Market Update: Reality returns to the marketplace

William F. (Ted) Truscott, CEO - U.S. Asset Management & President, Annuities — Ameriprise Financial, Inc.

July 6, 2010

The Dow Jones Industrial Average closed on June 30 with its first quarterly loss in more than a year. The index was down 10% for the quarter, while the NASDAQ lost 12% and the S&P 500 lost 11.9%. Corporate and high-yield bond spreads have widened as significant stock and bond market carnage has occurred since mid-May, due primarily to markets digesting the risk of a Greek sovereign default and excess indebtedness in much of the developed world.

There continues to be other worries as well. The U.S., European and Japanese economies are expanding at fairly anemic rates and not at levels sufficient to create employment after the steep downturn and loss of jobs that began in 2008. Concerns about deflation taking hold in developed countries are gaining traction just as developing nations, and notably China, fight off inflationary pressures brought on by currency pegs to the U.S. dollar.

What approach can we take?

We have been saying for some time that the "Great Recession" is very different from past recessions we experienced in the 1970s and 1980s. This recession is the result of a burst credit bubble, and most market participants continue to underestimate the dramatic effects of repairing the damage from this massive overshoot in the extension of credit to consumers, some corporations and governments. Fixing the problem is no easy task and policymakers are divided as to what approach to take.

Some believe that additional stimulus is necessary while others advocate fiscal responsibility and a decrease in deficits. The 2008 downturn was significant, and an error in policy at this point could have dramatic repercussions. As reported by the New York Times on June 30, policymakers are now deeply concerned that we could repeat the mistakes of the mid- to late-1930s by prematurely tightening our fiscal belts and raising taxes. The article points out that, "If anything, the initial stages of our own recent crisis were more severe than the Great Depression. Global trade, industrial production and stocks all dropped more in 2008-2009 than in 1929-1930." This debate is not idle chatter and I encourage you to read the entire article titled, "Governments Move to Cut Spending, in 1930s Echo" to learn more.

"Deleveraging," or the act of paying down or defaulting on debt, will be with us for some time and will continue to act as a ceiling on growth. Every dollar diverted to repaying debt will not be spent on goods and services. As states and municipalities rein in budget deficits, job and benefit cuts will also crimp growth. The dirty secret that no one wishes to discuss or admit is that there is no miracle cure out there that will make this all go away. Debt reduction must occur — it's painful but necessary and right now the only real question is when it must happen.

Japan as a model and deflation concerns

The only recent model we have that shows the effect of a burst credit bubble is Japan, and it's not a pretty one. As the chart below shows, Japan's stock market average, the Nikkei, has been trendless for almost 20 years and has never reached its old highs.

While we do not believe that the United States will end up like Japan, it is still a useful model to understand risk since there are some scary parallels and similar concerns — deflation being the most significant.

Japan's bubble was partly built upon rising property values just as what has occurred in the United States. When that bubble burst, it exposed a financial system that had loaned money in and outside of Japan at ludicrously low rates. Japanese banks and insurance companies found themselves saddled with bad debts. It took years for policymakers to craft an appropriate response and to lower interest rates sufficiently to counteract the effects of the burst debt bubble. The policy response was in fact too late. Japan has recorded very slow growth rates over the last 20 years and endured some recessions along the way. Of greater significance, deflation has taken root as consumers hoard savings despite low interest rates driven largely by fear of further problems ahead.

Concerns about deflation are now escalating in the United States. What is deflation? It is the phenomenon of falling prices. Most of us are used to inflation, which is the phenomenon of rising prices. Anyone who lived through the 1970s knows that high levels of inflation can distort the economy and are mostly unwelcome. That said, most central bankers are willing to tolerate low levels of inflation somewhere in the 2% to 3% range as completely stable prices are very hard to achieve. Low levels of inflation are actually preferable to deflation as falling prices can be ruinous to an economy — especially one loaded with debt. Of even greater significance is the fear central bankers have of deflation because they are unsure of how to unlock an economy from a deflationary grip as has been witnessed in Japan.

