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Britain Survived the Blitz and Will Survive Brexit

June 24, 2016 4 comments

So I see today that former Fed Chairman Alan Greenspan says this is the worst crisis he has seen. Bigger than the 1987 Crash? Bigger than Long Term Capital? Bigger than the internet bubble collapse? Bigger than the Lehman (et. al.) collapse? Really?

As humans, we tend to have short memories and (ridiculously) short planning horizons. Greenspan, especially in his apparent dotage, has a shorter memory even than he had previously – maybe this is convenient given his record. I don’t want to comment on his planning horizon as that would seem uncharitable.

Why is Brexit bad? The trade arrangements and treaties do not suddenly become invalid simply because the UK has voted to throw off the shackles of her overlords and return to being governed by the same rules they’ve been governed by basically since the Magna Carta. But Jim Bianco crystallized the issue for me this week. He pointed out that while Brussels could let this be a mostly painless transition, it has every incentive to make it as painful as possible. In Jim’s words, “if it isn’t painful then hands shoot up all over Europe to be the next to leave.” That’s an astute political observation, and I think he’s right. The EU will work hard to punish Britain for having the temerity to demand sovereignty.

But Britain survived the Blitz; they will survive Brexit.

Indeed, Britain will survive longer than the Euro. The sun is beginning to set on that experiment. The first cracks happened a few years ago with Greece, but the implausibility of a union of political and economic interests when the national interests diverge was a problem from the first Maastricht vote. Who is next? Will it be Greece, Spain, Italy, or maybe France where the anti-EU sentiment is higher even than it is in the UK? The only questions now are the timing of the exits (is it months, or years?) and the order of the exits.

As I said, as humans we not only have short memories but short planning horizons. From a horizon of 5 or 10 years, is it going to turn out that Brexit was a total disaster, leading to a drastically different standard of living in the UK? I can’t imagine that is the case – the 2008 crisis has had an effect on lifestyles, but only because of the scale and scope of central bank policy errors. In Iceland, which addressed the imbalances head-on, life recovered surprisingly quickly.

These are all political questions. The financial questions are in some sense more fascinating, and moreover feed our tendency to focus on the short term.

A lot of money was wagered over the last few weeks on what was a 52-48 proposition the whole way. The betting markets were skewed because of assumptions about how undecideds would break, but it was never far from a tossup in actual polling (and now perhaps we will return to taking polling with the grain of salt it is usually served with). Markets are reacting modestly violently today – at this writing, the US stock market is only -2.5% or so, which is hardly a calamity, but bourses in Europe are in considerably worse shape of course – and this should maybe be surprising with a 52-48 outcome. I like to use the Kelly Criterion framework as a useful way to think about how much to tilt investments given a particular set of circumstances.

Kelly says that your bet size should depend on your edge (the chance of winning) and your odds (the payoff, given success or failure). Going into this vote, betting on Remain had a narrow edge (52-48) and awful odds (if Remain won, the payoff was pretty small since it was mostly priced in). Kelly would say this means you should have a very small bet on, if you want to bet that outcome. If you want to bet the Leave outcome, your edge was negative but your odds were much better, so perhaps somewhat larger of a bet on Brexit than on Bremain was warranted. But that’s not the way the money flowed, evidently.

Not to worry: this morning Janet Yellen said (with the market down 2.5%) that the Fed stood ready to add liquidity if needed. After 2.5%? In 1995 she would have had to come out and say that every week or two. A 2.5% decline takes us back to last week’s lows. Oh, the humanity!

Just stop. The purpose of markets is to move risk from people who have it to people who want it. If, all of a sudden, lots of people seem to have too much risk and to want less, then perhaps it is because they were encouraged into taking too much risk, or encouraged to think of the risk as being less than it was. I wonder how that happened? Oh, right: that’s what the Fed called the “portfolio balance channel” – by removing less-risky assets, they forced investors to hold more-risky assets since those assets now constitute a larger portion of the float. In my opinion (and this will not happen soon), central banks might consider letting markets allocate risk between the people who want it and the people who don’t want it, at fair prices. Just a suggestion.

