Time to Consider a Harsh but Salutary Trend: Deflation
Signs are clearer every day that in the 1990s we have entered a new kind of economy, one that will demand a profound change in thinking. Most prominently, it is an economy with a deflationary bias, in which for the first time in at least three decades your dollar tomorrow may buy more than your dollar today.
Some signposts to the new reality will be discouraging. Stores will close, banks will fold and shopping malls will be turned into bowling alleys or basketball courts.
But the outlook is for recovery, not depression, and other signs are reassuring: Inflation and interest rates will be low--one leading banker predicts a 4% prime rate by the mid-’90s. There will be capital available for business investment, and possibly a new birth of the world economy within a few short years. Meanwhile you’ll need to watch some significant numbers to judge prospects and investments in this period of transition.
The bad news is severe indeed. The extent of the commercial real estate bust after the boom of the ‘80s, when 46% of the nation’s office structures were erected, is becoming evident. Some transactions in New York City have set the tone. Citicorp, for example, recently sold a building in the heart of Times Square for just over $100 million--or 50% of the property’s value when it was built a year or so ago.
That 50-cents-on-the-dollar price provides a benchmark for commercial real estate throughout the country, says James Noteware, national director of Price Waterhouse’s real estate advisory services. Buildings elsewhere can begin to sell at comparable prices.
And bankruptcy lawyers can look forward to overtime. The nation’s banks hold roughly $350 billion in commercial real estate loans. If many of the properties are worth half their historic value, a lot of banks will have to merge or close.
Office buildings are not the only problems. Fully 56% of the nation’s retail space was built in the 1980s. So now there is an oversupply of stores in fancy malls and strip shopping centers waiting for free-spending consumers to come back. And that just isn’t going to happen. It’s a matter of income. The consumer’s paycheck isn’t going up in the ‘90s as it did in the ‘80s. In the late 1980s, when malls were still being built and banks were financing buyouts of retail chains, Americans’ personal incomes were growing at 7% a year. But since 1989 personal income has grown 2.5% a year and may be slower than that this year.
Nor can the consumer count on pay raises to bail out today’s purchases, in a deflationary time when businesses can’t raise prices and have to cut costs. The outlook is clear: Consumer spending will be cautious and restrained--as it is today.
The implications for housing markets are profound. If buyers can’t count on pay raises, they won’t reach to buy bigger houses because their ability to absorb monthly payments won’t ease with the passage of time. Furthermore, in a deflationary time, borrowing is expensive--the dollars you pay back tomorrow have as much or more purchasing power than the dollars you borrow today.
That means the important “move-up” market, in which homeowners take the profit from one house and move up to a bigger one, turning over capital gains all the time, will be substantially diminished. In fact, the idea of profit in homeownership may no longer be valid. Federal Reserve figures show that the median price of existing homes has risen only about 4% in the last year, and that of new houses has declined. The number of Americans in the home buying 25- to 34-year-old age group is lower than it has been in decades.
That doesn’t mean housing will collapse, like commercial real estate. Only that for the first time in three decades, a house will be a home more than an investment.
The word for the new economy isn’t plastic. Installment debt has been declining for years, and is now at a low point previously seen only when the government imposed credit controls, says Charles Clough, chief investment strategist of Merrill Lynch. Clough, who has marked the economy’s deflationary pattern for over two years, is not surprised that major credit card issuers are lowering interest rates in a futile attempt to lure customers to borrow.
The game has changed. Interest rates are low and going lower as borrowers hold back in a time when just about everything is in oversupply--from cars to houses to airplane seats. Business finds little reason to expand in such a time. And so banker Victor Riley, chairman of Key Corp., predicts a 4% prime rate by the mid-’90s, compared to just over 6% today.
And with housing slow and fewer new mortgages being created, long-term interest rates will also decline. Why? Mortgage debt, totaling $4 trillion, is the real credit engine in the U.S. economy. By comparison, long-term business debt--excluding short-term financing for inventories and such--is under $1 trillion and the federal deficit is under $400 billion. So if mortgage debt doesn’t grow as it has in recent decades, there will be a lot of low interest money around for other purposes.
Two consequences to keep in mind. With interest rates low, the stock market will stay strong--even if individual stock prices fluctuate--because small savers and giant pension funds will continue to pour money into it. The corporate and public employee pension funds--with more than $2 trillion invested--wisely stayed away from real estate in the ‘80s and so retain undiminished investment power in the ‘90s.
The directions for individuals seem clear. Borrowing is out. Real estate, commodities, gold and other inflation hedges are out. Stock and bond investments are in. And cash will give you opportunities.
For corporations and nations, with capital available, investments will increase in Latin America, Eastern Europe and the other developing economies as they begin their cycle of home building and car-buying. Meanwhile, the United States, Japan and Western Europe will find investment opportunity in advances of knowledge--in telecommunications and computing, the further perfection of medical technology and so forth.
A new world is being born in this decade, even as the old one is written off. To profit from that you have to be nimble, and change your thinking.
