Here is a summary of my post-CPI tweets. You can follow me @inflation_guy:
- Well, that was boring. CPI exactly as expected. Although frankly, most big shops expected +0.2% on core (me too).
- Weird month where higher fuel prices seem to have taken edge off Shelter, but lower gasoline prices pushed Transp down!
- Apparel down, and New cars & trucks down despite rising in PPI. So much for new PPI. Medical care commodities up though…
- Medical Care as a whole +0.3%. Only 7.6% of the whole CPI, but reverses a recent trend caused by last year’s sequester.
- Core services remained at 2.3% y/y, core goods declined to -0.3%. My proxy, though, is rising so this latter won’t continue.
- Striking – core less shelter now at +0.933% y/y, the lowest since the real deflation crisis in 2004.
- accelerating CPI categories: Housing, Med Care, Other (52.4%), Decel: Apparel, Educ/Comm (10.5%). Unch: 37.1%
- Primary rents +2.88% y/y, virtually unch from +2.87%. But Owners’ Equiv Rent +2.517% from +2.488%.
- New & Used cars and trucks under tremendous pressure, +0.3% y/y, and that’s 7.5% of core CPI. And Apparel (another 4%) has flatlined.
The reason that most big shops – and me too – expected +0.2% or even +0.3% on core, as opposed to the +0.13% that we got, boils down to three things: second, the housing part of core CPI, which is huge, is clearly accelerating and continues to do so. Second, core goods, which represents most of the rest, has been flat or deflating for a while, and normally that part of inflation is more mean-reverting.
The housing part of that view is working out. The Shelter subcomponent of Housing (which is ¾ of it, after extracting utilities and household furnishings and operations) is now rising at 2.58%, the fastest rate since 2008. Owners’ Equivalent Rent, the largest single component of the CPI, is at 2.52% y/y, and as I’ve illustrated often – here comes that chart again – there is every reason to expect this to continue. OER should be in the 3.3%-3.5% range by year-end.
Core Goods, on the other hand, remains stuck in the mud. There was some reason to expect a rise in that index this month, as the Passenger Cars component of PPI rose +0.5% (but new vehicles in the CPI rose only 0.08% m/m), and the pharmaceuticals part of PPI was +2.7% (but only +0.9% in the CPI). In all likelihood, this suggests that core goods will move higher in the months ahead.
However, the weakness in Apparel and in vehicles has a commonality – those are sectors that are either sourced from non-US manufacturers or (in the case of vehicles) receive heavy competition from non-US manufacturers, and especially Japanese manufacturers in the case of autos. The recent strength of the USD with respect to the Yen and Yuan is not irrelevant here. Although early 2014 has seem some reversal in that trend with respect to the Yen, it’s not likely to have a serious reversal for a while – the Yen is going to keep getting weaker, and that will keep pressure on goods prices in the US.
Indeed, by one measure price dynamics in the US are closer to deflation than they have been since 2004. And it’s not a measure which should be taken lightly: core inflation, ex-shelter, is only 0.9% y/y, as the chart below (source: Enduring Investments) shows.
In the mid-2000s, the Fed flirted much more with deflation than they thought they were, because the housing bubble hid the underlying dynamic. Conversely, in 2010 we weren’t really very close to deflation, but the fact that housing was collapsing made it appear that we were. You can see both of these episodes on the chart. It is possible that the 2004-type stealth deflation could be happening again, but I don’t think so for one big reason: in 2004, money growth was in the 4-5% range as the economy was recovering, which created disinflationary tendencies. But now, we’re coming off a period of 8-10% money growth, and it’s still at 6%. It’s much harder to get deflation in such a circumstance.
And, with rents rising smartly, there is almost no chance that core inflation ends 2014 lower than it currently is. I continued to expect core inflation to move towards 3% over the course of this year (and median CPI to reach that level).
Friday before a long weekend is probably the worst time in the world to publish a blog article, but other obligations having consumed me this week, Friday afternoon is all I am left with. Herewith, then, a few thoughts on the week’s events. [Note to editors at sites where this comment is syndicated. Feel free to split this article into separate articles if you wish.]
Follow the Bouncing Market
In case there was any doubt about how fervently the dip-buyers feel about how cheap the market is, and how badly they feel about the possibility of missing the only dip that the equity market will ever have, those doubts were dispelled this week when Monday’s sharp fall in stock prices was substantially reversed by Tuesday and new all-time highs reached on Wednesday. Neither selloff nor rally was precipitated by real data; Friday’s weak jobs data might plausibly have resulted in a rally (and it did, on Friday) on the theory that the Fed’s taper might be downshifted slightly, but there was no other data; on Tuesday, December Retail Sales was modestly stronger than expected but hardly worth a huge rally; on Wednesday, Empire Manufacturing was strong – but who considers that an important report to move billions of dollars around on? There were some memorable Fed quotes, chief among them of course Dallas Fed President Fisher’s observation that the Fed’s adding of liquidity has done what adding liquidity in other contexts often does, and so investors are looking at assets with “beer goggles.” It’s not a punch bowl reference, but the same basic idea. But certainly, not a reason for a sharp reversal of the Monday selloff!
The lows of Monday almost reached the highs of the first half of December, before the late-month, near volume-less updraft. Put another way, anyone who missed the second half of December and lightened up on risk before going on vacation missed the big up-move. I would guess that some of these folks were seizing on a chance to get back involved. To a manager who hasn’t seen a 5% correction since June of last year, a 1.5% correction probably feels like a huge opportunity. Unfortunately, this is characteristic of bubble markets. That doesn’t necessarily imply that today’s equity market is a bubble market that will end as all bubble markets eventually do; but it means it has at least one more characteristic of such markets: drawdowns get progressively smaller until they vanish altogether in a final melt-up that proceeds the melt-down. The table below shows the last 5 drawdowns from the highs (measuring close to close) – the ones you can see by eyeballing a chart, by the date the drawdown ended.
I mentioned last week that in equities I’d like to sell weakness. We now have some specificity to that desire: a break of this week’s lows would seem to me to be weakness sufficient to sell because it would indicate a deeper drawdown than the ones we have had, possibly breaking the pattern.
There is nothing about this week’s price action, in short, that is remotely soothing to me.
