Street Tends Home Fires as Deflation Threat Resurfaces

If you can’t impeach the President, take it out on the stock and bond markets.

Or so it appeared on Friday, as the Dow Jones industrial average slid 88.57 points to 9,274.89, completing its fifth losing week out of the last seven.

In the Treasury bond market, the mood was even more downbeat, as long-term yields soared to their highest levels since August amid a sudden dumping of bonds late Friday.

Little wonder that as of midweek, Morningstar Inc. calculated that 84% of all U.S. diversified stock mutual funds were down year-to-date. If you’re feeling a bit poorer this year, it’s not your imagination.

But for most investors, alarm bells probably aren’t ringing yet--not like they were in early August, as the Dow began to sink from its mid-July peak while Treasury bond yields were dropping.

The great concern then was that the world was on the verge of a deflation-fueled economic bust that lower interest rates wouldn’t cure. In other words, people began to fear that Japan’s vicious circle of falling prices, crumbling asset values and plunging consumer confidence was going global.

The deflation/bust worries quickly dissipated in the fall, as most world markets recovered from their late-summer plunge after the Federal Reserve cut short-term interest rates three times.

It helped a lot, too, that U.S. consumers rode to the rescue, spending up a storm and driving the domestic economy in the fourth quarter to its fastest growth rate in 2 1/2 years.

But aside from rising U.S. bond yields (more on that later), events in markets and key world economies last week arguably should have had that deja-vu-all-over-again feel for anyone who sold stocks in August amid that deflation/bust scare:

* On Friday, the Bank of Japan cut its benchmark short-term interest rate to 0.15%, from what was already a record-low 0.25%. The next stop will be for Japanese banks to lend at zero interest. Free money!

The Bank of Japan had two goals with the latest rate cut: First, to offer more relief to struggling borrowers, as the economy continues to hemorrhage. And second, to try to pull down long-term Japanese bond yields, which have soared since October as the government goes ever deeper into debt (via bond offerings) to try to spend the economy back to health.

But to many U.S. analysts, the rate cut just smacked of more desperation in the world’s second-largest economy.

* In Europe, the Bank of England warned on Wednesday that the British economy could slow to a growth rate of just 0.5% this year, barely above recession conditions.

And in Germany, the leftist finance minister, Oskar Lafontaine, was reported to have called for a sharp rise in government spending programs in Europe this year to reverse slowing economic growth.

The Finance Ministry denied the report, but Lafontaine has been quite vocal about the need to boost growth in the new Euroland to combat high unemployment.

For whatever reason, investors have turned jittery across Europe in recent weeks. The German stock market slid 3.8% last week and is down 2.3% for the year. The Dow industrial average, by contrast, is still up 1% for the year.

* Key commodity prices continued to sink, with the CRB/Bridge index of 17 commodities ending Friday at 186.77, its lowest since 1977 and even 4% below its cheapest point during August’s worldwide market calamity.

Sugar and soybean prices are now near 12-year lows, while cocoa hit a two-year low on Friday. For many commodities, the story is exactly the same: a glut of supply worldwide and too few buyers. (Note from African cocoa growers: Please eat more chocolate this Valentine’s Day.)

Gluts, of course, usually lead to lower prices, which is just another way of saying deflation.

Despite the valiant spending effort of American consumers, “the big problem on this planet is not enough demand,” sums up Jeffrey Applegate, investment strategist at Lehman Bros. in New York.

To put it another way, not a lot has changed in the global picture since August, other than Russia getting worse, Latin America getting worse, Japan getting worse and Britain getting worse.

The lack-of-demand issue figured prominently in the U.S. Commerce Department’s preliminary finding Friday that Brazil and Japan have dumped certain types of steel in the U.S. market, to the detriment of domestic producers.

That could trigger tariffs and other penalties against those countries. So far, nobody’s talking trade war, but the development is disturbing nonetheless: It speaks volumes about the threat of potentially protectionist sentiment in a world where too many goods are chasing too few buyers.

Why, then, aren’t more alarm bells going off on Wall Street? The blue-chip Standard & Poor’s 500 index is off 3.9% from its Jan. 29 record high but is still up marginally for the year. The tech-heavy Nasdaq composite index has slid 7.5% from its peak on Feb. 1 but still has a 5.9% gain year-to-date. And trading volume has thinned lately, a sign there’s little urgency in the selling.

Some investors may simply be suffering from ongoing “crisis fatigue”--in other words, they’ve become tough to shock anymore.

Also, fourth-quarter earnings for blue-chip companies overall have been 4.3% above analysts’ expectations, according to earnings tracker First Call. The year-over-year fourth-quarter profit gain for the average company is expected to be 6%, First Call says--a dramatic improvement from the 3% decline in the third quarter and a strong supporting factor for stock prices.

Finally, and ironically, Wall Street so far may be taking some comfort in the surge in long-term Treasury bond yields, which left the bellwether 30-year T-bond yield at 5.42% on Friday, up from 5.36% a week earlier and the highest since Aug. 24.

Higher bond yields aren’t good for stocks in the long run. But given the renewed weakness in foreign economies and in commodity prices, one could argue that the U.S. stock market would be more freaked out if Treasury bond yields were sinking right now--as during last summer’s deflation/bust scare.

Instead, with the rise in yields thus far attributed to the amazingly robust U.S. economy, stock investors, and the Fed, can argue that that’s a nice problem to have.

What investors worldwide demonstrated late last summer is that they have a much tougher time (understandably) coping with the reverse: The possibility of a Japan-style crisis on a global scale.

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Tom Petruno can be reached by e-mail at tom.petruno@latimes.com.

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Deflation At Work

About the best one can say for commodity markets over the last year is that some prices have held steady. But many key commodities have plunged, a decline that has continued into 1999 amid a continuing glut of supply--and weak demand--worldwide. Price changes since Dec. 31, 1997, for 10 commodities:

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Year-end ’97 Latest Commodity price price Change Gold (ounce) $289.20 $290.50 Nil Platinum (ounce) 370.80 370.60 Nil Copper (pound) 0.78 0.66 -15% Cotton (pound) 0.69 0.57 -17 Wheat (bushel) 3.26 2.57 -21 Cocoa (ton) 1,630.00 1,271.00 -22 Soybeans (bushel) 6.71 4.92 -27 Crude oil (barrel) 17.64 11.88 -33 Coffee (pound) 1.68 1.06 -37 Sugar (pound) 0.12 0.07 -43

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Note: Prices are for near-term futures contracts on principal exchanges.

Source: Reuters