Inflation or Deflation?: UUP, FDX, GLD, AAPL, SDS

June 18, 2010, 08:15 am ET, BY Patrick- Contributor, Stock Traders Daily| Editor: Thomas H. Kee Jr. (Follow on LinkedIn)

When the economy began to show some signs of life in the beginning of 2009, many analysts and money managers predicted that inflation would be the next significant challenge facing the country. A common belief was that a combination of rock-bottom interest rates and a flood of federal stimulus spending would slowly erode the dollar, causing a problematic bout of inflation. Then, later in the year, we saw early signs in the corporate world that inflation would indeed soon be a factor when FedEx (NYSE: FDX) announced in December that it was raising its ground services by 20%.

This fear was also evident in the movements of the Powershares DB U.S. Dollar Index (NYSE: UUP) and the SPDR Gold Shares ETF (NYSE: GLD). From March 2009 through the end of that year, the UUP declined 14% while GLD increased 18%. Seemingly strong economic data continued to cross the wires early this year as manufacturing, industrial production, consumer debt levels, retail sales, and even housing starts showed marked improvement. However, despite the encouraging data, the FOMC stated in mid-February that while the economy may grow more rapidly in 2011 and 2012, many members expected inflation to remain subdued. Therefore, the Committee affirmed its 0 to 0.25 percent target range for the federal funds rate.

Recent Data Suggesting Deflation

Over the past few weeks, there has been a building sentiment on Wall Street that we may be facing an even more troubling problem than inflation. Deflation is a decrease in the general price level of goods and services and occurs when the annual inflation rate falls below 0%. Simply stated, deflation is bad for just about every asset class – unless, of course, you’re Apple (Nasdaq: AAPL) and your stock goes higher no matter what.

On June 17, the market received some economic data that deflation may in fact rear its ugly head. Consumer prices declined 0.2% in May following a 0.1% decline last month. Also, the year-over-year Core CPI – which excludes food and energy – fell to 0.9%, which is well below the Fed’s target rate of 2.0-2.5%. This data should provide further indication that interest rates will remain at low levels for some time.

Bear Funds Best (Only) Bet?

There were two other pieces of economic data that indicate inflationary pressures will be subdued – or worse, deflation could become a reality. The June Philadelphia Fed, which monitors business activity in the Philadelphia region, came in far below expectations. Perhaps most troubling was that the data showed that disinflationary pressures are causing companies to cut back on prices they can charge, which of course, dampens profitability outlooks. Additionally, there was another round of disappointing jobs data, as initial jobless claims came in at 472K versus the 450K Street expectation. Without a strong labor market, it’s difficult to see demand for goods and services expanding to a point where prices move materially higher.  As we previously stated, in a deflationary environment, asset prices across the board depreciate. Therefore, if we are indeed heading for a deflationary period, investors should consider bear funds, such as the ProShares Ultrashort S&P 500 ETF (NYSE: SDS).

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