Economists, fixed-income managers and investment strategists pooh-poohed the Federal Reserve Board's deflation concerns.
They see a period of low inflation and low economic growth for several years ahead, which could produce blah returns on both stocks and bonds, and hurt the old-line industrial companies.
In addition, investors should prepare for a rise in interest rates.
"It's not very likely we would have deflation in the U.S.," said Roger G. Ibbotson, a professor of finance at Yale University's school of management and the chairman of Ibbotson Associates, Chicago.
"There is no evidence of deflation," said Carl Pellegrini, a Dallas-based economist and head of CycleTrack.com, an economic consulting firm.
Mark Seidner, director of domestic taxable fixed income at Standish Mellon Asset Management, Boston, added: "The perception of deflation may be greater than the actual risk of deflation."
Self-fulfilling prophecy
Mr. Pellegrini said the Fed's recent "irresponsible" comments could become a self-fulfilling prophecy. "It's like yelling `fire' in a theater." The result: Investors could become wary of investments in low-investment-grade companies, starving such companies of access to capital markets, he warned.
Experts generally agree that deflation would prompt many investors to lower their exposures to stocks, shun real estate and corporate bonds, and move into 30-year zero-coupon Treasury bonds. Falling interest rates that would accompany deflation also would cause pension liabilities - the present value of future pension benefits - to soar.
But falling interest rates do not necessarily equal deflation.
"The problem is that people are seeing low and declining interest rates and are interpreting slowing of inflation as deflation," said Chuck Zender, managing director at the Leuthold Group, Minneapolis.
Instead, some experts say, the Fed's comments should be interpreted to mean it has successfully contained inflation and is preemptively taking on deflation before it takes hold in the U.S. economy.
Said Ben Inker, director of asset allocation at Grantham Mayo Van Otterloo & Co. LLC, Boston: "(Mr.) Greenspan is trying to emphasize ... now that we have won the fight against inflation, we have to be on guard against deflation."
Mystifying
What mystifies Edgar Peters, chief investment officer at PanAgora Asset Management Inc. Boston, is that the Fed did not express concerns about deflation when indicators such as the personal consumption expenditure index plummeted to 0.5% in February 2002. That index is now back up to 2.9%, he said.
And while the core consumer price index has continued to fall - to 1.75% as of the end of March (the most recent number available) from 2.85% in December 2001 - Mr. Peters isn't worried.
"I was more concerned about deflation all of last year and up to a couple of months ago, when it became clear all of the indexes were accelerating," he said.
But the central bank's repeated efforts at loosening credit - combined with the Bush administration's war-related spending spree and proposed tax cuts of hundreds of billions of dollars - could cause the federal deficit to soar to well beyond its current $270 billion levels, some of those interviewed said.
What's more, the administration's deliberate abandonment of support for the dollar has caused the U.S. currency to sink, which should cause imports to become more expensive.
These factors could cause some level of inflation.
Consequently, investors should position their portfolios to take advantage of a resurgence in stocks. They also should reduce the duration of their fixed-income exposure to avoid losses from rising interest rates, some suggest. And, they should consider alternative investments that can produce higher returns than either domestic stocks or bonds, such as emerging market debt, or market neutral and other absolute-return strategies.
No one expects inflation to become rampant. Most see a several years of low inflation and low economic growth that could hurt the old-line industrial companies.
In such an environment, investors might earn 4% returns on stocks and 2% on fixed income, said James M. Prusko, managing director and senior portfolio manager of core fixed income at Putnam Investments, Boston.
Gary Shilling, president of an eponymous Springfield, N.J., consulting firm and hedge fund manager, was the lone Chicken Little interviewed for this story.
Mr. Shilling, who has warned of the specter of deflation for years, said several sectors of the economy already are in depression. "Within the next year or two, it will be obvious to everyone that we are in a depression," he said. Pension plan sponsors will pile up long-term Treasuries and hire money managers for their absolute, rather than relative, skills.
"If the benchmark is going down, the idea of losing less money than the benchmark is not thrilling," he observed.
Regardless of economic trends, pension plan sponsors need to pay more attention to asset-liability management than ever before. And, as unpalatable as the thought might be, they need to immunize their liabilities by locking in long-duration bonds.
"If interest rates rise, the fall in liabilities will far exceed any damage done on the asset side by having long bonds," said Robert D. Arnott, managing partner of First Quadrant LP, Pasadena, Calif. n
