BEARS EAT CAMEL CAKES
For investors, this is a near "perfect storm" of favorable macroeconomic trends: Falling wholesale prices have the Federal Reserve worrying about deflation, and have pushed inflationary concerns to the back burner. This means that no rate increase is likely for the foreseeable future; indeed, speculation is already rampant that the Fed will cut the federal funds rate at its next meeting.
The weaker dollar makes American exports cheaper to foreigners; the strong euro also reduces the price pressure on American manufacturers who compete with European producers. And low longer-term rates means the yield curve is flattening, finally bringing down the longer-term rates that determine mortgage rates and business borrowing costs. This encourages consumers to spend and businesses to invest.
Stocks and bonds are worth more
What does this mean for various investment options?
Let's start with stocks. No wonder the Standard & Poor's 500 ($INX) and Nasdaq ($COMPX) hit new highs for the year. (The Nasdaq plowed through my profit-taking threshold of 1,550, which I discussed last week.) Near-zero inflation (even slight deflation) is practically ideal for stocks.
The Wall Street Journal noted last week that stock research firm Leuthold Group found that since 1929, stocks have returned an average of 23.2% a year in periods of moderate deflation (then prices were flat to declining up to 2.4% a year) and gained an average of 15.7% in periods of moderate inflation (up to 2%). Serious deflation (a remote possibility, in my view) can cause economic turmoil and lead to a self-sustaining recession, which hurts stocks. But slight deflation is fine. Income-producing assets, which include stocks, become more valuable because the income buys more. And the weak dollar is great news for the cyclical manufacturing companies I've been recommending in recent months.
The latest developments are also a boon to bondholders. I admit to being surprised that the bond market still had room to rally, and I can't believe now that yields are likely to drop much further from their historic lows. So I wouldn't be a buyer of U.S. Treasurys at this point. But the good news is that, if you already own them, you can probably keep holding them, reaping the income stream, without fear that interest-rate increases will erode the value of their principal. (Bond values drop as interest rates rise.) So I don't think there's any urgency to taking profits.
Be wary of debt
With interest rates so low, there's been a stampede into higher-yielding alternatives, especially investment-grade corporate bonds and high-yield, or junk, bonds. Their yields have dropped dramatically, and the spreads between them and Treasurys have narrowed. That means the easy money has been made, but junk bonds are still yielding an average of nearly 7%, far better than Treasurys. Again, I wouldn't be putting new money into the asset class now, but I'm in no rush to sell the bond funds I already own given the Fed's accommodative stance toward rates.
Bonds, too, do well in an environment of low inflation or slight deflation, for the same [next page]