Inflation v. deflation: an investor’s perspective

Much has been written over the course of the past few months regarding inflation and deflation, and to laymen such as myself, I think there is a potential for it all to sound very academic. Having said that, I appreciate the ideological considerations inherent in the discussion. Many political conservatives feel that we are brewing a big vat of inflation that will, sooner or later, flow over and cause a lot of economic trouble; meanwhile, liberals tend to discount these worries, concentrating instead on the current trend toward deflation, which can be harmful as well if unchecked and prolonged.

These attitudes naturally condition individual perspectives on the proposed “stimulus,” or vice versa, one’s opinion of the stimulus conditions one’s view on inflation/deflation. Folks who see the stimulus as wasteful and unneeded tend to buy the inflation argument, while those who want the federal stimulus tend to discount inflation worries (and some privately acknowledge that inflation is just what the economy needs right now).

The data and arguments drummed up by economists, many of them fine and smart people, are often so nuanced and qualified as to be no help at all to the ordinary man on the street, who is left to figure things out in the usual fashion – by gut and instinct.

My instinct tells me that the inflation side of the argument is stronger and more apt to be accurate over the long term. Of course, I would say that: I have vague memories from childhood of the stagflation of the 1970s, and inflation remains for me something to be avoided at all costs. That is in addition to my rather conservative understanding of economic policy.

I cannot say if the stimulus will be an enormous waste of money. I don’t know. Not being a believer in market efficiency (I see waste in the free market every day), I am not convinced by the wastage argument against stimulus. There will be waste, and the taxpayer will pay for it, but how much waste?

I have a preference against further deficit spending at this point, but if I had to mount an argument for the stimulus, I would say that it has value, not as a spur to economic growth, but as a societal safety valve. As economic pain travels down the spine of economy at large, the stimulus can act as an analgesic. Yes, it’s wasteful and doesn’t really correlate with economic growth, but just as pain-killers don’t treat the causes of pain, the stimulus’ main goal is not to ‘fix’ the economy, but merely to give at-risk Americans a little something to tide them over until the economy fixes itself.

There are economists out there who claim more for the stimulus, that it can actually help generate sustainable economic growth – I simply don’t believe them. My sense is that the growth generated by such measures is slower and lower than that financed by private sources through the market itself.

Future rates of inflation will be influenced by a great deal more than whether or not congressional Democrats and President Obama get their stimulus package. For example, as the economy eventually shows signs of recovery, the actions of the Federal Reserve will have as great an impact, but again, there will be significant political pressure on the Fed from all quarters to keep interest rates low, further stoking inflationary forces. After spending more than a trillion dollars to re-inflate the economy, don’t believe for a second that policy-makers will allow the Fed to take the punch bowl away from the party.


Investing Amid Economic Policy Uncertainty

Again, the temptation for most folks is to feel that all of this is too academic to merit further consideration, but the inflation/deflation argument has huge implications for investors.

For instance, consider the following example. Imagine a company – a company involved in, say, clean-coal technology – that is currently struggling beneath a debt burden made worse by the fact that it hasn’t turned a profit in three of the last five quarters; it is burning through cash just to stay afloat. The company has valuable proprietary technology and excellent growth prospects if it can only turn the corner toward sustained profitability before the cash runs out.

The company’s shares currently trade 56% lower than where they opened 2008 – and also trade at just 35% the company’s book value. The long-term debt ratio is 0.84, high but not outrageously so. It has cash and current assets on hand to weather a few more bad quarters, and – especially important – the company seems tailor-made to receive favorable treatment from the incoming Obama administration, given its operations in infrastructure and clean energy. Analysts are currently calling for a 68% rise in earnings for FY2010, or $1.08 per share.

Seems like a pretty decent investment idea that warrants more study, right? After all, with an average five-year industry P/E ratio of 26, that would translate into a stock price of $28.08, a rise of 391% from current levels. That’s one hell of a return for an 18- or 24-month investment.

The above scenario assumes fairly stable levels of inflation. If there should be a significant increase in the rate of inflation during the time until realization of your investment, you can only benefit as a shareholder. Depending upon the costs of inputs and outputs, the company above could possibly benefit from inflation, and in any event, it will benefit in a very real sense: the inflation-adjusted level of its debt will fall appreciably. Besides, the nominal value of equities tends to rise in inflationary cycles, along with everything else; therefore, you shouldn’t lose value by way of inflation alone.

But what if the stimulus-mongers are correct and we experience prolonged deflation over the course of the next few years?

Because the nominal value of long-term debt ($532 million in 2008) to be serviced remains stable, the company’s actual debt burden will rise as the value of the company’s equity – its property, plant and equipment, its receivables, its inventory – falls. This could increase the company’s cost of borrowing, further cramping the company’s ability to fund ongoing growth plans and stall revenue generation. Suddenly, the investment thesis charted out above looks remote. Rather than generating $1.08 in FY2010 earnings, the company only manages $0.55. Furthermore, the company’s financial position slowly deteriorates, which acts as a drag on the P/E premium folks are willing to pay for its shares; instead of 26, the highest P/E over the next 24 months is only 12.5. Suddenly, the projection is for a share price of $6.88, a gain of “only” 31% from current levels. And if deflation is particularly acute, even that scenario, which seems conservative today, might be too rosy.

This is important, because it is at this point that the risk profile for the company’s debt actually looks more attractive than its equity. The company has debt issues currently trading at 31% of par. Granted, the coupon is only 2.5%, but still, because of the bonds’ deep discount, this would generate a 29.6% yield if held to maturity, which is February 2014. Furthermore, deflation benefits bondholders – the yield-to-maturity figure is set in stone more or less, regardless of the vagaries of economic policy, money supply, or what have you, and the only risk is if the company defaults.

So, as you can see from the example above, the inflation/deflation argument does have implications for investors. If we are in for a protracted period of deflation – which I don’t believe is the case – then corporate debt will often provide safer and – in some cases – higher returns than stocks.

By the way, the hypothetical company from the study above is not so hypothetical: it’s Headwaters Incorporated (NYSE:HW), a Utah-based company operating building products, coal-combustion products, and energy units.