Even as Federal Reserve Chair Janet Yellen sounded a generally optimistic note in her speech before Congress in early May – noting that GDP stepped up to an average annual rate of about 3-1/4 percent over the second half of 2013, a faster pace than in the first half of 2013 and during the preceding two years – revised GDP growth estimates that show the economy contracted in the first quarter of 2014 should be a cause for concern.

Particularly, as a major support for the economy – Federal Reserve stimulus – is now at a major inflection point, or at the halfway point and steadily declining to zero. And some economists are not yet convinced the real economy has recovered enough – or that it is growing fast enough to replace the Fed’s economic support. Investors should take heed and make sure their portfolios can manage in both an inflationary and deflationary environment – whereas current indicators are pointing toward a deflationary environment.  

To be sure, there is general disagreement by economists on the direction of the economy as is nearly always the case. Those tracking growth last year blame the poor first quarter 2014 GDP numbers on this year’s extreme weather in the Northeast, Janet Yellen included among them. These economists generally anticipate 3 percent GDP growth in the second quarter.  And some expect that pace to last through year-end.

The Fed Chair, in her own remarks before Congress, said, “Looking ahead, I expect that economic activity will expand at a somewhat faster pace this year than it did last year, that the unemployment rate will continue to decline gradually, and that inflation will begin to move up toward 2 percent . . . Moreover, U.S. financial conditions remain supportive of growth in economic activity and employment,” she argued.

Many question if bad weather can truly explain the dire economic numbers that came out first quarter. In April the U.S. government estimated that the economy had grown at a tepid 0.1 percent in the first quarter – only to be revised significantly downward on new data that finds the U.S. trade deficit shrank less than expected in March. The trade gap narrowed 3.6 percent in March to $40.38 billion. But the Commerce Department baked in a larger drop for its initial estimate of first-quarter growth, according to news reports.

As for economists’ forecasts, JPMorgan Chase analysts now predict GDP contracted 0.8 percent in the first quarter. Macroeconomic Advisers projected a dip of 0.6 percent, Barclays Capital a 0.2 percent decline and BNP Paribas a 0.1 percent slide, according to The Wall Street Journal.

To add to the general belief that something might be amiss in the growth picture for the U.S. and the world, the Organization of Economic Co-Operation and Development (OECD) in early May cut its global growth expectations from its November outlook from 3.6 percent to 3.4 percent for 2014, although it kept its forecast for 2015 at 3.9 percent.

Chart A: Is the Market Bubble About to Burst?

Source: The New York Times, 2014

Furthermore, the OECD now expects growth across its 34 member countries to come in at 2.2 percent in 2014 and 2.8 percent the following year. The U.S economy is expected to grow by 2.6 percent in 2014 and 3.5 percent in 2015, while the Euro zone is forecast to notch up growth of 1.2 percent this year, and 1.7 percent next year. Japan’s economy, meanwhile, is seen expanding by 1.2 percent both this year and next.

Will the Market Bubble Go Pop?

Adding to this growing concern that the recovery in growth may have been illusory is the view that as the stimulus withdraws, stock markets that have been beneficiaries of the Federal Reserve largesse will also decline due to having been–in reality–a stimulus-induced asset bubble.  

Relative to long-term corporate earnings – stocks have been more expensive only three times over the past century than they are today, according to data from Robert Shiller, a Nobel laureate in economics. According to an April 2014 New York Times report, those other three periods are not exactly reassuring: the 1920s, the late 1990s and in the prelude to the 2007 financial crisis. See Chart A.

Moreover, even as the Dow Jones Industrial Average (DJIA) hit another all-time high value, closing at 16580.84 on April 30, this is a level which even Factset analysts believe is inconsistent with the corporate earnings picture – supporting the view that the markets are significantly overvalued.  

“Given this record value, have companies in the DJIA been reporting strong earnings and revenue growth for the first quarter?  The answer is no. To date, 24 of the 30 companies in the DJIA have reported actual results. The blended earnings growth rate (which combines actual results for companies that have reported and estimated results for companies yet to report) stands at -3.3%. If -3.3% is the final earning growth rate for the quarter, it will mark the third year-over-year decline in earnings in the past four quarters for the DJIA,” according to a Factset research report.  

