Deflation is coming. Be prepared.
From Merrill Lynch today (emphasis ours) a very useful quick look at the new economic order - lessons from Japan:
1. Bonds are the ultimate inflation/deflation barometer; equities go up and (much more often) go down with bond yields in a period of deflation.
… bond yields and equities become positively correlated, watch the 10yr US Treasury.
2. Yen strengthened in the initial stages of Japan’s deflation (as is the US$ today, a -ve for EM); but in an extended period of deflation the currency becomes correlated and ultimately declines with financial sector stocks.
The Yen (read dollar) was a very strong currency during the first half of the crisis but then weakened in line with deflationary expectations and the BoJ’s ever more strident bailout actions (USD in this phase already?)
3. The equity market trading pattern after an inflationary boom and deflationary bust is emphatically sideways, a big, fat trading range.
See also “The Mega Bear Quartet” from Doug Short.
4. Deflation did not prevent +20% equity rallies every year in Japan; and every other year there were rallies in excess of 33%
5. The business cycle does not die and the inventory cycle in particular drives equity market inflection points within the big, fat trading range
6. “Best of Breed” stocks massively outperform a deflationary trading range (and once volatility subsides should do again in Asia & EM next year)
7. Small cap never comes back because small cap is a “price-taker” not a “pricemaker”; monopolistic companies with pricing power outperform, e.g. utilities
8. Deflation makes interest rate sensitive stocks such as banks become interest rate insensitive; sectors reliant on bank capital (e.g. construction in Japan) massively underperform; and the deflationary price action never dies until real estate prices and bank lending recover.
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