A Couple of Further Thoughts on Thursday’s CPI Data
I have written previously about why it is that you want to look at some measure of the central tendency of inflation right now other than core CPI. In a nutshell, there is one significant drag on core inflation – the deceleration in medical care CPI – which is pulling down the averages and creating the illusion of disinflation. On Thursday, the Cleveland Fed reported that Median CPI rose to 2.1%, the first 0.1% rise since February (see chart, source Bloomberg).
Moreover, as I have long been predicting, Rents are following home prices higher with (slightly longer than) the usual lag. The chart below (source Bloomberg ) shows Owners’ Equivalent Rent, which jumped from 2.37% y/y to 2.49% y/y this month. The re-acceleration, which represents the single biggest near-term threat to the continued low CPI readings, is unmistakeable.
Sorry folks, but this is just exactly what is supposed to happen. An updated reminder (source: Enduring Investments) is below. Our model had the December 2013 level for y/y OER at 2.52%…in June 2012. Okay, so the accuracy is mere luck, but the direction should not be surprising.
For the record, the same model has OER at 3.3% by December 2014, 3.4% for OER plus Primary Rents. That means if every other price in the country remains unchanged, core inflation would be at 1.4% or so at year-end just based on the weight that rents have in core inflation (of course, median inflation would then be at zero). If every other price in the country goes up at, say, 2%, then core inflation would be at 2.6%. (Our own core inflation forecast is actually slightly higher than that, because we see other upward risks to prices). And the tails, as I often say, are almost entirely to the upside.
Famous Last Words?
So, Dr. Bernanke is riding off into the sunset. In an interview at the Brookings Institution, the “Buddha of Banking,” as someone (probably himself) has dubbed the soon-to-be-former Chairman spoke with great confidence about how well everything, really, has gone so far and how he has no doubt this will continue in the future.
“The problem with Q.E.,” he said, with more than a hint of a smile, “is that it works in practice, but it doesn’t work in theory.” “I don’t think that’s a concern and those who’ve been saying for the last five years that we’re just on the brink of hyperinflation I would point them to this morning’s C.P.I. number.” (“Reflections by America’s Buddha of Banking“, NY Times)
Smug superiority and trashing of straw men aside, no one rational ever said we were on the “brink of hyperinflation,” and in fact a fair number of economists these days say we’re on the brink of deflation – certainly, far more than say that we’re about to experience hyperinflation.
“He noted the Labor Department’s report Thursday that overall consumer prices in December were up just 1.5% from a year earlier and core prices, which strip out volatile food and energy costs, were up 1.7%. The Fed aims for an annual inflation rate of 2%.
“Such readings, he said, ‘suggest that inflation is just not really a significant risk of this policy.’“ (“Bernanke Turns Focus to Financial Bubbles, Instability”, Wall Street Journal )
And that’s simply idiotic. It’s simply ignorant to claim that the policy was a complete success when you haven’t completed the round-trip on policy yet by unwinding what you have done. It’s almost as stupid as saying you’re “100 percent” confident that anything that is being done for the first time in history will work as you believe it will. And, of course, he said that once.
I will also note that if QE doesn’t have anything to do with inflation, then why would it be deployed to stop deflation…which was one of the important purposes of QE, as discussed by Bernanke before he ever became Chairman (“Deflation: Making Sure “It” Doesn’t Happen Here”, 11/21/2002)? Does he know that we have an Internet and can find this stuff? And if QE is being deployed to stop deflation, doesn’t that mean you think it causes inflation?
On inflation, Bernanke said, “I think we have plenty of tools to manage interest rates and tighten monetary policy even if (the Fed’s) balance sheet stays where it is or gets bigger.” (“Bernanke downplays cost of economic stimulus”, USA Today)
No one has ever doubted that the Fed has plenty of tools, even though the efficacy of some of the historically-useful tools is in doubt because of the large balance of sterile excess reserves that stand between Fed action and the part of the money supply that matters. No, what is in question is whether they have the will to use those tools. The Fed deserves some small positive marks from beginning the taper under Bernanke’s watch, although it has wussied out by saying it wasn’t tightening (which, of course, it is). But the real question will not be answered for a while, and that is whether the FOMC has the stones to yank hard on the money supply chain when inflation and money velocity start heading higher.
It’s not hard, politically, to ease. For every one person complaining about the long-run costs, there are ten who are basking in the short-run benefits. But tightening is the opposite. This is why the punch bowl analogy of William McChesney Martin (Fed Chairman from 1951 to 1970, and remembered fondly partly because he preceded Arthur Burns and Bill Miller, who both apparently really liked punch) is so apropos. It’s no fun going the other way, and I don’t think that a wide-open Fed that discourses in public, gives frequent interviews, and stands for magazine covers has any chance of standing firm against what will become raging public opinion in short order once they begin tightening. And then it will become very apparent why it was so much better when no one knew anything about the Fed.
The question of why the Fed would withdraw QE, if there was no inflationary side effect, was answered by Bernanke – which is good, because otherwise you’d really wonder why they want to retreat from a policy that only has salutatory effects.
“Bernanke said the only genuine risk of the Fed’s bond-buying is the danger of asset bubbles as low interest rates drive investments to riskier holdings, such as stocks, real estate or junk bonds.But he added that he thinks stocks and other markets ‘seem to be within historical ranges.’” (Ibid.)
I suppose this is technically true. If you include prior bubble periods, then today’s equity market valuation is “within the historical range.” However, if you exclude the 1999 equity market bubble, it is much harder to make that argument with a straight face, at least using traditional valuation metrics. I won’t re-prosecute that case here.
So, this is perhaps Bernanke’s last public appearance, we are told. I suspect that is only true until he begins the unseemly victory lap lecture circuit as Greenspan did, or signs on with a big asset management firm, as Greenspan also did. I am afraid that this, in fact, will not be the last we hear from the Buddha of Banking. We can only hope that he takes his new moniker to heart and takes a Buddhist vow of silence.
We are a people of language. The way we talk about a thing affects how we think about it. This is something that behavioral economists are very aware of; and even more so, marketers. There is a reason that portfolio “insurance” was such a popular strategy. Language matters. When we call a market decline a “correction,” we tend to want to buy it; when we call it a “crash” or a “bear market”, we tend to want to sell it.
