How and Where to Invest to Outmaneuver the Risks of Falling Inflation

posted in: Writing | 0

David Evanson and Oliver Pursche, Spring, 2015

The risks of disinflation or falling inflation, and perhaps even deflation, to the U.S. economy are real, and we will likely contend with it for years to come.

As a result, investors will have to invest in a low interest rate environment for years, perhaps for the next decade.

This will require a significant change in how investors view the landscape, as negative returns from bonds along with flat commodity prices will limit investorszz choices in terms of how to lower portfolio volatility.

Disinflation and Deflation

Disinflation occurs when the rate of inflation slows. But it is also a harbinger of deflation, if only mathematically, and deflation is a hairy, hairy beast that is, no doubt, on the minds of central bankers all over the world.

In a deflationary environment, declining prices encourage businesses, government and consumers to wait for lower prices. But the delay in purchasing diminishes economic activity, and the economy can seize up in a death spiral.

The last time deflation occurred on a worldwide basis, 1870 to 1890, it re-arranged the world order, with the U.S. economy coming to prominence while the fortunes of Great Britain waned, and it has been that way ever since.

Although there are promising signals in our economy, there are risks — some might say systemic — that expose us to the ravages of deflation. One such risk is well illustrated in the recent fall in oil prices, down more than half from their summer 2014 highs.

Many were quick to point to the benefits of lower oil prices to consumers, as cheaper gasoline was expected to increase consumer spending, more than offsetting any negative impact to the energy sector.

Unfortunately, the recent decline in oil prices doesnzzt appear to have had the positive impact on consumer spending that most expected, while still having the expected negative impact on energy companies in the form of layoffs at Chevron (CVX – Get Report), Exxon Mobil (XOM) and a host of smaller public and private companies.

Further, we are just beginning to see cuts in capital expenditures from these companies. ConocoPhillips (COP) announced a 2015 capital budget of $13.5 billion, compared with 2014 capital expenditures of about $17 billion.

Itzzs Different This Time

Given that the U.S. Federal Reserve has used almost all the tools in its kit, the environment probably looks risk-laden to many central bankers. Raising rates to head off deflationary pressure may stall the economy.

“U.S. inflation is too low, and Fed officials should wait for more evidence that it will return to the central bankzzs official 2% target before raising interest rates,” Fed governor Jerome Powell said Monday.

The best-case scenario and most bullish expectation is that oil prices will stabilize and slowly climb to the mid-$60 level by the end of the year, consumer spending will increase further, and economic growth will climb to near 3%. Mind you, this is a “Goldilocks” scenario, and to play out properly, everything has to go right.

Should oil prices not rebound or only rebound slightly and energy companies cut spending further, the impact to our economy could be broader than expected. Although unlikely to provoke a recession, this weakness will keep the Fed from raising rates, and our view is, if it does raise rates, it may only be a token gesture of a quarter point.

Here To Stay, Where To Invest

Of course, stocks have made an impressive run the past six years under just these circumstances. However, the change in the United States and really almost worldwide is significant.

The expectation that the Fed would end its zero interest rate policy is coming into question, low rates will persist, and as a result, some investors, will need to consider new ways to put their money to work to avoid outliving their nest egg.

We are advising investors to focus on companies that are building their top and bottom line and have a history of raising their dividends. Large-cap pharmaceutical and technology companies fit this bill and are a good place to start.

Of these variables, we are placing significant emphasis on dividend growth. Remember about a third of all the returns earned in the S&P 500 since 1926 have come in the form of dividends.

In the pharmaceuticals sector, we like Eli Lilly (LLY), Pfizer (PFE) and Sanofi (SNY), all impressive dividend growers. For instance, since 2009, Sanofi has increased its dividend north of 6%, on average each year.

In technology, we like Cisco (CSCO), Intel (INTC) and Microsoft (MSFT).

Although a tech bellwether, Intel might be a dividend aristocrat candidate, too. Since 2009, Intel has increased its dividend about 10.5% a year.

And Cisco, which started paying a dividend in 2011, has increased its dividend by 60% per year on average, through the end of last year.

This article is commentary by an independent contributor. At the time of publication, the author held positions through client accounts in Cisco, Conoco Phillips, Eli Lilly, Intel, Microsoft, Pfizer and Sanofi.