One final point to be made today. I have seen people draw comparisons between this episode and other historical episodes. This is refreshing, since it reflects at least some thoughtful attempt to remember history. Not all of these are apt or useful comparisons; I saw one that this is the “Archduke Ferdinand” moment of this generation and that’s just nuts. Europe is not a military powderkeg at the moment and war in Europe is not about to begin. But, to the extent that trade barriers begin to rise again, the idea that this may be a “Smoot-Hawley” moment is worth consideration. The Smoot-Hawley tariff is generally thought to have added the “Great” to the phrase “Great Depression.” I think that’s probably overstating the importance of this event – especially if everybody decides to respect Britons’ decision and try to continue trade as usual – but it’s the right idea. What I want to point out is that while rising tariffs tend to produce lower growth and lower potential growth, they also tend to produce higher inflation. The fall of the Berlin Wall and the opening of Eastern Europe is one big reason that inflation outcomes over the last few decades have been lower than we would have expected for the amount of money growth we have had. The US has gone from producing all of its own apparel to producing almost none, for example, and this is a disinflationary influence. What would happen to apparel prices if the US changed its mind and started producing it all domestically again? Give that some thought, and realize that’s the protectionist part of the Brexit argument.

We can cheer for a victory for independence and freedom, while continuing to fight against any tendency towards economic isolationism. But I worry about the latter. It will mean higher inflation going forward, even if the doomsayers are right and we also get lower growth from Brexit and the knock-on effects of Brexit.

Summary of My Post-CPI Tweets

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy or sign up for email updates to my occasional articles here. Investors with interests in this area be sure to stop by Enduring Investments. Plus…buy my book about money and inflation, just published! The title of the book is What’s Wrong with Money? The Biggest Bubble of All; order from Amazon here.

  • CPI coming up in 15 mins. Consensus is +0.3% headline +0.2% core, putting y/y core up to 2.2% again.
  • Base effects for core suggest better chance for y/y rise for next 4mo or so.
  • Stay tuned, 10mins to CPI. In the meantime why not check out our Crowdfunding campaign? https://www.crowdfunder.com/enduring-investments-llc … (Accredited inv only)
  • Core CPI +0.203% m/m; y/y rises to 2.235%.
  • Core goods remains at -0.5% y/y; core services rises to 3.2%, highest since 2008.
  • Housing jumped to 2.37% y/y from 2.11%. Looking at breakdown to see if that’s in rents or elsewhere in housing.
  • Medical Care had fallen from 3.29% y/y to 2.98% last month. Back up to 3.17%, which is the general trend: higher.
  • Apparel flipped to +0.58% y/y vs -0.57% y/y. Only about 5% of core CPI, but a bellwether we’ve been watching (with little result so far).
  • tweeted this earlier…note that strong base effects lifted y/y CPI but next 3 months comparison also easy.

last12

  • Within Housing, Primary rents rise to 3.80% from 3.73%. OER jumps HUGE, to 3.264% from 3.147%. Big jump for a big part of basket.
  • …and that’s not a misprint. All pressures on rents are higher, and remain higher.
  • Lodging away from home is small, but was a drag last mo. Not this mo: rises to 3.83% y/y from 1.32%
  • In Medical Care, drugs actually fell to 2.34% y/y from 2.84%. But professional svcs 2.81% from 2.26%; Hospital svcs 3.25% v 3.15%
  • Health insurance 6.30% y/y from 5.80%.
  • y/y change in Health Insurance CPI

bfmE9AC

  • y/y in med care services – resuming uptrend

medcaresvcs

  • optimists can look at core ex-housing and see a rise to only 1.42%. But that’s b/c goods carry much more weight in that look.
  • W/in transportation, new and used vehicles was actually a drag, -0.50% y/y from -0.27%. That’s in core goods.
  • y/y core hasn’t been above 3% for 20 years. But will be in 2017.
  • y/y core hasn’t been above 3% for 20 years. But will be in 2017.
  • Early estimate of Median CPI…+0.26% m/m with y/y going to 2.53%, a new cycle high.
  • Probably a good time to mention the crowdfunding for Enduring Investments again: https://www.crowdfunder.com/enduring-investments-llc… Own an inflation manager!
  • Bottom line for today: nothing at all soothing in this report. Upward inflation trend continues.