And so as the “arctic vortex” reaches its cold fingers down from the frozen northland, it is really hard for us to think about economic “overheating.” Even though economic overheating doesn’t lead to inflation, I really believe that it is hard for investors to worry about inflation (the “fire” in the traditional “fire versus ice” economic tightrope that central bankers walk) when it is so. Darn. Cold.
But nevertheless, we can take executive notice of certain details that may suggest, overheating or not, inflation pressures really are building. I have been writing for some time about how the recent rapid rise in housing prices was eventually going to pass through to rents, and although the lag was a couple of months longer than it has historically been, it seems to be finally happening as an article in today’s Wall Street Journal suggests. This is significant for at least two reasons. The first is that housing costs are a very large part of the consumption basket for the average consumer, so any acceleration in those prices can move the otherwise-ponderous core CPI comparatively quickly. The second reason, though, is more important. Over the last couple of years, as housing prices have improbably spiked again and inventories have declined sharply, many observers have pointed out the presence of an institutional element among home purchasers. That is to say that homes have been bought in large numbers not only by individuals, but by investors who saw an inexpensive asset (they sure solved that problem!). And some analysts reasoned that the prevalence of these investors might break the historical connection between rents and home prices, at least in the short run, in the same way that a sudden influx of pension fund money could change the relationship between equity prices and earnings (that is, P/Es).
In the long run, of course, this is unlikely, but to the extent it happens in the short run it could delay the upturn in core inflation for a long time. But recent indications, such as that article referred to above, are that this effect is not as large as some had thought. The substitution effect does work. Higher home prices do cause rents to rise as more potential buyers choose to rent instead. It is a question for econometricians in the next decade whether the institutions had a large and lasting effect, or a short and ephemeral effect, or no effect at all. But what we can begin to say with a bit more confidence is that this influx of investors did not remove the tendency of home prices and rents to move together, with a lag.
On to other matters. The market curve for inflation has remained remarkably static for a long time. It is relatively steep, and perennially seems to forecast benign inflation for the next couple of years before headline inflation becomes slightly less-benign (but still not high) a few years down the road. The chart below (Source: Enduring Investments) shows the first eight years of the inflation swaps curve from today, and one year ago.
If that was the only story, I probably wouldn’t bother mentioning it. But inflation swaps settle to headline CPI, like TIPS and other inflation-linked bonds do; however, a fair amount of the volatility in headline inflation comes from movements in energy. This is why policymakers and prognosticators look at core inflation. You cannot directly trade core inflation yet, but we can extract expected energy inflation (implied by other markets) from the implied headline inflation rates and derive “implied core inflation swaps” curves. And here, we find that the relatively static yield curves seen above hide a more interesting story. The chart below (Source: Enduring Investments) shows these two curves as of today, and one year ago.
At the beginning of 2013, investors has just experienced a 1.94% rise in core prices (November to November, which is the data they would have had at the time), yet anticipated that core inflation would plunge to only 1.22% in 2013. They actually got 1.72% (as of the latest report, so still Nov/Nov). Now, investors are anticipating about 1.8% over the next 12 months – I am abstracting from some lags – but expect that inflation will ultimately not rise as much as they had feared at this time last year.
Another way to look at this change is to map the implied forward core inflation rates onto the years they would apply to. The chart below (Source: Enduring Investments) does that.
The blue line shows the market’s forecast of core inflation as of January 7th, 2013, year by year. So investors were implicitly saying that core CPI would be 1.22% in 2013, 2.36% in 2014, 2.68% in 2015, 2.87% in 2016, and so on. One year later, the forecast (in red) for 2014 has come down to 1.80%, the forecast for 2015 has declined to 2.20%, the forecast for 2016 has dropped to 2.41%, etcetera.
Has this happened because inflation surprised to the downside in 2013? Hardly. As I just noted, the market “expected” core inflation of 1.22% in 2013 and actually got 1.72%. And yet, investors are pricing higher confidence that inflation will stay low – remaining basically unchanged in 2014 before rising very slowly thereafter – and in fact won’t seriously threaten the Fed’s core mission basically ever.
As I wrote yesterday, we need to tread carefully around consensus. Now, some investors might prefer to be non-consensus by anticipating and investing for deflation in the out years, but taking the whole of the information I look at and model I think the more dangerous break with consensus would be a more-rapid and more-extreme rise in core inflation. I do not think that this economically-cold pricing environment will continue into what is essentially a monetary summer.
This will be my last “live” post of 2013. As such, I want to thank all of you who have taken the time to read my articles, recommend them, re-tweet them, and re-blog them. Thanks, too, for your generous and insightful comments and reactions to my writing. One of the key reasons for writing this column (other than for the greater glory of Enduring Investments and to evangelize for the thoughtful use of inflation products by individual and institutional investors alike) is to force me to crystallize my thinking, and to test that thinking in the marketplace of ideas to find obvious flaws and blind spots. Those weaknesses are legion, and it’s only by knowing where they are that I can avoid being hurt by them.
In my writing, I try to propose the ‘right questions,’ and I don’t claim to have all the right answers. I am especially flattered by those readers who frequently disagree with my conclusions, but keep reading anyway – that suggests to me that I am at least asking good questions.
So thank you all. May you have a blessed holiday season and a happy new year. And, if you find yourself with time to spare over the next few weeks, stop by this blog or check your email (if you have signed up) as I will be re-blogging some of my (subjectively considered) “best” articles from the last four years. Included in that list is an article on long-run returns to equities, one on Yellen’s defense of large-scale asset purchases, an article on the Phillips Curve, one on why CPI isn’t a bogus construct of a vast governmental conspiracy, and so on. Because I don’t expect some of the places where this column is ‘syndicated’ to post the re-blogs, you should consider going to the source site to sign up for these post, or follow me @inflation_guy on Twitter.
And now, on to my portfolio projections as of December 13th, 2013.
Last year, I said “it seems likely…that 2013 will be a better year in terms of economic growth.” It seems that will probably end up being the case, marginally, but it is less likely that 2014 improves measurably in terms of most economic variables on 2013 and there is probably a better chance that it falls short. This expansion is at least four years old. Initial Claims have fallen from 650k per week in early 2009 to a pace of just barely more than half that (335k) in the most-recent 26 weeks. About the best that we can hope for, plausibly, is for the current pace of improvement to continue. The table below illustrates the regularity of this improvement over the last four years, using the widely-followed metric of the Unemployment Rate:
Sure, I know that there are arguments to be made about whether the Unemployment Rate captures the actual degree of pain in the jobs market. It plainly does not. But you can pick any one of a dozen other indicators and they all will show roughly the same pattern – slow, steady improvement. There is no doubt that things are better now than they were four years ago, and no doubt that they are still worse than four years before that. My point is simply that we have been on the mend for four years.
