Prepared by Richard A Brock & Associates, Inc.
The financial markets were given some soothing tonic this week for the case of jitters that had developed over the past month. Several government agencies released data that showed both strong economic growth and surprisingly low inflation.
The market was particularly encouraged by the tame rate of inflation. The bond futures market broke out of its trading range and scored its second largest one-day advance in the 1990s. Renewed confidence the Federal Reserve won't be forced to raise interest rates until sometime early next year, at the earliest, put much of the financial community into a state of euphoria.
It's inflation, not economic activity, that the Fed must stay focused on when deciding when and by how much it will bump interest rates. Therefore, the consensus opinion is that action to raise rates will not be taken until there are visible signs that prices are raising rapidly, no matter how strong the economy is.
There is no solid evidence inflationary pressures are building. Despite the tight job market and rising personal earnings, the year-to-year core inflation rate as measured by the Consumer Price Index (CRI) is up only 2.3% from 1996, according to the Labor Department. As shown on the graphic, this is an extremely low rate of increase for prices at the consumer level. In fact, you have to go all the way back to 1966 to find a core CRI inflation rate this low.
This inflation reading would have been even lower if it transportation costs hadn't jumped 0.6% last month. The main reason for that increase was higher gasoline prices at the pump.
Making the low reading on inflation even more impressive is that the divergence between economic growth and inflation is widening. Several readings on economic activity released this week suggest the rate of growth is strong and probably sustainable.
Figures released by the Federal Reserve on Tuesday show that industrial output jumped a healthy 0.7% from a month earlier. Financial market watchers were especially impressed with a hefty 1% advance by the manufacturing sector. This increase came after a huge increase in inventories during the 2nd quarter. It was feared that this buildup would be a drag on 3rd quarter business activity, but that was not the case.
If industrial production remains strong throughout September (and there is no reason to think it won't), the annualized rate of growth for real Gross Domestic Production should be above 4%. Real GDP has stayed in a narrow range between 2% and 4% most of the 1990s after seeing much wider swings throughout the 70s and 80s.
Adding fuel to the fire, the Commerce Department reported business inventories rose just 0.2% in July while sales increased by a full percentage point. That combination pushed the inventory-to-sales ratio to the lowest level in 24 years, suggesting lean inventories and solid output growth in the months ahead.
Attitudes?
No matter how it's measured, the confidence level among consumers and investors is extremely high. That was true for consumers even before the release of this week's batch of economic reports, but the new data allowed many investors and analysts to also breathe a sigh of relief.
In some ways, expectations of low inflation become self-fulfilling. Consumers, investors and businessmen become less willing to accept higher prices for everything from retail goods to supplies. The expectation of lower inflation actually helps keep prices from rising. When the rate of inflation is high, the psychology is exactly the opposite. Most people become more accepting of higher prices and inflation snowballs.
One major source of concern is that the current psychology in the financial markets may be too bullish. As we've discussed many times, all markets are subject to swings in the attitudes of market participants. Stocks and bonds are no different than agricultural markets in this regard. Tops always occur when the news and therefore attitudes are most bullish. The hard part is knowing when the news is as bullish as it's going to get.
There has been at least a subtle change in the collective psychology of stock market investors over the past several weeks. Fearful the bubble was about to burst, many have taken a more defensive stance.
The calendar is at least partially responsible for this more defensive attitude. The stock market has entered a treacherous time of the year. Most big-time corrections have occurred in the fall. Remember the October crash of 1987?
What will be the reaction of individual investors if another October crash occurs? It would certainly test the resolve of a group that has collectively become a huge player in the stock market–baby boomers. One of the main driving forces behind the equity market's incredible upmove in the 1990s has been the strong inflow of money into mutual funds. Much of that money has come from baby boomers saving for retirement or for their kid's college.
Will baby boomers stick to their investment plans if the market breaks hard? No one knows for sure, but the idea that price dips provide buying opportunities is now deeply entrenched in this type of investor. This attitude has been reinforced many times over the past few years, most recently in mid-August. Every time the market declines it has been followed by a rebound. This has given baby boomers a high degree of confidence in the stock market. It will take a major event to shake that confidence.
It has been a long time since the economy saw a bout of deflation. Many people aren't even aware of what it would mean. The definition of deflation is a sustained drop in general price levels. This would certainly include agricultural commodities.
Although economists are split on how likely deflation is in the United States, there are some signs that a deflationary period may be on the way. The Commodities Research Bureau's index of farm and industrial commodities has been trending lower for about a year now. A huge drop in gold prices has been the biggest driving force behind weakness in the CRB index, but farm commodities also contributed this summer and could get sucked into a more sustained break.
Few analysts are saying with confidence the U.S. economy is heading towards a deflationary period. There is even widespread disagreement on whether deflation would be bad for the economy in general. But the deflationary bugs warn that certain international factors bear watching. They cite weakness in Asian currencies, the slumping Japanese economy and general sluggishness in European economic growth as warning signs that U.S. products may overpriced in a global economy.
This week's low readings on inflation despite the fact unemployment is extremely low in the United States makes a hike in interest rates unlikely the rest of this year and probably into 1998. This does not guarantee, however, that all financial markets will sail along smoothly the rest of the year. Investors in the stock market need to be students of market psychology, and be aware the equities could be entering a turbulent period.
September 19, 1997
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