Over time prices rise and fall at varying rates. The rate of inflation and its effects on an economy are often talked about endlessly.

The latest jobs report has significantly increased the likelihood of a December rate hike. But is this rate hike necessary in the face of what appears to be underlying deflationary pressures and weaknesses in many sectors of the economy?

It’s difficult to cheer a rate rise when sales for the S&P 500 are now suggesting a fall about 1 per cent for 2015. We will take a look at what is happening at a more micro level due to the Wal-Martization of the planet and the resulting implications for “everyday low prices”. We live in a world with global overcapacity, price pressure and a fight for market share.

Wal-Martization Effect

The Wal-Martization effect I’m referring to reflects the series of macroeconomic aspects that have perpetuated a near deflationary and hyper-competitive environment. Here are a few with commentary:

1. The Amazon effect. Over the last three years Wal-Mart revenues have grown less than 1 per cent per year while Amazon’s sales have grown about 20 per cent per year. After decades of outpricing smaller retailers that lacked scale, Wal-Mart is now getting beat-up by online competition that offers more convenience and choice. The surge in the e-commerce industry pretty much assures Wal-Mart margins will be pressured for some time to come. With intensifying competition from more efficient and lean online retailers many “bricks and mortar” companies have a big disadvantage.

Although many postulate that people still like to touch and feel products, there are many that are simply commodities in nature and have been digitised. A digital song or book, for example, has essentially a zero incremental marginal cost. The result is a world where technological competition is fierce and resulting margins are low and razor thin.

What has evolved is an environment where pricing power is illusive for many companies fighting in a space where scale is valued more so than profits. In some cases the winner will not necessarily be the one who make the most profit today but who establishes the broadest and “stickiest” network. Time and technology often wins.

Amazon vs. Wal-Mart*

2. Excess capacity. Maybe the easiest and most personal example for Bermuda of this is the reinsurance market. Reinsurance rates have fallen for some time now but the downward price spiral doesn’t seem likely to end anytime soon. It has been suggested that rates will fall a further 10 to 12 per cent for January renewals. Recently in the reinsurance sector, for example, European property catastrophe rates fell to 26-year lows and US pricing to a 10-year nadir.

The level of excess capacity continues to grow and with another relatively quiet storm season it is likely to grow even further. Pricing power in this market has virtually disappeared.

This overabundance of capacity is prevalent throughout many sectors and not just reinsurance.

Just take a look at what is happening in the oil patch where global supplies are hitting a surplus of up to two million barrels per day. The result is a series of sectors and industries where excess capacity has not been absorbed and companies have not failed (yet). Thus there is far too much competition fighting over a stagnant or shrinking pie and profitability is being eroded while pricing power is non-existent.

I suspect that the low interest rate environment that has perpetuated the last few years is not helping in this regard. In fact low rates are helping “prop-up” dying companies by giving them cheaper financing. Without failures and bankruptcies, existing competitors continue to wage war in an environment of excess.

Global Property Cat. Price Index*

3. Debt and not much deleveraging. As I have stated many times in the past, debt is a form of temporal shifting in consumption. Leverage used today accelerates current spending at the expense of less spending sometime in the future.

After the financial crisis many assumed the world would deleverage. It has not. Instead, according to the February 2015 report by McKinsey & Company Debt and (Not Much) Deleveraging, the level of debt continues to grow in nearly all countries in both absolute terms and relative to GDP.

Since 2007, global debt has grown by $57 trillion, raising the ratio of debt to GDP by 17 percentage points. At the end of the fourth quarter of 2014, global debt amounted to some $199 trillion dollars or 286 per cent of global GDP. This ever-growing pile of leverage will and has restricted consumption and or overall aggregate demand as it is repaid.

In fact in a world with deflationary tendencies the deleveraging process tends to be more difficult and burdensome as the debt level in real terms doesn’t fall much at all over time and requires similar resources to repay. Ultimately, deleveraging is deflationary and reduces financial flexibility for companies and governments.

Implications of Wal-Martization

1. Inflation protection is cheap. The markets, for good reason, are focused on the risk of deflation. If you look at the ten-year breakeven rates in the Treasury Inflation Protection (TIPS) market they are pricing in only about 1.5 per cent inflation over the next ten years. This is below the Federal Reserve’s target of 2 per cent and the ten-year average of the same.

For those with a more contrarian streak they may want to think about adding some inflation protection at a point when no one sees a risk for it.

US 10-Year Breakeven Rates*

2. Pricing power and growth is scarce and revered. Markets that are walking through periods of deflationary pressures tend to prize companies with earnings growth and pricing power.

Earnings are the main driver of stock prices. In the 1950s and the 1960s companies that could grow earnings sold for much higher multiples, sometimes 40 times or more. This probably explains a lot of the reason that fast growers with secular revenue growth stories have attracted such high valuations.

Companies like Amazon, Facebook or Netflix, for example, now trade at 964 times, 109 times and 288 times earnings respectively. In a world where growth is scarce and extremely difficult to find, those companies that do not rely on overall economic growth but are driven by their own secular story or product become increasing rare and valuable. They also can defy reality as momentum takes over so one needs to be careful that you’re not investing late at the peak of euphoria.

3. Reversion to the mean has become a value trap. Hyper competition and technological disruption changes the competitive dynamics and business model in so many industries.

We are going through one such period now where the effect of technology and innovation are constantly blowing up old business models and disrupting staid ways of conducting operations. As a result, the value based mentality of the reversion to the mean can often fail miserably. Quite simply, companies trading at historic discounts to their own longer term averages in many cases deserve to do so.

Thus any strategy that assume a reversion to some historic level average associated with some companies is likely to be unsuccessful. The reason is simple. The game has changed in many industries. What once may have a been a stable industry that embed and flowed with the general economic climate now has become altered by technology and no longer resembles anything that it once did.

4. Mergers and acquisitions. If you can’t raise prices or sell more goods what do you do? You buy growth.

So far in 2015 there has been about $5 trillion of mergers globally. This is up 27 per cent year-over-year. Plus the recent wave of mergers and acquisitions (M&A) is set to continue with 59 per cent of global companies now planning to acquire in the next 12 months, according to the 13th edition of the Global Capital Confidence Barometer, a biannual survey of more than 1,600 executives, conducted by the Economist Intelligence Unit on behalf of EY.

Scale is becoming increasingly more valuable to compete in various industries. Those left behind are likely to be marginalised and squeezed. We are seeing waves of consolidation throughout various sectors.

Examples include the massive consolidation in the healthcare industry in the US with the deals between Allergan and Pfizer or Aetna and UnitedHealth Group or the ongoing consolidation in the insurance industry with the ACE and Chubb deal or the XL and Caitlin deal. How about in the beer industry where SABMiller is the target for Anheuser-Busch Inbev, a deal where, if done, would leave less than five large global distributors.

In the technology sector, the disruption we are seeing with cloud computing has forced EMC into the hands of Dell. No matter where you turn large and small deals are getting done. With global growth now expected to be less than 3 per cent for 2015 and only 3.3 per cent for 2016 according to the OECD, growth through acquisition, coupled with the non-existent return on cash and cheap financing, should continue to foster an environment of even further consolidation globally.

The Wal-martisation of the world continues unabated. Hyper competition, low pricing power, and an environment of anaemic global demand, partially as a result of the ongoing deleveraging process, presents an interesting backdrop for investing. We are in an environment where we should continue to see “everyday low prices”.

* Source: Bloomberg

Nathan Kowalski CPA, CA, CFA, CIM is the Chief Financial Officer of Anchor Investment Management Ltd. and can be reached at nkowalski@anchor.bm. Disclaimer: