December 10, 2001; Deflation, Growth and Inflation

Fear of Deflation Subsides For Now

The yield on the benchmark ten-year U.S. Treasury Note has zoomed from a low of 4.19% on November 7 to 5.17% on December 7.   That much of an increase in yield means about a 7% decrease in present value, or the current price of the note.  It also means a decrease in the value of a dollar of cash flow from future oil and gas production before taking into account any other changes. 

Reduced to its most fundamental investment meaning, the yield on government securities is a measure of investors' fear of deflation.  While the term, deflation, means declining prices, it is a code word for extended weak economic times as in depression or as in the prolonged stagnation in Japan for the past decade.   Government bonds in those circumstances perform well because the issuer does not default and the fixed stream of income payments becomes relatively more valuable.  

For more than the past year, investors demand for deflation protection has been rising.  The concern has reached the point, it seems, that it is a frequent topic of discussion in the popular business media. Ironically, just as we are hearing more about deflation, the sharp reversal in interest rate suggests that such concern has peaked, at least temporarily.  

Expectations for Growth Advance  

Treasury inflation indexed securities (TIIS), also known as Treasury Inflation Protected Securities (TIPS), trade on a real yield basis.  We visualize the real yield as a measure of investors' minimum expectations for growth.  If the guaranteed real income were reinvested in new TIPS, principal would grow at a guaranteed rate in excess of inflation.  When risk-adjusted growth in other investments, mainly non-energy stocks, seems relatively more appealing, the real yield increases to remain competitive.   

For most of the past year, real yield has been declining (see middle line on Chart above).  During the past month it has recovered sharply.    

One coincident factor appears to be favorable progress in the Afghanistan War.  The defeat of the Taliban, who ruled Afghanistan with medieval backwardness, removes an obstacle to economic and political progress.   

Fear of Inflation Remains Low  

The difference between the real yield on TIIS and the nominal yield on conventional Treasury securities is inflation (see lower line on Chart).   The pattern seems quite clear that for the past month, the reversal in deflation expectations is matched more by an increase in growth expectations than by an increase in inflation expectations.  Growth without inflation is the best of all worlds.   

Diversify Investments By Deflation Protection, Growth and Inflation Protection  

Fascinated as we are with the implications of bond markets and commodity markets for oil and gas valuation, we still can only judge where the trends are headed.  As a result each investor must make his or her own allocation that seems comfortable.  Energy stocks are strongest on inflation protection.  Energy stocks combined with TIPS may be sufficient protection for most investors.  Energy stocks also offer reasonable growth though not as much as non-energy stocks.  Low debt energy stocks even offer a little deflation protection because default risk is low and energy is an everyday necessity even in weak economic times.  

Our Chinese energy stock recommendations offer perhaps more sensitivity to growth than a Mega Cap energy stock, for example.  Worldwide growth is especially important for developing countries.  As such countries get stronger, concerns about political risk are likely to diminish and the valuation discount is likely to narrow.