By David Barol, CFP

Published June 1999

• React to this article in the Discussion Forum.

Over the past fifteen years, inflation in the US has averaged under four percent. After a decade of oil shocks and failed attempts at price and wage controls, fiscal and monetary policy both accepted the theory that low inflation would provide the foundation of sustained national growth in productivity and real income. Consequently, we have enjoyed years of low mortgage rates, fueling a record expansion in almost every sector of our economy and in the stock market.

Overseas, particularly in the Pacific Rim, inflation did not stop at merely being low. Japan experienced deflation, not just disinflation. Prices have fallen, not just merely risen at a slower pace.

Remember when we last had deflation in this country during the 1930s. Was that a good time? Now think back on the Seventies. Besides discos, we had high inflation, which fueled high interest rates, rising wages and rapidly increasing house prices. A house bought for $12,000 was worth more than ten times that amount by the mid-eighties.

But what of newlyweds a generation later? Those who bought their first house in 1990, thinking that in five years they would parlay their housing appreciation into a bigger house, found that the rules had changed. Ten years later, they would be lucky to get back enough to pay their remaining mortgage. Disinflation not only freezes property values but also keeps the young family from shrinking the percentage they spend on housing.

But that same couple living in Japan faces a worse situation. Deflation causes real estate values to plunge. If you held a $150,000 mortgage on a house that fell in value to $75,000, would you walk away from your debt? Deflation causes a squeeze on prices. In times of low inflation, companies can raise prices to maintain their profit margin without losing market share. In deflationary times, most companies cannot raise their prices without losing business. If they cannot raise prices—after all, how much of a premium would someone in Indonesia pay to buy a bar of soap—then they have to cut their costs. Cutting costs also means cutting jobs and reducing salaries.

One would think that if high inflation lenders hurt, they would benefit from the opposite, deflation. True, if borrowers continue to pay their loans. However, deflation causes people to default on loans. Last August, the Harvard University endowment fund lost 15 percent or $2 billion. We should not single out Harvard for scolding: the S&P 500 also fell 15 percent. Yet, by the end of October, both made their money back. Who lost money? The banks lost money. They lost it in reality, not just on paper. Default on a loan, with shrunken collateral, is not just a paper loss. There is no easy way out of that mess.

If banks lose money during deflationary periods, who makes money? Current monopolists do as they can hold prices steady. Who are the current monopolists? You will find no answer on these pages, but the Justice Department seems to think that the Microsoft Corporation is one. Who else will do well? Companies like Cisco or Intel that integrate voice and data which changes the way people work and communicate as well as companies that save other companies money.

The United States has an eight trillion-dollar economy of which 15 percent depends on trade. This year in 1999, the government forecasts a 90 billion-dollar decline in trade. That translates to one percent of economy decline due to trade. Sure we can tighten our belts by one percent, but that is not how the hurt will fall. Some parts of our economy and some regions of our country will face a worse hurt than others will. The New York Times reported that the apples waiting for shipment to the Pacific Rim countries was stockpiling in the Port of Seattle to the tune of being able to fill enough boxcars to link Chicago with the port. Although that would revitalize the boxcar industry, it does nothing for the apple growers. Will some miracle happen which will enable the young Japanese couple to not only keep their house but also to afford Washington apples? Not bloody likely.

What will happen to prices and hence profits over the next year? Wages had been growing at a four percent clip. Will labor unions acknowledge what is happening around the world or will they balk? What will happen to the prices of steel, cars and consumer items from overseas when companies and governments make critical decisions as to whether to close their doors or cut their prices? Will the US respond with trade barriers, suffer through an increase in crippling strikes or experience a further decline in prices?

Many consider Federal Reserve Chairman Allan Greenspan the single most powerful person in our economy. When he speaks, the world listens, although it is questionable whether it fully understands. In September, the Chairman said he had never seen the US economy in better shape. CNN showed Greenspan’s testimony along with stock prices running across the bottom of the screen. Although one would expect the prices to rise or fall during the speech, prices were curiously flat. Then when the analysts came on to say that he was signaling a further decline in interest rates the prices on the screen rose dramatically. A week or two later when the Fed lowered rates 25 basis points, the markets fell because everyone had thought the Fed would reduce fifty points.

Let’s pick up a Coke. In July 1998, with the market outrageously priced at 22 times earnings, Coca-Cola (KO) traded at over fifty times earnings, selling above 88. From July to September 30, Coke fell to a low of 56 (although Coke was still trading at 35 times earnings).

Why the plunge? Coke serves over one billion eight-ounce servings each day. Nearly two-thirds of these drinks and almost three-quarters of the profits from these beverages are from overseas. Troubles overseas spell trouble with Coke’s profits and investors reacted accordingly.

With my 200 shares—and with Warren Buffet holding considerably more—should we have followed the flight to safety by selling Coke and buying utilities? Does the foreign market meltdown also spell disaster for Coke? Is Coke a foreign stock, after all?

Coke sells seven servings per person a year in China, 395 in the USA. If China increases its consumption, not to the level of US but to that of, say, Albania, the company, Coca Cola, would double in size.

Quick quiz: Which sector suffered the worse over the summer of 1998? Answer: The banks. They lost real money, remember. Consequently, the availability of loans in many parts of the world, but especially the Far East, has dried up.

Although Coke is IT in Korea and Japan, the company has just begun to quench thirsts in China, India and Indonesia (representing about half the world’s population). The local drink producers, bottlers and distributors in those countries lack the money to invest in infrastructure with the plunge in real estate values, the collapse of banks and the meltdown of foreign stock markets. Coke, on the other hand, does not have to wait in line at a bank window. It has the money to build plants, to research local tastes, to sponsor soccer matches and all the other ways it uses to build its market. Some day, these regions, teeming with thirsty people, will again find the means to buy even more soft drinks. And when they do, Coke is it.

The summer of ‘98 brought us our first "correction" in nearly a decade. International companies like Coke may continue to face a squeeze in profits. Just like our economy, those companies are financially sound, and with a long-term strategy and the resources to build market share, they will emerge more profitable than before. The mistake is not that we have invested and held, but that we did not buy more. The price for companies with real long-term values is never too high. After Coke splits and splits again, remember the lessons learned from the summer of ‘98.

David Barol, CFP, is an investment adviser representative in Radnor, Pa. offering financial planning and securities through 1717 Capital Management Company, a Registered Investment Adviser, member NASD, SIPC.