Now, perhaps this expansion will last much longer than the typical expansion. But I don’t find terribly compelling the notion that the expansion will last longer because the recession was deeper. Was this recession deeper because the previous expansion was longer? If so, then the argument is circular. If not, then why would that connection only work in one direction? What I know is that the Treasury has spent the last four years running up large deficits to support the economy, and the Fed has nailed interest rates at zero and flooded the economy with liquidity. Those two things will at best be repeated in 2014, not increased; and there is a decent chance that one or the other is reversed. Another 0.8% improvement in the Unemployment Rate would put it at 6.2%, and I expect inflation to head higher as well. A taper will be called for; indeed, it should never have been necessary because policy is far too loose as it is. Whether or not an extremely dovish Fed Chairman will actually acquiesce to taper is an open question, but economically speaking it is already overdue and certainly will appear that way by the middle of the year, absent a crack-up somewhere.
Global threats to growth do abound. European growth is sluggish because of the condition of the financial system and the pressures on the Euro (but they think growth is sluggish because money isn’t free enough). UK growth has been improving, but much of that – as in the U.S. – has been on the back of housing markets that are improving too quickly to make me comfortable. Chinese growth has recently been downshifting. Japanese growth has been irregularly improving but enormous challenges persist there. Globally, the bright spot is a modest retreat in Brent Crude prices and lower prices of refined products (although Natural Gas prices seem to be on the rise again despite what was supposed to be a domestic glut). Some observers think that a lessening of tensions with Iran and recovery of capacity in Libya, along with increasing US production of crude, could push these prices lower and provide a following wind to global growth, but I am less sanguine that geopolitical tensions will remain relaxed for long and, in any event, depending on a calm Iran as the linchpin of 2014 optimism seems pretty cavalier to me.
Note that the muddled growth picture contains some elements of risk to price inflation. The ECB has been kicking around the idea of doing true QE or experimenting with negative deposit rates. The UK housing boom, like ours, keeps the upward pressure on measures of core inflation. There is no sign of an end to Japanese QE, and the PBOC seems willing to let the renmimbi rise more rapidly than it has in the past. And all of these global risks to domestic price inflation are in addition to the internally-generated pressures from rapid housing price growth in the United States.
The good news on inflation domestically is that M2 money growth has slackened from the 8%-10% pace of last year to more like 6%-8% (see chart, source Bloomberg). This is still too fast unless money velocity continues to slide, but it is certainly an improvement. But the bad news is that money growth remains rapid in the UK and is accelerating in Japan. The only place it is flagging, in Europe, has a central bank that is anxious not to be last place on the global inflation scale. I expect core inflation (and median inflation) in the U.S. to rise throughout 2014 and for core inflation to end up above 3% for the year.
Now, I have just made a number of near-term forecasts but I need to change gears when looking at the long-term projections. In what follows, I make no effort to predict the 3-month, 6-month, or 12-month returns of any market. Indeed, although I will present long-term risk and return outlooks, and they are presented as point estimates, I want to make it very clear that these are not predictions but rather statements of relative risk and return possibilities. For many types of instruments, the error bars around the average annual performance are so large as to make point estimates (in my view) nearly useless. The numbers come from models of how markets behave when they are priced “like they are now” in terms of several important metrics. They are not prescient. However, that is what investing is really all about: not making the “right” bet in terms of whether you can call the next card off the deck, but making the “right” bet with respect to the odds offered by the game, and betting the right amount given the odds and the edge.
I also will not make portfolio allocation recommendations here. The optimal portfolio allocation for you depends on more variables than I have at my disposal: your age, your career opportunities, your lifestyle, your goals, any insurance portfolio and your risk tolerance, to name just a few.
What I will do here, though, is to give top-down estimates of the long-run returns and risks of some broad asset classes, and make some general observations. I don’t analyze every possible asset class. For this exercise, I limit the universe to stocks, TIPS, nominal bonds (both long Treasury and corporate bonds), commodity indices and (since many of us already own it) residential real estate. My estimates and some notations about the calculations are in the table below.
|Inflation||2.50%||Current 10y CPI Swaps|
|TIPS||0.68%||Current 10y TIPS. This is not at equilibrium, but it is what we can lock in today. It is the highest rate available at year-end since 2010.|
|Treasuries||0.37%||Nominal bonds and inflation-linked bonds ought to have the same a priori expectation, but Treasuries trade rich to TIPS because of their value as repo collateral. Current 10y nominal rate is 2.87%, implying 0.37% real.|
|T-Bills||-0.50%||Is less than for longer Treasuries because of liquidity preference.|
|Corp Bonds||-0.69%||Corporate bonds earn a spread that should compensate for expected credit losses. A simple regression of Moody’s “A”-Rated Corporate yields versus Treasury yields suggests the former are about 45bps rich to what they should be for this level of Treasury yields.|
|Stocks||1.54%||2.25% long-term real growth + 1.83% dividend yield – 2.54% per annum valuation convergence 2/3 of the way from current 24.3 Shiller P/E to the long-run mean. Note that I am using long-run growth at equilibrium, not what TIPS are implying. This is the worst prospective 10 year real return we have seen in stocks since December 2007. Now, to be fair in 1999 we did get to almost -2%, which would imply up to another 35-40% upside to stocks before we reached an equivalent height of bubbliness. That is a 35-40% that I am happy to miss.|
|Commodity Index||6.26%||Various researchers have found that commodity futures indices have a long-run diversification return of about 3.5%. To this we add 1-month LIBOR to represent the return on the collateral behind the futures, and a ‘relative value’ factor to reflect the performance (relative to the expected model) of hard assets relative to currency.|
|Real Estate (Residential)||-0.19%||The long-run real return of residential real estate is around +0.50%. Current metrics have Existing Home Sales median prices at 3.79x median income, versus a long-term average of 3.55x. Converging to the mean over 10 years would imply an 0.69% per annum drag to the real return. This is the first time since 2008 that housing prices have offered a negative real return on a forward-looking basis.|
The results, using historical volatilities calculated over the last 10 years (and put in terms of ‘real annuitized income,’ a term that means essentially the variance compared to a fixed 10-year real annuity, which in this analysis would be the risk-free instrument), are plotted below. (Source: Enduring Investments).