Given this performance during the Q1 earnings season to date, it does not appear that results for Q1 are fueling the rally, Factset argued, though leaving open the possibility that perhaps the market is looking ahead at expectations for higher earnings and revenue growth in the future. 

Analysts do expect a significant improvement in earnings growth in the near future. Over the next four quarters (Q214 – Q115), the estimated earnings growth is projected to be at or above 5.5%. However, growth of just 5.5% would mark the highest earnings growth for the DJIA since Q212 (16.6%), according to Facset. 

We’ve Been Here Before

Since last year’s announcement of Federal Reserve tapering we have been arguing that the economy can go either of two ways: high growth or a slip back into recession. It all would depend on the Federal Reserve’s timing on winding down its stimulus program.

The period to watch is when the Fed’s bond buying program is reduced to $45 billion, which is where we are today.  That level was held up previously until December 2012 as part of its Operation Twist, which involved selling $45 billion a month of short-term Treasuries to fund the purchase of long-term bonds. Before the Fed nearly doubled the stimulus program last year, your correspondent (who studied the Great Depression and wrote an economics thesis at Georgetown University on the subject) was becoming increasingly alarmed at the various deflationary signals that were appearing.

During this period, growth in GDP had been stalling, while the output gap had been widening. Meanwhile, Europe had already been suffering from an economic contraction. Additionally, oil and gold were losing value, and US industrial activity was declining. And sales at economic bellwethers such as Wal-Mart Stores Inc (NYSE: WMT) and McDonalds Corp (NYSE: MCD) had disappointed investors. Furthermore, large investors were considering shorting high-yield bonds and the government’s sequestration seemed sure to stifle growth in economic activity.

But just as it seemed the world was about to fall apart, the stimulus resulting from the Fed’s $85 billion per month bond-purchasing program, which includes both mortgage-backed securities and Treasuries, began to be felt in the real economy.

The impact of the increased stimulus seemed to result in improved US GDP and employment numbers. All was seemingly going well. Economists breathed a sigh of relief, believing that perhaps Mr. Bernanke’s untested approach to a balance sheet recession was the right course. Central bankers from Europe to Japan followed his lead.

But today, again at the $45 billion mark – set in April 2014 – there are similar deflationary signals. Global declines in growth, paltry earnings from businesses and disturbing deflationary signals seem to be coming from the real economy.

For example, Dollar General (NYSE: DG), the nation’s largest dollar-store chain with 11,100 locations, offered a weak profit outlook in the early part of the year after reporting weak fourth-quarter sales. And Dollar Tree (Nasdaq: DLTR), which operates about 5,000 locations, missed profit expectations for the holiday quarter in February. What has happened to the American consumer? Even McDonald’s sales were flat in April.

And while some may argue that this performance can all be explained away with bad weather, there is no arguing with the Congressional Budget Office, which earlier this year acknowledged that the future GDP growth will be significantly more muted than once believed.  

Chart B: Potential GDP Output Revised Downward

According to a standard economic definition, a positive output gap occurs when actual output is more than full-capacity output. This happens when demand is very high and, to meet that demand, factories and workers operate far above their most efficient capacity. A negative output gap occurs when actual output is less than what an economy could produce at full capacity. A negative gap means that there is spare capacity, or slack, in the economy due to weak demand.­

On Feb. 28, the CBO revised an estimate for potential GDP for 2017 that it had made in 2007. The new estimate is 7.3 percent lower than the original forecast. This downward revision wipes out $1.5 trillion of potential output, according to Andrew Fieldhouse, fellow at the Century Foundation, a think tank, according to a Bloomberg news report. So instead of forecasting a potential GDP of almost $20.7 trillion, the CBO predicts potential output closer to $19.2 trillion.

