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Defensive


There was a great deal of excitement about today’s Employment Report. The S&P rallied 1.1%, erasing the month-to-date losses at a stroke. And for what? Nonfarm Payrolls were reported at 203k with a net +8k upward revision to the prior months, versus expectations for 185k. That’s a miss that is easily within the standard error. The 6-month average stayed at about 180k and the 12-month average at about 190k. The 3-month average reached 193k, but that is lower than it was in Q1 of this year so no great shakes there.

True, the Unemployment Rate dropped from 7.3% to 7.0%, reversing the unexpected uptick from last month as the labor force participation rate rebounded. Economists were always suspicious of that steep drop in the participation rate, and some bounce was expected (pushing the Unemployment Rate down). But so what? As the chart below (Source: Bloomberg) shows, this is just another step in a long, steady, slow improvement.

usurtot

I think the reasoning must be something like this: the economy is stronger than we thought, by a little, yet this doesn’t change much about the timing of the taper. Unemployment is 7%, and core PCE is 1.1%. Neither one is close to the Evans Rule targets, so there’s plenty of time (at least, if you are a committed dove like is Yellen). They’re looking for reasons to be slow on tapering, not to accelerate it. At least, this is why equity investors were excited. Perhaps. It does not, though, change my own views in any way – the economy is moving along at roughly the pace that is now normal, adding jobs at a pace that is about what we should expect in the thick of an expansion. The expansion is still growing long in the tooth. But forecasting growth is no longer nearly as important as forecasting the Fed, and that seems fairly easy right now: mo’ money is mo’ better. Stocks are nearing an ugly disconnect, I think – but not today.

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I seem to regularly take a lot of heat in the comments section of this column for several things. Some readers take me to task for covering up for The Man and his CPI Conspiracy. I won’t address that here, but on December 18th I’ll be running a combination of two old blog posts that explain why CPI isn’t a made-up number, and why most people perceive inflation as being higher than it actually is. The other major complaint is that I have been “calling for inflation forever” and that I am somehow an unrequited inflation-phobe.

I want to refute that specifically. The people who say that are sometimes confusing me with someone else, and that’s okay. But sometimes they make an assumption that since my Twitter handle is @inflation_guy, because I traded inflation derivatives on Wall Street and was the designer and market maker of the CPI futures contract that launched in 2004, and because I run a specialty investment management firm with a core focus on inflation, I must always be super bullish on inflation.

In fact, people who have followed my comments off-line and on-line for the last decade know that is very far from the truth. In fact, when I was an inflation swaps trader the dealer I worked for often got exasperated because I routinely told clients that I did not expect inflation to head higher very soon because of the huge overhang of private debt. “How can you expect us to sell inflation products,” they asked, “if you keep telling everyone there is no inflation?” My rejoinder: “If we are only selling these products when inflation goes up, we only have a business half the time, or whenever we can convince the client that inflation is going up. But these products almost always reduce risk, since almost every client has a natural exposure to inflation going up, and although they have systematically profited over the last two decades from a bet they didn’t know they were making, that cannot continue forever. That’s the reason people should buy inflation products: to reduce risk.”

So, for many years I was exactly the opposite of what I am sometimes accused nowadays of being: although I didn’t worry about deflation very much, I certainly wasn’t worried about runaway inflation.

When the facts change, I change my mind. What do you do, sir?[1]

It was clear that the Fed’s actions in 2008 were going to change things in a big way, but it is interesting that my models anticipated that inflation would continue to decline into 2010 and bottom in Q3 or early Q4 (which is what I said here among other places). It is from that point that I began to diverge with Wall Street opinion (again – since the consensus expected inflation in the middle 2000s while I did not). I published what I think is a helpful time series of my 12-month-ahead model forecasts in early 2012, contrasting it with a chart from Goldman.[2]

So now, let me update the model chart with a forecast for the next twelve months. Before I do, note that in the chart I have substituted Median CPI for Core CPI, for the reasons I have written about for a while now: Core CPI is being dragged down by several one-off movements, most notably in Medical Care, and so Median CPI is currently a better measure of the true central tendency of inflation.

ensemble

The black line is the actual Median CPI. The red line is the average of the other two models depicted as green and blue lines. The blue line is quite similar to the model I have been using for a very long time; it uses a couple of macro variables including a role for private indebtedness. The green line is something I introduced only in the last few years; it models shelter separately from the ex-shelter components because we have a pretty decent idea of what drives shelter inflation. Frankly, I like that model better, which is why my firm’s forecast for 2014 is for core (or median) inflation to be 3%-3.6%. The model says 3%, and I believe the tails are on the high side.