Nothing at all soothing, indeed. A day after the FOMC chose to stand pat on interest rates, core inflation pushed back higher and median inflation is about to push above 2.5% for the first time since 2009 (when it was on the way down). Of course, nothing about this inflation picture, and the rotten internals that suggest higher figures are in store, would have changed the Fed’s decision yesterday. As noted previously in this space, the Yellen Fed fundamentally does not believe that inflation is a threat; if it is a threat, they believe a little inflation is okay if allowing inflation to run hot helps the overall economy and the little guy; and if they later decide inflation does need to be addressed, it can be easily reined in.

They are wrong on all three counts, and we may well be seeing the beginnings of a colossal error. Honestly, the question here is between whether it is only a bad error that is fixable or a colossal error that isn’t fixable without much pain. Inflation is headed higher.

And yet, ironically, standing pat on interest rates will slow down the near-term rise in inflation since it will keep money velocity from rising as rapidly as it would if interest rates were rising. The best way to keep cash inert is for alternative investment opportunities to remain poor! But money growth around 7% is too fast, even if velocity merely flatlines. Inflation will continue to rise for the balance of this year and into 2017 (at least).

Categories: CPI, Tweet Summary

Not Enough TIPS to Go Around

June 14, 2016 2 comments

Some days – well, on days like today, and for the last few days – it seems like there are far too many TIPS. Although energy has slipped only mildly, and (let’s not forget!) core and median inflation are both over 2% and rising, today ten-year breakeven inflation fell to only 1.48%, the lowest level since early March (see chart, source Bloomberg).

panickybei

The panicky-feeling downtrade is exacerbated by the thin risk budgets on the Street in inflation trading. From an investment standpoint, with inflation over the next few years highly likely to exceed the current breakeven rate (unless energy prices go to zero, or median inflation and wages abruptly reverse their multi-year accelerations), investors who buy TIPS in preference to nominal Treasuries (which is the bet you’re putting on in a breakeven trade, but works from a long-only perspective as well) are likely to outperform unless US inflation comes in below, say, 1.25% for the seven years starting in three years. And even if inflation does come in below that, the underperformance will be slight in comparison to the potential outperformance if inflation rises from its current level. TIPS don’t continue to underperform worse and worse in deflationary outcomes; their principal amounts are guaranteed in nominal terms.

But that doesn’t help at times like these. We have to remember, core inflation has been below 3% for twenty years. There are people in college today who have never seen core inflation with a 3-handle, and a generation of investors who have never had to factor the possibility of higher inflation into their calculations. (See chart, source Bloomberg).

corebelow3

If that seems incredible, then consider that it may be even more incredible to ignore inflation-linked bonds at these levels even if you think inflation will stay low! Core inflation has not been lower than 1.9% compounded, over a ten-year period, since the 1960s. Even trailing 10-year headline inflation, which is currently 1.73% only since Crude Oil is -35% over the last ten years (remember all of the smack talk about how the Fed should stop focusing on core inflation since energy was no longer mean-reverting?), hasn’t been as low at 1.5% for an entire decade since 1964, and hasn’t been below 1.25% since 1942.

But prices at any moment are about supply and demand, and there are about $1.27trillion in TIPS outstanding right now while investors struggle to remember what 3% inflation felt like.

I am here to tell, though, that there is a terrible shortage of TIPS.

So we know the supply number. About $1.25 trillion, and only $310bln is over 10 years in maturity. Not all of that is float, mind you – many of these bonds are held as long-term hedges by investors who know better. We don’t have to add corporate inflation-linked bonds (ILBs), municipal ILBs, or infrastructure-backed ILBs, because the aggregate outstanding of those markets is rounding error.

How about demand? Let’s tick off some of the inflation exposures that exist institutionally, which admittedly completely ignores demand by individual investors (who are also inflation-exposed by nature).

  • Total US endowment and foundation assets: ~$1 trillion as of 2013 (latest I have handy)
    • Endowments and foundations’ liabilities are almost wholly inflation-sensitive
  • Total US pension fund assets: ~$16 trillion
    • Most pension funds in the US don’t have COLAs, but they still have large exposures to inflation if they still have employees earning benefits
  • Insurance companies: exposure to inflation in 125mm workers’ compensation policies covering $6 trillion in wages, and very long-dated to boot
  • Post-employment medical (OPEB) benefits liabilities: $567bln as of 2014, for US states alone (that is, ignoring corporate OPEBs)

I will stop counting here. I didn’t have to look very hard to get inflation-linked liabilities that are a multiple of available ILB supply – and a very large multiple of long-dated ILB float. I am sure someone will complain that I left something out, or have old data, or something…but this isn’t an accounting class: I am just pointing out orders of magnitude. And, by an order of magnitude, there are not enough TIPS to go around if investors decide that inflation is a salient risk.