Return as a function of risk is, as one would expect, positive. For each 0.33% additional real return expectation, an investor must accept a 1% higher standard deviation of annuitized real income. However, note that this is only such a positive trade-off because of the effect of commodities and TIPS. If you remove those two asset classes, which are the cheap high-risk and the cheap low-risk asset classes, respectively, then the tradeoff is worse. The other assets lie much more closely to the resulting line, which is flatter: you only gain 0.19% in additional real return for each 1% increment of real risk. Accordingly, I think that the best overall investment portfolio using public securities – which has inflation protection as an added benefit – is a barbell of broad-based commodity indices and TIPS.
TIPS by themselves are not particularly cheap; it is only in the context of other low-risk asset classes that they appear so. Our Fisher model is long inflation expectations and flat real rates, which merely says that TIPS are strongly preferable to nominal rates but not a fabulous investment in themselves (although 10-year TIPS yields are better now than they have been for a couple of years). Our four-asset model remains heavily weighted towards commodity indices; and our metals and miners model is skewed heavily towards industrial metals (50%, e.g. DBB) with a neutral weight in precious metals (24%, e.g. GLD) and underweight positions in gold miners (8%, e.g. GDX) and industrial miners (17%, e.g. PICK). (Disclosure: We have long positions in each of the ETFs mentioned.)
Feel free to send me a message (best through the Enduring website http://www.enduringinvestments.com ) or tweet (@inflation_guy) to ask about any of these models and strategies. In the new year, I plan to offer an email “course”, tentatively entitled “Characteristics of Inflation-Protecting Asset Classes,” that will discuss how these different assets behave with respect to inflation and give some thoughts on how to put an arm’s-length valuation on them. Keep an eye out for the announcement of that course. And in the meantime, have a happy holiday season and a merry new year!
Below is a summary of my post-CPI tweets. You can follow me @inflation_guy. And, given where all of this seems to be going…you ought to.
- Core inflation only up 0.122%. But housing continues to accelerate! Apparel -0.5% this month.
- Core dips slightly to 1.734% from 1.766% y/y. At odds with our forecast, due to the continued weakness in core goods.
- Still think core ends 2013 over 2%, but depends on core commodities coming up some. Our housing forecast looks good.
- Primary Rents stays at 3%, OER at 2.2%.
- Medical Care 2.4% y/y from 2.3%. And that’s with “health insurance” falling to 2.5% from 2.9%. Obviously, that’s all pre-ACA.
- Accel Major groups: Medical Care (7.2%). Decel: Apparel, Recreation, Educ/COmm (16.3%). Everything else sideways.
- This really IS mostly about the apparel decline. Bad back-to-school adjustment probably.
- I think given apparel, what we know will happen in medical care, and the housing stuff…next month may be over 0.3% on core.
This has all the signs of one of those numbers (and we’re seeing a lot of them this month) that should be averaged with next month’s number because of data collection quirks. Actually, we probably ought to average September, October, and November data together to get a “before, during, and after” average around the government shutdown. The apparel decline hit women’s apparel, men’s apparel, and girls’ apparel, but boys’ apparel inflation accelerated. Medical care prices re-accelerated slightly, as I think is destined to happen because the current run-rate is significantly due to the effect of the sequester on Medicare reimbursements, but we can already see that the “insurance” category is going to be accelerating markedly in the next few months because of the large number of cancellations and re-policying that is going on around the implementation of Obamacare. While direct consumer purchase of insurance and/or medical care is just a small part of overall inflation, a big jump will still be felt in the overall data.
The key conundrum continues to be the softness in core goods, but as I’ve argued previously the biggest part of the effect is from the very low readings from medicinal drugs and medical equipment – both of which accelerated this month. If the apparel reading really is a quirk, then core inflation is going to start heading higher with alacrity now. All of the “interesting” parts of it already are.
Everyone expected markets to provide a lot of late-day volatility today, and so they did. The Fed apparently doesn’t mind surprising the market with a non-consensus outcome when that surprise gooses stocks and bonds higher. Here are some (fairly unstructured) thoughts about today’s declaration from the Fed that there will be no “taper” in its QE program yet:
- This has nothing to do with the fact that there was a minor wiggle in the Employment data, some weakness in Retail Sales, and some other disappointments this month. If that is now the standard…that the Fed plans to expand its balance sheet without bound as long as growth is not smashing the cover off the ball, then we are truly lost for QE will never, ever end. This month’s numbers were all within the normal variation for economic data, which do in fact vary even when the underlying economy is not. The old standard was “ameliorate a deep recession.” Then Greenspan turned that to “resist even a mild recession.” And now, is the standard “robust growth no matter what the long-term cost?” I don’t think so, and so I reject the notion that the failure to begin the taper has anything to do with the growth numbers.
- Similarly, the inflation numbers cannot be the reason. Core inflation is now rising, and the Fed has previously recognized that some of the decline in inflation has been due to transient effects of the sequester. Median inflation has remained steady at 2.1%, which is basically the Fed’s long-term target. The cost of 10-year deflation floors in the market are at the lowest level since they began to trade in 2009 (see chart, source Bloomberg and BGC Partners – the price is in up-front basis points). So it isn’t a lingering fear of deflation that has the Fed concerned.
- The Fed speakers over the last month have had ample opportunity to shoot down the idea that taper would start at this meeting, which has been the consensus for a long time. None of them did so, implying that the Fed was comfortable with that consensus. But something changed in the last few days, and that is that the odds-on next Fed Chairman went from being Larry Summers to being Janet Yellen, who happened to be in the meeting today. Does this change the dynamic? Absolutely, since one reason Bernanke has started thinking and talking about tapering is so as to leave as clean a slate as possible so that the next Chairman wouldn’t have to start his term by tightening (sorry, I mean “reducing accommodation”) and scaring asset markets. Once Summers withdrew his name, Yellen’s vote got automatically much more important and the urgency to start the taper much less (since Yellen doesn’t believe there are any important costs to QE). Indeed, in his post-meeting presser Bernanke noted that the “first step” on a taper is “possible this year.” That is far to the dovish side of what the Street was expecting, but consistent with the notion that Yellen’s opinion will carry a heavy weight unless someone else is appointed to the post.
