As the U.S. economy stumbles slowly further into 2010, the economic picture has suddenly become very murky. Economists were expecting a painfully slow recovery, accompanied by a high, but improving, unemployment rate. However, economic data in the first couple months of the year hasn't been terribly encouraging, with plummeting consumer confidence and a record low in new housing sales. As if that weren't enough, inflation data shows that we may still be battling old enemies.
Deflating expectations
Last month, the "core" consumer price index, which excludes volatile food and energy costs, fell for the first time since 1982. This core measure of inflation includes items like automobile and housing costs, which fell from the previous month, contributing to the 0.1% drop during February.
True, the full CPI measure rose by 0.2% once food and energy costs were included, but we shouldn't write off the significance of a decline in the core CPI measure. Such drops are exceedingly rare, and indicate that pricing pressures remain remarkably contained. Given that this is the first time in almost 30 years that core CPI has declined month over month, some folks are starting to wonder if we've really won the battle against deflation.
At first glance, a little bit of deflation may not seem like such a bad thing. After all, as prices of goods and services fall, consumers' incomes go further when they can purchase more with the same amount of money. But that doesn't happen in a vacuum. Lower prices on goods and services cut into companies' bottom lines. That translates into reduced wages and layoffs as companies struggle to maintain profitability.
Also, deflation can hurt debt loads for companies, consumers, and governments as fixed loans become more expensive relative to falling prices. For evidence of the harmful long-term effects of persistent deflation, look no further than Japan, which endured years of falling prices starting in the 1990s, taking down asset prices and contributing to a stagnating economy.
Stand down the alarm
However, despite the ominous CPI reading for February, I wouldn't go so far as to declare deflation the comeback kid of 2010. One must be careful not to make trends out of a single month's economic readings. I do think this data shows us that inflation will continue to be a non-factor, at least in the short run. Despite an economy that has picked up from its lows and massive government intervention, more complete economic healing still eludes us. The housing and automobile sectors continue to struggle, and employers are unlikely to meaningfully step up hiring anytime soon. All of this will keep a lid on inflation for the near future.
However, over the long term, inflation will almost certainly rise. Given the length of time that short-term interest rates have been held close to zero and the fact that the government printing presses have been working overtime to create new money, all the factors needed for a bout of inflation are in place. And because the Fed will likely overshoot its accommodating policy stance for fear of choking off a nascent recovery, I'd say the odds of prices on goods and services starting to rise in the not-too-distant future are pretty solid. That means investors will need to moderate their expectations right now, but be prepared for a jolt of inflation down the road.
Keeping a level head
Because it's likely 2010 will continue to be a year of uncertainty for both the economy and the stock market, investors will need to exercise extra caution not to get caught up in trends and not to abandon their long-term asset allocation plans.
Gold has been one of the biggest targets of investor fear and uncertainty in recent years. Stocks like Freeport McMoRan Copper & Gold (NYSE: FCX) have more than doubled in the past year, while other mining-related names like Yamana Gold (NYSE: AUY) are suddenly attracting attention from all quarters.
While gold may seem like a safe place to hide from the extremes of either deflation or runaway inflation, I'd caution investors against throwing their lot in with this shiny metal now. Gold has done well recently, but over the very long run, it simply hasn't kept up with stocks. And at its current levels, there's quite a bit of price risk involved. If, however, you insist on having gold in your portfolio, keep it to a very small percentage and stick to a low-cost exchange-traded fund like the SPDR Gold Trust (NYSE: GLD).
Likewise, while equity returns probably won't dazzle this year, you're going to need the long-term staying power of these investments to keep ahead of inflation. Because small-cap stocks have had a pretty decent run over the past decade, I wouldn't count on them to be market leaders in the next few years.
Instead, consider high-quality, dividend-paying blue chips. Dividend income will be even more important in the near future as stock returns are unlikely to impress. Consumer goods stalwarts like Kraft Foods (NYSE: KFT) and Coca-Cola (NYSE: KO) are good choices for any investor's portfolio, along with health-care plays like Pfizer (NYSE: PFE) and Johnson & Johnson (NYSE: JNJ). All of these blue chips have a dividend yield in excess of 3% and are trading at fairly reasonable valuations.
Economists no doubt will be watching measures of inflation very closely. While pricing pressures will likely remain under wraps for now, there will come a day when inflation takes back the spotlight. Investors would be wise to prepare now.