What are the issues with deflation? At the corporate level, companies will face falling prices, making it hard to grow revenue, which in turn affects corporate earnings. Few companies know how to deal with deflation, except those in the technology industry, which has had to cope with falling prices for most of its existence. Wal-Mart, a company that strives to bring lower prices to consumers, is also an expert in this area. These companies are certainly the exception, not the rule.

High levels of debt can cripple a company or consumer in a deflationary environment. Why? Debt is a fixed cost and paying back debt when revenues or wages are falling or stagnant can become a crushing burden. Paul Krugman continues to be one of the most outspoken voices on this subject. In an op-ed piece for the June 28 New York Times, he wrote, "After all, unemployment — especially long-term unemployment — remains at levels that would have been considered catastrophic not long ago and show no sign of coming down rapidly. And both the United States and Europe are well on their way toward Japan-style deflationary traps. In the face of this grim picture, you might have expected policymakers to realize that they haven't yet done enough to promote recovery." Again, I would encourage you to read his piece titled, "The Third Depression" in its entirety.

Remember that Krugman's advocacy of continued deficit spending is no panacea. It is in fact a bet. The bet is that additional fiscal stimulus will result in faster growth and that the faster growth will help bring down the huge deficits spawned as a result. The Fed has few weapons left. Interest rates are already at zero and thus cannot go lower. The only option is to further expand its balance sheet, which carries its own risks. We are in a tough place and there are no easy answers.

Product solutions in a deflationary environment

Assume we are in an environment of no inflation or deflation. Investors first need to realize that low nominal rates of return may be more powerful than they appear. Most investors are used to subtracting inflation from a nominal rate of return to calculate the real rate of return. Let's say an investment returns 8% and inflation is 4%. The nominal return is 8% but the real return (the purchasing power of that return not eroded by inflation) is only 4%. Now consider an investment with a 4% return in a deflationary environment of -1.5%. The nominal return is 4% and the real return is 5.5%. This is because the purchasing power of an asset in a deflationary environment is increased as prices fall.

Many insurance and annuity products offer fixed crediting rates in the range of 2% to 4% or higher. Some variable annuity products with living benefits offer annual credits of 6% to 8% if the stock market falls or does not equal the crediting rate. I believe that investors should thoughtfully consider these product solutions as the credits may be very valuable in a no inflation/deflation scenario. The tax deferred nature of insurance products is an added bonus. Consult your own financial professional to learn more about the potential product solutions that might make sense for you.

Another investment vehicle of choice in a deflationary environment that we have discussed in the past is government bonds. The U.S. Treasury market highlights this opportunity as Treasuries were up 5.8% in the first half of 2010 — the best start these vehicles have seen since 1995 according to The Wall Street Journal.

I must also add that not all the news is bad. Economies around the world are growing, albeit slowly, and that is certainly better than a contraction. Many large corporations around the world are sitting on record levels of cash as a result of massive cost-cutting and a general unwillingness to invest given the uncertain environment. That cash will need to be put to use at some point or returned to investors in the form of dividends. In a low inflation environment, dividends will be increasingly valuable. If companies do not choose to pay dividends, they may buy back stock and potentially reward shareholders with modest gains in stock prices.

Finally, in a low growth environment companies may choose to use that cash to buy growth. We predict, therefore, that merger and acquisition activity will surge in the coming one to two years. We also continue to see value in investment-grade corporate bonds; high-quality, high-yield bonds; and municipal bonds. Bond coupons or mutual fund dividends from bond funds will be valuable in the same way as stock dividends in the equity market.

I urge you to ensure you have the proper product diversification to deal with the challenges of today's volatile environment. This update has discussed the risks of deflation and slow growth, but we have also discussed previously that under the right conditions inflation could return in a few years' time. The concept of product diversification recognizes that no one financial product can deal with all the risks of a particular environment nor maximize the opportunities that may be present. In the end, spreading your exposure across multiple product sets may help you deal with the dynamic nature of the marketplace and feel more confident about reaching your long-term financial goals and objectives.