But the real purpose of my presenting that chart, and the aforementioned discussion, is to defend myself against the calumny that I am a perpetual bull on inflation. Nothing could be further from the truth. From 2004-2010, if I was bullish on inflation at all it was only a “trading opinion” based on market prices.[3] It is only since then that I have been loudly bullish on inflation. And, even then, while I will tell you why inflation could have extremely long tails on the upside, you will not find me forecasting 8%. Nor claiming that inflation really is somewhere that I said it would be, because I don’t like the numbers the BLS is reporting.

I have said in the past, and reiterate now, that one of the main reasons I write this column is mainly to hear reasoned counterarguments to my theses. I think I get sucked far too often into debates with unreasoned or unreasonable counterarguments, not to mention ad hominem attacks.

It goes with the territory of writing a public blog, I suppose. At some level it doesn’t matter much, because I wouldn’t have been on Wall Street for two decades if I bruised easily. But on the other hand, I have a right to self-defense and I have now exercised that right with respect to this particular charge!


[1] A quote variously attributed to Keynes, Samuelson, and others…and apropos here.

[2] Incidentally, note that our firm forecast may differ from the model forecast based on our discretionary reading of the model and other factors. In the last two years, the naked model has handily whupped our discretionary forecast.

[3] Of note is the fact that my company Enduring Investments was formed in early 2009 – even though my models still indicated that inflation was going to be swinging lower for a while.

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  1. Mike Thorson
    December 6, 2013 at 11:05 pm

    The quote is from Keynes.

    A reasoned “opposite” argument against a roaring inflation rate is that we are only about 40 bps away from real rates (Baa corporate) being more than 250 bps over growth, a level which, for the past 50 years, has always been followed by a recession, a collapse in monetary velocity, and disinflation.

    • December 7, 2013 at 12:04 am

      Well, you’re right on recession. But since not all recessions have been associated with declining monetary velocity or disinflation, those can’t both be true…unless you’re saying that the inflationary recessions weren’t preceded by corporate real rates at least 250bps over growth?

      I thought the quote was Keynes too. But look at this: http://quoteinvestigator.com/2011/07/22/keynes-change-mind/ Apparently the first time anyone was actually recorded in some fashion saying it, it was Samuelson. And I’ve heard it attributed elsewhere. Just goes to show you. Something. 🙂 Good to hear from you Mike!

  2. Elliot Royce
    December 8, 2013 at 1:16 pm

    tried to comment once…hope it’s not pending. First, it doesn’t matter whether people agree with you or not….your value-add is bringing informed perspectives for consideration. As it happens, I agree with you, but we have to recognize (as James Montier points out) that those who disagree with us, even if obnoxiously, are more useful than those that agree.

    Two comments:
    – We will eventually have inflation because of the following logic: 1) Americans are not Germans and will not stand for years of declining living standards for the 99%; 2) the government with the exception of the Fed is paralyzed; 3) the only way to reduce the debt load which is hampering recovery (and gets even more crushing as the population ages and interest rates rise) is through inflation; ergo, we will have inflation even if the Fed has to spend 20 years repressing (remember the post-WW II Fed/Treasury compact).

    – Just as you don’t wait till your neighbor’s house is on fire, to buy home insurance, those who are exposed to inflation (pretty much everyone) needs to get the protection in place today. If you accept the logic of my first point, then the insurance is worth buying today as the option value will increase substantially once inflation picks up.

  3. December 13, 2013 at 10:38 am

    Mr. Ashton – I want take this time to thank you for publishing this blog. I require its reading by any junior coworker at my mega-ultra-super financial conglomerate. It’s not only hilarious/irreverant reading, but it allows me the opportunity to slaughter my poorly-read coworkers in workplace technical arguements (rare as it may be that we argue technical matters). You’re much too well read to work in finance; it’s almost unbelieveable. but, or and, keep the book recommendations comming. and merry xmas!

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