According to various economists, the assumption has always been that the U.S. economy would gain back what was lost in the recession. “But academics are coming to the realization that this time is different and that those losses appear permanent and cannot be regained,” an economist told Bloomberg News. As such, many economists have concluded that the lower potential growth indicates that the recession did permanent damage to the economy.

Moreover, accordingly, the CBO didn’t just revise potential GDP down. Usually the agency assumes the economy will eventually realize its potential within a decade. This time, although the CBO sees the output gap narrowing, it doesn’t project the economy ever reaching even the new, lower potential GDP, according to Bloomberg.  Moreover, while in the long-term the CBO does project the output gap narrowing to the lower potential GDP, the CBO’s data shows today an output gap of $754 billion.

Squaring with inflation

When the Fed does draw down to $45 billion, last December we advised investors to evaluate various economic indicators such as the output gap, GDP, consumer demand, industrial and business activity, as well as the unemployment numbers, to discern whether the economy was headed toward inflation or deflation.  

We said back then, if the US economy does prove to have turned the corner by the end of 2014, and growth is on a tear, that’s when the potential start of inflation is at its greatest. As the price level increases, more companies can pass on their costs.

Before we can return to a more inflation fighting posture, we would look to see positive GDP growth next few quarters, a narrowing of the current output gap, improved unemployment figures (particularly an increase in the participation rate and the hiring of the long-term unemployed). Not to mention, we would also want to see continued increases in consumer demand, the CPI and the producer price index. In the meantime, we would advise investors to have their portfolios insulated from either inflation or deflation, but with a focus on deflation given the present economic environment. 

Top Utilities
The electric utility industry typically does well in a deflationary environment, because these firms provide relative certainty of cash flows and high dividends. Here are our favorites now:

Duke Energy Corp (NYSE: DUK) is a well-run, regulated energy utility in an accommodative regulatory environment. The firm expects earnings per share (EPS) to grow 4 percent to 6 percent annually in the coming years. Management has narrowed its full-year 2013 adjusted diluted EPS guidance range to $4.25 per share to $4.45 per share. However, the company has yet to provide its 2014 earnings guidance range, or capital expenditure and cost-savings estimates for 2015 and beyond.

Duke remains committed to investing in the expansion of its generational capacity in South Carolina and Florida, as well as improving the efficiency of its generational fleet in Indiana. Moreover, management hopes to improve profitability by focusing on the company’s international business operations and renewable energy sources. Duke Energy is a buy up to 62.

NextEra Energy Inc (NYSE: NEE) has produced one of the strongest records of earnings growth among US electric utilities, driven by its large and expanding portfolio of renewable generation at its unregulated unit, as well as load growth at regulated utility FP&L. The latter’s favorable regulatory environment and the highly hedged, clean and well-positioned wholesale generation portfolio establish a solid platform for continued earnings outperformance versus NextEra’s peers.

NextEra’s third-quarter 2013 operating EPS of $1.43, up 13.5 percent from a year ago, beat analyst estimates. The results were due to the company’s effective execution of development projects, continual customer additions, and service start-up of renewable contracted projects. NextEra is a buy up to 94.

Entergy Corp (NYSE: ETR) is another steady player that has delivered consistent shareholder value over the years. The utility recently posted third-quarter 2013 operating earnings of $430.4 million, or $2.41 in EPS, up 23.6 percent year over year.

This performance was due to higher net revenue and a lower effective income tax rate, partially offset by higher non-fuel operation and maintenance and depreciation expenses. Entergy affirmed its 2013 operating earnings guidance range of $4.60 to $5.40 in EPS, noting that current expectations point to around the middle of the range.

“During the quarter, we saw positive results in utility top-line growth, reflecting strong industrial sales during the quarter,” said Leo Denault, Entergy’s chairman and chief executive officer, who added, “As we look ahead, we see opportunities in each of our businesses.”

These opportunities include growth prospects and investment opportunities presented by a strong economic development pipeline. The company reported increases in residential, commercial and industrial energy sales, with the biggest jump, in the industrial sector, attributed to growth in chemical and oil-refining operations. Entergy is a buy up to 75.