But if there is already such an imbalance, then why don’t TIPS trade as if there is a shortage? For the answer, we go back to the chart above. The people managing these liabilities (and you may be one!) haven’t had to worry about inflation exposure for a very long time. To the extent that savvy institutional investors buy TIPS, they dislike them because the nominal and real returns are awful. Therefore, they seek to replace these bonds with other real assets which may provide some protection if inflation rises. Among these are commodities – which are also loathed at present – as well as illiquid assets like real estate or private equity.

I have had insurance company risk managers say to me, “we cannot own enough TIPS to matter if inflation rises to a level that would concern us, because the return if inflation does not rise is so horrible. And, in fact, our hedge ratio would probably be above 100%.” I am not sure that is a great excuse to do nothing at all (and we try to help them square that circle) but I present the comment to give some notion of the mindset.

The mindset will change. It will not change overnight, probably, but when inflation exceeds 3% and then starts the assault on 4%, it will change. And then, abruptly, it will all too obvious that a trillion in TIPS doesn’t go as far as you think.

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(Interested in what we do? Take a look at Enduring Investments’ Crowdfunder campaign, which is open to accredited investors who are willing to be verified as accredited by a third party verification agent.)

Categories: TIPS

Obamacare, Monopsonies, and Inflation – Nice Try!

June 9, 2016 1 comment

Recently, the San Francisco Federal Reserve published an Economic Letter in which they described why “Medicare Payment Cuts Continue to Restrain Inflation.” Their summary is:

“A steady downward trend in health-care services price inflation over the past decade has been a major factor holding down core inflation. Much of this downward trend reflects lower payments from public insurance programs. Looking ahead, current legislative guidelines imply considerable restraint on future public insurance payment growth. Therefore, overall health-care services price inflation is unlikely to rebound and appears likely to continue to be a drag on inflation.”

The article is worth reading. But I always have a somewhat uncomfortable reaction to pieces like this. On the one hand, what the authors are discussing is well known: healthcare services held down PCE inflation, and core CPI inflation, due to sequestration. Even Ben Bernanke knew that, and it was one reason that it was so baffling that the Fed was focused on declining core inflation in 2012-2014 when we knew why core was being dragged lower – and it was these temporary effects (see chart, source Bloomberg, showing core and Median CPI).

baffling

But okay, perhaps the San Francisco Fed is now supplying the reason: these were not one-off effects, they suggest; instead, “current legislative guidelines” (i.e., the master plan for Obamacare) are going to continue to restrain payments in the future. Ergo, prepare for extended lowflation.

This is where my discomfort comes in. The article combines these well-known things with questionable (at best) assumptions about the future. In this latter category the screaming assumption is the Medicare can affect prices simply by choosing to pay different prices. In a static analysis that’s true, of course. But it strikes me as extremely unlikely in the long run.

It’s a classic monopsonist pricing analysis. Just as “monopoly” is a term to describe a market with just one dominant seller, “monopsony” describes a market with just one dominant buyer. The chart below (By SilverStar at English Wikipedia, CC BY 2.5, https://commons.wikimedia.org/w/index.php?curid=13863070) illustrates the classic monopsony outcome.

217px-Monopsony-static-partial-equilibrium.svg

The monopsonist forces an equilibrium based on the marginal revenue product of what it is buying, compared to the marginal cost, at point A. This results in the market being cleared at point M, at a quantity L and a price w, as distinct from the price (w’) and quantity (L’) that would be determined by the competitive-market equilibrium C. So, just as the San Fran Fed economists have it, a monopsonist (like Medicare) forces a lower price and a lower quantity of healthcare consumed (they don’t talk so much about this part but it’s a key to the ‘healthcare cost containment’ assumptions of the ACA neé Obamacare). Straight out of the book!

But that’s true only in a static equilibrium case. I admit that I wasn’t able to find anything relevant in my Varian text, but plain common-sense (and observation of the real world) tells us that over time, the supply of goods and services to the monopsonist responds to the actual price the monopsonist pays. That is, supply decreases because period t+1 supply is related to the reward offered in period t. There is no futures market for medical care services; there is no way for a medical student to hedge future earnings in case they fall. The way the prospective medical student responds to declining wages in the medical profession is to eschew attending medical school. This changes the supply curve in period t+1.

Any other outcome, in fact, would lead to a weird conclusion (at least, I think it’s weird; Bernie Sanders may not): it would suggest that the government should take over the purchase and distribution of all goods, since they could hold prices down by doing so. In other words, full-on socialism. But…we know from experience that pure socialist regimes tend to produce higher rates of inflation (Venezuela, anyone?), and one can hardly help but notice that when the government competes with private industry – for example, in the provision of express mail service – the government tends to lose on price and quality.

In short, I find it very hard to believe that mere “legislative guidelines” can restrain inflation in medical care, in the long run.

Math is Bad for Equities

June 7, 2016 4 comments

In recent years, equities have been carried higher by several compounding effects: the growth of the economy, expanding profit margins, and expanding multiples.

These three things, by definition, determine equity prices (if we assume that gross sales are tied to economic growth):

Price = Price/Earnings x Earnings/Sales x Sales

When all three are rising, as they have been, it is a strong elixir for stock prices. Now, this explains why stock prices are so high, but the devil lies in predicting these components of course – no mean feat.

Yet, we can make some observations. It has been the case for a while that P/E ratios have been extremely high by historical measures, with the Shiller Cyclically-Adjusted P/E ratio (CAPE) roughly doubling since the bottom in 2009. With the exception of the equity bubble in 1999-2000, the CAPE has never been very much higher than it is now, at 26.4 (see chart, source Gurufocus). This should come as no surprise to anyone who follows markets regularly.

chart

Somewhat less obviously, recently sales have been declining. However, on a rolling-10-year basis, the rise has been reasonably steady as the chart below (Source: Bloomberg) illustrates. Over the last 10 years, sales per share have risen about 2.85% per year.

sales

Finally, profit margins have recently been elevated. In fact, they have been elevated for a long time; the 10-year average profit margin for the S&P 500 (see chart, source Bloomberg) has risen to 8% from 6% only a few years ago. Recently, however, profit margins have been receding.

profmgn

Both the rise in profit margins and the current drop in them make some sense. Value creation at the company level must be divided between the factors of production: land, labor, and capital. When there is substantial unemployment, labor has little bargaining power and capital tends to claim a higher share. Moreover, labor’s share is relatively sticky, so that speculative capital absorbs much of the business-cycle volatility in the short run. This is ever the tradeoff between the sellers of labor and the buyers of labor.

I used 10-year averages for all of these so that we can use CAPE; other measures of P/E are fraught. So, if we take 26.4 (CAPE) times 7.84% (10-year average profit margin) times 1005.55 (10-year average sales), we get an S&P index value of 2081, which is reasonably close to the end-of-May value of 2097. That’s not surprising – as I said, these three things make up the price, mathematically.

So let’s look forward. Recently, as the Unemployment Rate has fallen – and yes, I’m well aware that there is more slack in the jobs picture than is captured in the Unemployment Rate, but the recent direction is clear – wages have accelerated as I have documented in previous columns. It is unreasonable to expect that profit margins could stay permanently elevated at levels above all but a few historical episodes. Let’s say that over the next two years, the average drops from 7.84% to 7.25%. And let’s suppose that sales continue to grow at roughly 2.85% per year (which means no recession), so that sales for the S&P are at 1292 and the 10-year average at 1064.15. Then, if the long-term P/E remains at its current level, the S&P would need to decline to 2037. If the CAPE were to decline from 26.4 to, say, 22.5 (the average since 1990, excluding 1997-2002), the S&P would be at 1736.

None of this should be regarded as a prediction, except in one sense. If stock prices are going to continue to rise, then at least one of these things must be true: either multiples must expand further, or sales growth must not only become positive again but actually accelerate, or profit margins must stop regressing to the mean. None of these things seems like a sure thing to me. In fact, several of them seem downright unlikely.

The most malleable of these is the multiple…but it is also the most ephemeral, and most vulnerable to an acceleration in inflation. We remain negative on equities over the medium term, even though I recently advanced a hypothesis about why these overvalued conditions have been so durable.

Categories: Investing, Stock Market, Theory

The Destination Currency in the Global Carry Trade: USD?

