Merrill's Rosenberg's Latest: Deflation Rules!

Here it is folks.

Not much to add here. The best economist on Wall St lays everything out perfectly. Inflation will be hard to create as production free falls to 25 year lows and unemployment sits at 13.5% and rising. Can you say depression? It won't be long now folks. The news flow continues to be terrible.

The fact that he expects $20 trillion dollars in household wealth to disappear by the end of 2009 is simply mind boggling. Be careful with stocks this week. We are pretty oversold and a rally wouldn't surprise me"


"Deflationary pressures are both building and spreading

Consumer prices may not have declined as much as the consensus expected, but the 0.7% decline in December represented the fifth decline in as many months for the longest stretch in over 60 years. And this is not just about food and energy because the core was also negative to the second decimal place and is now running at a -0.3% annual rate over the past three months which has not occurred since 1960. The deflation is visibly gripping a wide swath of sectors -- hotels, appliances, clothing, home improvement, autos, personal care products and services, airlines, and recreation just to name a few. We also see that tremendous deflation is coming through the pipeline based on the steep price declines we saw in the core crude and intermediate PPI for December - - both sliding at a record rate over the past three months (-83% and -25% at an annual rate respectively).

The deflation process is hardly temporary…

While the government is rapidly expanding its balance sheet and the Fed is dramatically boosting liquidity, these are only a partial offset to the fact that the $50 trillion household balance sheet is contracting at an unprecedented rate and it is the household that ultimately determines the demand for and pricing of the goods and services that comprise the consumer price index. In the interim, the fiscal stimulus will, at best, offset the rapid accumulation of excess capacity in the real economy. As industrial production data highlighted, capacity utilization rates in manufacturing have fallen to 70%, levels not seen in more than a quarter-century. And in the labor market, the 'real' unemployment -- the U-6 measure that provides the broadest definition of the labor force -- is at a record- high of 13.5%.






…and will take years to reverse

It will literally take years of fiscal and monetary pump-priming to bring these measures of economic slack to levels that will precipitate the next inflation cycle. In our view, that is too far beyond the forecasting horizon to be concerned about right now and we expect long Treasuries and indeed, any fixed-income instrument with both duration and relative safety attributes to be very compelling at this juncture, low coupons notwithstanding. It will not take much in the way of even further reduction in yields to generate high single-digit returns for long-term bonds given the convexity at low levels of interest rates. The odds of a bear market in the fixed-income market given how long this recession is going to last and how muted the recovery is likely to be thereafter, even after accounting for all the government stimulus, is quite remote in our view.

Deflation the primary risk for the foreseeable future

While the debate continues to rage, deflation, not inflation, is the primary risk for the investment outlook for the foreseeable future. Government intervention will act as an antidote, but the magnitude of the trauma on the household balance sheet from an estimated $13 trillion of lost net worth since the third quarter of 2007 -- a cumulative loss that we believe will approach $20 trillion by the end of 2009 -- is on its own, via the lagged effect on the personal savings rate, enough to drain consumer spending by between 2% and 3% annually over the next two to three years. And with the unemployment rate very likely heading to at the least test 9% in this cycle, it is truly difficult to believe that inflation is going to be revived in the intermediate term.

Sustained widening in the output gap a powerful backdrop

It is perfectly understandable, but still dangerous, to be clueless about the mechanism that determines whether we experience inflation or deflation. Even with the upcoming stimulus, this economy, which has been growing below potential since June 2006, will very likely continue to do so not just this year but well into next year as well. This means a sustained widening in the output gap -- in other words, growth in aggregate demand exceeding available supply, higher unemployment rates and lower capacity utilization rates -- will be a reality as far as the eye can see.

The deflation story is going to prove to be a much more enduring theme than many realize, in our view, and investors will want to ensure the portfolio is positioned for it, which comes down to five characteristics:

1. A focus on safe yield, wherever you can get it: long-term non-callable government bonds, closed-end muni funds and high-quality corporates.

2. Screen for dividend yield and consistent dividend growth in the equity market.

3. Whether it be credit or equities, a focus on companies with low debt/equity ratios and high liquid asset ratios – balance sheet quality is even more important than usual. Avoid highly leveraged companies at all costs. The same methodology should be applied to municipal bonds – differentiate between those with and without high cash reserves and high debt rollover calendars.

4. Ultra-selectivity with regards to financials since the real cost of debt and debt-service rise in a deflationary period, as do default, delinquency and charge-off rates. The same can be said for retailing, where margins become crimped. Screening for inventory turns is very important because cost-containment is imperative as top-lines are suppressed by declining final sales prices.

5. Focus attention on sectors or companies with these micro characteristics: low fixed costs, high variable cost, no unionization, high barriers to entry/some sort of oligopolistic features, and a relatively high level of demand inelasticity (utilities, staples, health care). Also focus on companies with high inventory turnover ratios in a deflationary backdrop."