 Some of the securities we’ve highlighted in this article are trading above their buy targets at present. For those who are looking to establish positions in these names, simply set a buy limit with your broker at or below our buy target on a good ‘til cancelled basis, and wait for your order to fill.

Portfolio Update

Wells Fargo (NYSE:WFC) reported record net income of $5.9 billion, or  $1.05 per diluted common share, for first quarter 2014, up from $5.2 billion, or $0.92 per share, for first  quarter 2013, and up from $5.6 billion, or $1.00 per share, for fourth quarter 2013.

Revenue was $20.6 billion, compared with $20.7 billion in fourth quarter 2013, as higher noninterest income was more than offset by the expected decline in net interest income due to two fewer days in the quarter. Several businesses contributed to growth in the quarter, according to company materials, including retirement services, equipment finance, wealth management, asset-backed finance, merchant services, personal lines and loans, and retail sales finance.

The bank has also made major progress in cutting costs; its efficiency ratio was just under 58% during the first quarter, as the company cut both employee costs (reducing staff by 9,000) and expenses related to professional services. And it is believed that the bank can achieve an even better ratio of expenses to revenues as costs related to compliance with new regulatory regimes and legal issues decline over time, according to management statements.  

As we’ve long argued the firm’s strong balance sheet and overall financial performance, particularly in the last quarter, makes this bank a continued standout as an inflationary hedge. WFC is a Buy up to 51

Pall Corp. (NYSE: PLL) delivered earnings of $0.75 per share in the second quarter, a 6% improvement over the prior year. These result reflected solid operational earnings growth.  Pall’s life sciences businesses delivered both core revenue growth and operating margin improvement in the quarter, leading to operating profit grown of just over 10%. Further, consolidated operating margins improved to 18.2% from 17.0% as a result of lower corporate overhead as well as improvements in the aforementioned life sciences business.

Pall is a global business in the diverse field of filtration, separations and purification. Pall has been called the “original clean technology company” since many of its products deliver sustainable social benefits. The firm functions as an excellent inflation hedge as its customized systems mean low competition which allows the firm to pass on costs. Further, Pall’s global diversification also means the firm’s earnings would always stay ahead of inflation in any one country. Pall enjoys outstanding growth opportunities in biopharmaceuticals. This market is growing at twice the rate of traditional pharma products, and it uses 8-10 times as many filtration applications as traditional products. PLL is a Buy up to 80

Tiffany & Co (NYSE: TIF) reported financial results for the fourth quarter and full year ended January 31, 2014. Worldwide net sales rose 5% in the quarter and 6% in the year.

A net loss in the fourth quarter was due to a recorded charge that related to a ruling in an arbitration proceeding however, excluding that and specific charges recorded in the first quarter, net earnings increased 6% in the fourth quarter and 15% in the full year, reflecting the sales growth and improved operating margins. For the fiscal year ending January 31, 2015, management forecasts net earnings to be in a range of $4.05 – $4.15 per diluted share.

One of the key future growth opportunities for Tiffany is in Asia. During the January-ended quarter, Asia-Pacific sales were up 23% year over year. And China looks to become one of Tiffany’s biggest markets. A decade ago, Tiffany only had 11 stores in China. Now it has 45. And China already has the second-largest jewelry market, but it’s set to keep growing given the rising middle-class in the country. Also helping it grow will be the rise in penetration of engagement rings in the country (about 80% of U.S. marriages involve an engagement ring, whereas in China it’s 30%).

With the affluence in China growing, that number could see the same type of growth that engagement rings saw in the U.S. in the mid-1900’s. From the 1940’s to 1960’s, engagement ring usage rose from 10% to 50%.

We have long argued that Asia will continue to be a key emerging markets growth area, and give Tiffany’s the ability to deliver global earnings diversification. Moreover, Tiffany’s business has that one timeless driving force or demand that allows it to pass along costs during inflationary environments and sometimes defy the business cycle entirely; and that is the human quest for eternal love that is increasingly expressed with diamonds. TIF is a Buy up to 90.