment. The result is higher unemployment and decreasing asset prices (e.g., industrial machinery and commercial real estate). Higher unemployment means lower consumption. Remember GDP? At a high level, consumption and business investment make up nearly 80% of GDP. Therefore, the decline in both of those aggregates would have a materially negative impact on GDP… which, no one wants.
Am I confusing you ? Didn’t you think that the Fed was supposed keep prices low? Well… technically, the Fed is supposed to keep inflation in check, and that means keeping prices from rising too quickly. And by not “too quickly,” the Fed has chosen +2% as a target. The Fed believes that +2% growth in prices is enough to keep companies, investments, and consumption healthy enough to sustain GDP growth. Further, the Fed believes that +2%, would be tolerated by consumers without diminishing demand. You see, it is all a vicious circle. I am sure that you have heard one of the old adages about “moderation.” Well, in this case, a little bit of inflation is considered healthy, but too much inflation is dangerous… and now you know that deflation is also unhealthy. So, if you thought that the Fed’s job was difficult, think again. The Fed’s job is really, really… REALLY difficult.
EARLY MARKET MOVERS
The Walt Disney Company (DIS) is higher by +1.52% in the premarket after it announced an EPS beat for Q2. Investors like Disney’s cost cutting measures as well as its recent foray into sports betting, reported here yesterday. Finally reports about the company’s expected price hiking of its Disney+ offering is positive for revenues. No deflation here . Potential average analyst target upside: +29.8%.
Illumina Inc (ILMN) shares are lower by -5.32% in the premarket after the company slashed full-year revenue guidance in its earnings release. The gene-sequencing equipment manufacturer has had a challenging year drastically cutting costs and fighting a proxy battle with Carl Icahn. In the past month 50% of analysts have lowered their target prices, 1 up, 9 down, and 10 unchanged. Potential average analyst target upside: +21.4%.
YESTERDAY’S MARKETS
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