- Yellen said last June that the Fed’s objective is a quick return to full employment, and that Fed action might be justified “to insure against adverse shocks [emphasis mine],” or even if the Fed concludes that the recovery “is unlikely to proceed at a satisfactory pace.” So, perhaps I need to reconsider my point #1 above. Maybe that is the standard now.
- If in fact QE has no cost, then there is no reason to ever stop it. In fact, it should be accelerated. Most Fed officials seem recently to be coming to the realization that there is highly unlikely to be a costless economic remedy, even if they are not sure what the costs are or think they can be contained. Those people clearly have no voice any more, even though it appeared that those views in the last few months were gaining currency (no pun intended, since the dollar dropped to the lowest level since February after the announcement today – a Fed that was edging however slowly to being more-hawkish than average was good for the dollar; a weak, more-dovish than average central bank will be worse for the dollar all else equal). This is pedal-to-the-metal time.
- TIPS got a lot more expensive today, with the 10-year rallying 20bps to 0.475% and breakevens up 4.5bps one day before the Treasury auctions another slug of them. The auction ought still to go well, because caution has been thrown to the wind by our beloved central bankers. This is also good for commodities, and they rose today led by precious and industrial metals. Is it good for equities? Well…
- Equity analysts are like puppies. They completely forget what happened 5 minutes ago and every experience is brand new. There is never any context. So stocks shot higher today, with the S&P gaining 1.2%, because of the dovish Fed and lower interest rates. But over the last few months, as the taper grew closer and interest rates shot higher, all equities did was move to new highs. So, higher interest rates and a (relatively) hawkish Fed doesn’t hurt stock prices, but lower interest rates and a dovish Fed helps them? This may be why the Fed thinks that buying bonds keeps interest rates low and selling bonds doesn’t raise them. It’s a strange market-based notion of a perpetual motion machine. For goodness’ sake, let’s crank interest rates down 200bps, back up 200bps, down 200bps, and keep doing that and the stock market will be at 1,000,000 before you know it. Prosperity! But in fact it is probably more like a bicycle pump. Pushing down inflates the tire, pulling up doesn’t deflate it. It seems costless. However, if you keep doing that, eventually the tire will pop.
- Speaking of the perpetual motion machine, I enjoyed this little gem from the FOMC statement:
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. Taken together, these actions should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative…
Really? It hasn’t worked recently. Lest they forget: the taper hadn’t started yet, but until today it was busy being discounted in the bond market. I don’t expect that merely continuing to buy bonds into the SOMA will push rates much lower again. We all know that this game ends, and we know how it ends. With 10-year notes at 2.70% I wouldn’t be selling them, but I also wouldn’t expect a massive rally to unfold. I would hold long positions in September and October, because those are the right months in which to hold bonds (especially with debt ceiling fight #2, Syria, Italy’s government disintegrating, and Germany’s election), but if the market gave me 2.45% to sell, I would sell.
 Note, though, that no person who has ever held the office of Fed Vice-Chairman has later been appointed to be Chairman…although Donald Kohn, since he was Vice-Chairman from 2006-2010, would also represent a departure from this same tradition. However, he was not in the room.
Here is a summary of my tweets after the CPI release this morning. You can follow me @inflation_guy.
- CPI +0.1%/+0.1% core, y/y core to 1.8%. Core only slightly weaker than expected as it rounded down to 0.1% rather than up to 0.2%.
- Housing CPI was weak, second month in a row. Rents will eventually catch up w/ housing prices…but not yet.
- Apparel CPI was weak after a couple of strong up months. I’ll have the whole breakdown in a bit.
- Core was actually only 0.13%, suggesting last August’s 0.06% and this August’s number might merely be bad seasonals.
- Market was only looking for 0.17% or so, so it’s not a HUGE miss. Still disappointing to my forecasts as upturn in rents remains overdue.
- Core CPI now 1.766% y/y. More difficult comparison next month although still <0.2%.
- Accelerating major grps: Apparel, Medical Care, Educ/Comm, Other (20.9%); decel: Food/Bev, Housing(!), Transp (73.1%), unch: Recreation
- Housing deceleration actually isn’t worrisome. Primary rents were 3.0% y/y vs 2.8% last. OER was 2.23% vs 2.19% last.
- Housing subcomponent drag was from lodging away from home, household energy, other minor pieces. So housing inflation story still intact.
- Core services inflation unch at 2.4% y/y; core goods inflation up to 0% from -0.2%. Source of uptick: mean reversion in core goods.
- So OER still reaches a new cycle high at 2.23%…it’s just not accelerating yet as fast as I expect it to. Lags are hard!
The initial reading of this number, as the tweet timeline above shows, was negative. The figure was weaker-than-expected, and Housing CPI decelerated from 2.26% to 2.17%. This seemed to be a painful blow to my thesis, which is that rising home prices will pass through into housing inflation (expressed in rents) and push core inflation much higher than economists currently expect.
Housing CPI is one of eight major subgroups of CPI, the other seven being Food and Beverages, Medical Care, Transportation, Apparel, Recreation, Education and Communication, and Other. Housing receives the most weight, at 41% of the consumption basket and an even heavier weight in core inflation. So, a deceleration in Housing makes it very hard for core inflation to increase, and vice-versa. If you can get the direction of Housing CPI right, then you’ll have a leg up in your medium-term inflation forecast (although it isn’t very helpful in terms of projecting month-to-month numbers, which are mostly noise). Thus, the deceleration in Housing seemed discouraging.
But on closer inspection, the main portions of Housing CPI are doing about what I expected them to do. Primary Rents (aka “Rent of primary residence”) is now above 3%, in sharp contrast to the expectations of those economists and observers who thought that active investor interest in buying vacant homes would drive up the price of housing but drive down the price of rents. Though I never thought that was likely…the substitution effect is very strong…it was a plausible enough story that it was worth considering and watching out for. But in the event, primary rents are clearly rising, and accelerating, and Owners’ Equivalent Rent is also rising although less-obviously accelerating (see Chart, source BLS).
