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Thursday, October 8, 1998

FOOL ON THE HILL
An Investment Opinion
by Alex Schay

An Inflated Look at Deflationary Recession

Surveying the glum countenance of a Swiss banker en route to Zurich by train, I got the feeling that the reality of global market activity was turning out to be an unwilling partner with prior hopeful projections. A rare conversation ensued, as the normally reserved bank official began to reel off a litany of concerns surrounding global credit quality amidst my characteristically intrusive American questioning.

Having just returned from nearly two weeks overseas, it was definitely "interesting" to get a Western European perspective (albeit anecdotal) on the market turmoil in Asia, Latin America, and Russia. The steady stream of "1929" comparisons made it pretty clear that attitudes within the walls of fortress America were dramatically different than in Europe, where the financial combatants often break camp on an open plain buffeted about by the elements. However, returning to the United States and seeing negative opinion beginning to solidify around a crumbling corporate earnings edifice was dramatic confirmation that incremental information over even the briefest period of time can serve to crystallize suspicions raised in months' past.

As Merrill Lynch reported in its Weekly Economic & Financial Commentary for the end of September, "Action by the Fed would be an acknowledgement of the depth of the global economic and financial crises. A severe deflationary shock is coursing through the world economy, and it will not be easy to cushion that shock no matter what policymakers might do during the next few months. The sizable Fed easing that we think will occur in the months ahead is fully necessary to avoid an abrupt slowdown in U.S. growth." Now, with the Fed's first move already under its belt, it might be instructive to take a look at how economists view a classic deflationary recession. Here are some of the classic calling cards:

A Decrease/Decline in:       An Increase in: 
 Household Income             Unemployment 
 Consumer Spending            Treasury Bond Prices 
 Business Revenues 
 Business Start-Ups 
 Leading Economic Indicators 
 CPI/PPI 
 GNP 
 Investment Yields 
 "Cyclical" Stock Prices 
 *courtesy of Acme Econ Text
The thing is, these "indications" are really the symptoms of a patient (economy) with a full-blown case of deflationary recession. The real action occurs -- in market terms -- when the symptoms begin to manifest themselves. It's important to note that, as yet, only a few Wall Street houses have voiced the possibility of even mild recession in 1999 (J.P. Morgan key among them). When confined to one sector or one element of the economy, like the oil business, agriculture, or the Rust Belt, deflationary recession is not uncommon, and in some instances (not the previous examples) it can even go unnoticed. As economist Donald R. Nichold notes, "The total economy could, for example, be unaffected by the demise of the cigar-store Indian industry."

Here is the fear though, as illustrated by a very basic causal chain of deflationary events. Declining producer prices eventually make their way onto retail shelves, threatening the ability of some producers to meet their costs of production. Producers will then try to reduce costs by gross adjustments, spreading the entire affair to employees, lenders, suppliers, inventors, lender's lenders, supplier's suppliers, and on and on. In some instances things can get so bad that banks and other lenders see the diminishing corporate and household revenues and perceive a greater risk associated with doling out loans. That's the way it works in theory anyway.

The ever-vigilant Alan Greenspan, who has been monitoring the export of deflation all year, commented yesterday before the National Association for Business Economics, "We are far short of anything that could resemble a credit crunch in the United States." As well, he noted that borrowing difficulties aren't having a significant effect on the economy, which remains "impressive."

However, Greenspan did note that investors' exaggerated aversion to risk and rush to embrace liquidity since August has threatened the efficient operation of the markets as investors reason (according to Greenspan), "I want out. I don't want to know anything about whether a particular investment is risky or not. I just want to disengage." This phenomenon, of course, presents opportunities for investors, and in future columns (Boring Port and News) I will try and take a look at some segments that might just be shifting into the "unfairly maligned" category -- even when considering the possibility of a fundamental economic shift.

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