For as long as anyone can remember, the Federal Reserve has been
tasked with keeping a close eye on
. But these days, Ben Bernanke and his peers are not worried about
prices rising so much as they fear falling prices.
In some respects,
can be a lot worse than inflation. And even though we are unlikely
to see prices drop on a nation-wide level, certain industries must
deal with it in this low-growth environment.
Housing Prices take Down a Sector
To get a sense of the corrosive effects of deflation, look back at
the housing market implosion. We all became familiar with the
notion of homeowners being "underwater." Sinking home values meant
that many homes were worth less than the money still owed to the
bank. That led a lot of homeowners to walk away, leaving mortgage
lenders holding the bag. That's why banks want you to put 20% down.
It's a cushion against deflation.
For some industries, deflation is a normal part of doing business.
Generic drug makers, for example, must account for annual price
decreases as more and more drug makers start making these copycat
drugs. Their challenge is to always find ways to lower costs to
keep profit margins intact.
Industries enter into a price spiral for a fairly prosaic reason:
too much capacity. When a company needs to keep a factory at full
output, it will need to cut prices on goods to find customers and
that often kicks off a price war as rivals fight to retain
. This is why economists track monthly data regarding factory
utilization. As long as there is ample idle capacity in any
industry, price wars may be just around the corner.
On an economy-wide level, factories need to be operating at least
80% of capacity in order to see pricing power. Anything above that
invites the prospects of inflation as bottlenecks start to kick in
and prices begin to rise. Anything below 80% implies that companies
have little or no pricing power. The chart below shows a recent
positive trend, but note that many firms have idled factories. If
the economy improves, some of the factories would start back up --
so we need not worry about inflationary pressures any time soon.
Even though the trend is improving, any pullback in the economy
would send this figure moving back down, which would be trouble for
many industries that are just now getting pricing power. Take auto
makers as an example.
Ford Motor (NYSE:
has been able to boost sales and profits in recent quarters simply
because demand has climbed back up to meet industry capacity. (A
large number of factories were closed, which helped). But if the
economy falls back, look for another round of $2,000 and $3,000
rebates on cars and trucks and kiss Ford's profit forecasts
Steel makers are another example. Companies have a high degree of
fixed costs, so pricing power becomes crucial. With the economy on
the mend, steel prices began to rise and that has led many analysts
U.S. Steel (NYSE:
to think per share profits
might nearly triple next year
to around $6. But what if prices don't rise? Well, U.S. Steel lost
more than $11 a share in 2009. That's deflation.
The key factor here is balance sheets. If an industry is suffering
from deflation, companies with lots of cash can ride out the storm.
But for those sitting on a lot of debt, deflation can be lethal.
You can also find trouble lurking on the
. Steadily falling gross margins are a possible sign that companies
are cutting prices to retain market share. And when coupled with
rising costs for inputs such as labor, deflation can provide a
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The upside of deflation: many industries will see their costs drop
as input prices deflate. For example, what's bad for steel makers
is good for auto makers like Ford Motor and appliance makers like
. Lower prices for
Round-Up has netted big savings for farmers.
In the past few years, makers of flat panel TVs built too many
factories, creating a global glut. A comparable TV now sells for
half of what it did a few years ago and lower prices enable
retailers to move more merchandise, so consumer electronics vendors
Best Buy (NYSE:
are a clear beneficiary.
As noted above, falling gross margins could clue you in to the fact
that a deflationary spiral is kicking in. But the converse is true
as well. Look for companies with steadily rising gross margins to
find deflation beneficiaries.
-- David Sterman
David Sterman has worked as an investment analyst for nearly two
decades. Most recently, he served as Managing Editor of
RealMoney.com, the premium website of TheStreet.com. David has made
numerous media appearances over the years, primarily on CNBC and
Bloomberg TV, and has a master's degree in management from Georgia
Tech. Read More...
Disclosure: Neither David Sterman nor StreetAuthority, LLC hold
positions in any securities mentioned in this article.