So, it is much less clear upon further review that this is a terribly encouraging CPI figure. It is running behind my expectations for the pace of the acceleration, but it is clearly meeting my expectations for what should be driving inflation higher. As I say above, econometric lags are hard – they are tendencies only, and in this case the lags have been slightly longer, or the acceleration somewhat muted, from what would typically have been expected from the behavior of home prices. Some of that may be from the “investors producing too many rental units” effect, or it might simply be chance. In any event, the ultimate picture hasn’t changed. Core inflation will continue to rise for some time, and will be well above 2% and probably 3% before the Fed’s actions have any meaningful effect on slowing the increase.
In our business, one must be very careful of confirmation bias of course (as well as all of the other assorted biases that can adversely affect one’s decision-making processes). And so I want to be very careful about reading too much into today’s CPI report. That being said, there were some hints and glimmers that the main components of inflation are starting to look more perky.
Headline (“all items”) inflation rose in June to 1.75% y/y, with core inflation 1.64%. About 20% of the weights in the major groups accelerated on a year-on-year basis; about 20% declined, and 60% were roughly flat. However, two thirds of the “unchanged” weight was in Housing, which moved from 2.219% to 2.249% y/y…but the devil is in the details. Owner’s Equivalent Rent, which is fully 24% of the overall CPI and about one-third of core CPI, rose from 2.13% to 2.21%, reaching its highest rate of change since November 2008. Primary Rents (that is, if you are a renter rather than a homeowner) rose from 2.83% to 2.89%, which is also a post-crisis high. Since much of my near-term expectations for an acceleration in inflation in the 2nd half of the year relies on the pass-through of home price dynamics into rentals, this is something I am paying attention to.
This is what I expected. But can I reject a null hypothesis that core inflation is, in fact, in an extended downtrend – that perhaps housing prices are artificially inflated by investor demand and will not pass through to rents, and the deflation in core goods (led by Medicare-induced declines in Medical Care) will continue? I cannot reject that null hypothesis, despite the fact that the NAHB index today surprised with a leap to 57, its highest since 2006 (see chart, source Bloomberg, below). It may be, although I don’t think it is, that the demand is for houses, rather than housing and thus the price spike might not pass into rents. So, while my thesis remains consistent with the data, the real test will be over the next several months. The disinflationists fear a further deceleration in year-on-year inflation, while I maintain that it will begin to rise from here. I still think core inflation will be 2.5%-2.8% by year-end 2013.
In fact, I think there is roughly an even chance that core inflation will round to 1.8% next month (versus 1.6% this month), although the 0.2% jump will be more dramatic than the underlying unrounded figures. The following month, it will hit 1.9%. That is still not the “danger zone” for the Fed, but it will quiet the doves somewhat.
Meanwhile, the Cleveland Fed’s Median CPI remained at 2.1%, the lowest level since 2011. The Median CPI continues to raise its hand and say “hello? Don’t forget about me!” If anyone is terribly concerned about imminent deflation, they should reflect on the fact that the Median CPI is telling us the low core readings are happening because a few categories have been very weak, but that there is no general weakness in prices.
Although I maintain that the process of inflation will not be particular impacted by what the Fed does from here – and, if what they do causes interest rates to rise, then they could unintentionally accelerate the process – the direction of the markets will be. And not, I think, in a good way. We saw today what happens when an inflation number came in fairly close to expectations: stocks down, bonds flat, inflation-linked bonds up, and commodities up. Now, imagine that CPI surprises on the high side next month?
Speaking of the fact that commodities have had (so far at least) their best month in a while, there was a very interesting blog entry posted today at the “macroblog” of the Atlanta Fed. The authors of the post examined whether commodity price increases and decreases affect core inflation in a meaningful way. Of course, the simple answer is that it’s not supposed to, because after all that’s what the BLS is trying to do by extracting food and energy (and doing that across all categories where explicit or implicit food and energy costs are found, such as in things like primary rents). But, of course, it’s not that simple, and what these authors found is that when commodity prices are increasing, then businesses tend to try and pass on these cost increases – and they respond positively to a survey question asking them about that – and it tends to show up in core inflation. But, if commodity prices are decreasing, then businesses tend to try and hold the line on prices, and take bigger profit margins. And that, also, shows up in the data.
To the extent this is true, it means that commodity volatility itself has inflationary implications even if there is no net movement in commodity prices over some period. That is because it acts like a ratchet: when commodity prices go up, core inflation tends to edge up, but when commodity prices go down, core inflation tends not to edge down. Higher volatility, by itself, implies higher inflation (as well, as I have pointed out, as increasing the perception of higher volatility: see my article in Business Economics here and my quick explanation of the main points here). It’s a very interesting observation these authors make, and one I have not heard before.
The following is a summary and further explanation of my tweets following today’s CPI release:
- core #inflation +0.167, a smidge higher than expected but basically in line. Dragged down by medical care (-0.13%).
- Housing #inflation a solid 0.3%…this part is, as we expected, accelerating.
- Core commodities still dragging down overall core, now -0.2% y/y while core services still 2.3%.
- I still think Owners’ Equiv Rent will get to our year-end target but core goods not behaving. Have to lower our core CPI range to 2.5%-2.8%
- That 2.5%-2.8% still much higher than Street. Still assumes OER continues to accelerate, and core goods drag fades. Fcast WAS 2.6-3.0.
- Note that CPI-Housing rose at a 2.22% y/y rate, up from 1.94% last month. Highest since late ’08 early ’09. Acceleration there is happening.
- Major #CPI groups accel: Housing, Trans, Recreation (63.9%), Decel: Food/Bev, Apparel, Med Care, Educ/Comm (32.7%)
- Overall, IMO this CPI report is much more buoyant than expected. Core goods is flattering some ugly trends.
The important part of this CPI report is that CPI-Housing is finally turning up again, as I have been expecting it would “over the next 1-3 months.” Hands down, the rise in housing inflation (41% of overall consumption) is the greatest threat to effective price stability in the short run. Home prices are rising aggressively in many places around the country, and it is passing through to rents. Primary rents (where you rent an apartment or a home, rather than “imputed” rents) are up at 2.8% year/year, the highest level since early 2009, but not yet showing signs that it is about to go seriously vertical. Some economists are still around who will tell you that rapidly rising home prices are going to cause a decline in rents, as more rental supply comes on the market. That would be a very bizarre outcome, economically, but it is absolutely necessary that this happen if core inflation isn’t going to rise from here.
The last 7 months of this year see very easy comparisons versus last year, when CPI rose at only a 1.6% annualized pace for the May-December period. Only last June saw an increase of at least 0.20%. So, even with a fairly weak trend from here, core CPI will rise from 1.7% year/year. If each of the last 7 months of this year produces only 0.2% from core CPI, the figure will be at 2.2% by year-end. At 0.25% monthly, we’ll be over 2.5%; at 0.3% per month core CPI will be at 2.9% by year-end. So our core inflation forecast, at 2.5%-2.8%, is not terribly aggressive (and if we are right on housing inflation, it may be fairly conservative).
We have not changed our 2014 expectation that core CPI will be at least 3.0%.
Numerous classic cognitive errors are on display at once in these markets. We have “overconfidence,” with large bets being made on the basis of strongly-believed models and forecasts…but these are forecasts of the dynamics of a system whose configuration is distinctly unlike anything we have seen before, even remotely. What does a “taper” do to rates? How can we know, since we have never even had QE, much less a taper, before? How aggressively does it make sense to bet on the outcome of such a transition period, given rational-sized error bars on the estimates?
We also see naïve extrapolation of trends. TIPS go down every day, it seems, for no better reason than that “core inflation is low, and the Fed is no longer going to be maintaining as loose a policy.” Ten-year TIPS yields have risen 83bps since April 25th (5y TIPS, +107bps since April 4th). Ten-year breakevens have fallen from 2.59%, within 15bps of an all-time high, on March 14th to 2.03% – the lowest since January 2012 – now. What has changed? Our model identified TIPS as cheap to Treasuries (that is, breakevens too low for the level of nominal rates) and went nearly max-long when breakevens were still at 2.30%. It is some solace that this position has fared better than a long position in TIPS, but when markets simply follow recent momentum mindlessly it can be painful.
Year-ahead core inflation is priced in the market at roughly 1.50%, despite the fact that current core inflation of 1.7% is only at this level because of persistently soggy core goods prices (and core goods are much more volatile than core services prices). Meanwhile, although core services prices remain buoyant, housing rents have not even begun to respond to the sudden boom in housing prices. To realize the core inflation priced into the 1-year inflation swap, core goods prices need to remain low and rends would need to decelerate while a shortage of owner-occupied housing drives the prices of existing homes skyward. It is possible, but it would be a very unusual economic occurrence. As I have previously written, we are maintaining our forecast for core inflation in 2012 at 2.6%-3.0%; although we may tweak that lowers if next week’s CPI is disappointing, we will not be changing it dramatically. Based on both top-down and bottom-up forecasts, we think the inflation market right now is very wrong. However, in accordance with paragraph 1, above, our 80% confidence interval for that estimate would be quite wide. Still, we feel that most errors looking out at least one year are going to be in the direction of higher inflation, not lower inflation.
Now, our forecast relies significantly on the behavior of the housing market, since shelter is the largest share of the budget for most of us. There has been a lot written recently about how the rise in rates could shatter the housing recovery. But let me explain why I don’t think that will happen.
I remember reading many years ago in “The Money Game” by Adam Smith (a pseudonym) that “you make more money with good investing decisions than with good financing decisions.” At least, I think that’s where I read it. In any event, it is true: if you are creating the next Microsoft, it makes very little difference if you finance it at 2% or at 15%, because the investment performance will completely obliterate the cost of financing. And this is why higher rates, even significantly higher rates, will not derail the housing market while prices are rising at 10%+ per annum. A home buyer is clearly happier to borrow at 3% than at 5% (tax-deductible), but if the home price is appreciating at 10% per annum (tax free, for much of it, and tax-deferred in any event) then it is a home run for the buyer either way. What hurts the housing market is when the expectation of future home price changes goes from go-go to stop-stop. And, with most consumers concerned with inflation and recent price trends in the home market, this isn’t going to change soon.
Here is an illustration of the real-world response of housing to rates. This first chart is the Mortgage Banking Association’s Refinancing index, plotted against 10-year Treasury rates (inverted). You can see that the recent rise in rates is having a significant impact on refinancing activity.
And this next chart is a chart of the MBA Purchase Index, showing activity on mortgages related to new purchases of homes. Again, the 10-year Treasury rate is inverted. You can see that there is no meaningful correlation here; if anything, purchase activity has been rising over the past year while rates have also been rising.
So, rest easy: higher interest rates are not going to meaningfully impact the housing market, unless they go much higher. Indeed, homebuyers might reasonably believe here that there is a “Bernanke put” on home prices in the same way that investors (correctly) believed there was a “Greenspan put” on stock prices. The Fed (and for that matter the state and federal governments) clearly have responded and can reasonably be expected to respond robustly to a future home price bust. So why not be long real estate here, if your downside is protected…and in any case, is limited to your home equity?
And if home prices do not decline, then rents are not going to decline, and in fact need to accelerate to keep up with the previously-seen rise in home prices. That is going to cause core inflation to rise going forward.
One final note: over the next month or two I hope to put out a few more articles like the one I wrote on June 8th about equity returns and inflation, but focusing on other asset classes such as real estate, infrastructure, commodity indices, etcetera. But in the meantime, I wanted to point out one security to keep an eye on. It is one of only two inflation-linked bonds that is traded on an exchange with a daily price and reasonable bid/offer spreads. The symbol is OSM (for Bloomberg users: you need the <CORP> key), and it is a floating-rate inflation-linked bond issued by SLM Corp with a March 2017 maturity. The problem with this security is that it is very hard to figure out what its true yield is unless you have an inflation derivatives curve, and even harder to figure out whether the issue is priced correctly given that you own SLM credit. The recent selloff has driven the real yield of this issue to (approximately) 3.40%, which is obviously much higher than is available for TIPS. The bad news is that the bond is still fairly expensive given the spread that should exist for a SLM bond, but in terms of raw real yield to maturity there are not many inflation-linked bonds out there with that yield. I am not recommending this security, but mention it as a point of information for investors who may want to check it out on their own.