If you are an investor of the Ben Graham school, you’ve lived your life looking for “value” investments with a “margin of safety.” Periodically, if you are a pure value investor, then you go through long periods of pulling your hair out when momentum rules the day, even if you believe – as GMO’s Ben Inker eloquently stated in last month’s letter – that in the long run, no factor is as important to investment returns as valuation.

This is one of those times. Stocks have been egregiously overvalued (using the Shiller CAPE, or Tobin’s Q, or any of a dozen other traditional value metrics) for a very long time now. Ten-year Treasuries are at 1.80% in an environment where median inflation is at 2.5% and rising, and where the Fed’s target for inflation is above the long-term nominal yield. TIPS yields are significantly better, but 10-year real yields at 0.23% won’t make you rich. Commodities are very cheap, but that’s just a bubble in the other direction. The bottom line is that the last few years have not been a great time to be purely a value investor. The value investor laments “why?”, and tries to incorporate some momentum metrics into his or her approach, to at least avoid the value traps.

Well, here is one reason why: the US is the destination currency in the global carry trade.

A “carry trade” is one in which regular returns can be earned simply on the difference in yields between different instruments. If I can borrow at LIBOR flat and lend at LIBOR+2%, I am in a carry trade. Carry trades that are riskless and result from one’s market position (e.g., if I am a bank and I can borrow from 5-year CD customers at 0.5% and invest in 5-year Treasuries at 1.35%) are usually more like accrual trades, and are not what we are talking about here. We are talking about positions that imply some risk, even if it is believed to be small. For example, because we are pretty sure that the Fed will not tighten aggressively any time soon, we could simply buy 2-year Treasuries at 0.88% and borrow the money in overnight repo markets at 0.40% and earn 48bps per year for two years. This will work unless overnight interest rates rise appreciably above 88bps.

We all know that carry trades can be terribly dangerous. Carry trades are implicit short-option bets where you make a little money a lot of the time, and then get run over with some (unknown) frequency and lose a lot of money occasionally. But they are seductive bets since we all like to think we will see the train coming and leap free just in time. There’s a reason these bets exist – someone wants the other side, after all.

Carry trades in currency-land are some of the most common and most curious of all. If I borrow money for three years in Japan and lend it in Brazil, then I expect to make a huge interest spread. Of course, though, this is entirely reflected in the 3-year forward rate between yen and real, which is set precisely in this way (covered-interest arbitrage, it is called). So, to make money on the Yen/Real carry bet, you need to carry the trade and reverse the exchange rate bet at the end. If the Real has appreciated, or has been stable, or has declined only a little, then you “won” the carry trade. But all you really did was bet against the forward exchange rate. Still, lots and lots of investors make precisely this sort of bet: borrowing money is low-interest rate currencies, investing in high-interest-rate currencies, and betting that the latter currency will at least not decline very much.

How does this get back to the value question?

Over the last several years, the US interest rate advantage relative to Europe and Japan has grown. This should mean that the dollar is expected to weaken going forward, so that someone who borrows in Euro to invest in the US ought to expect to lose on the future exchange rate when they cash out their dollars. And indeed, as the interest rate advantage has widened so has the steepness of the forward points curve that expresses this relationship. But, because investors like to go to higher-yielding currencies, the dollar in fact has strengthened.

This flow is a lot like what happens to people on a ship that has foundered on rocks. Someone lowers a lifeboat, which looks like a great deal. So people begin to pour into the lifeboat, and they keep doing so until it ceases, suddenly, to be a good deal. Then all of those people start to wish they had stayed on the ship and waited for help.

In any event, back to value: the chart below (source: Bloomberg) shows the difference between the 10-year US$ Libor swap rate minus the 10-year Euribor swap rate, in white and plotted in percentage terms on the right-hand scale. The yellow line is the S&P 500, and is plotted on the left-hand scale. Notice anything interesting?

carry1

The next chart shows a longer time scale. You can see that this is not a phenomenon unique to the last few years.

carry2

Yes, the correlation isn’t perfect but to me, it’s striking. And we can probably do better. After all, the chart above is just showing the level of equity prices, not whether they are overvalued or undervalued, and my thesis is that the fact that the US is the high-yielding currency in the carry trade causes the angst for value investors. We can show this by looking at the interest rate spread as above, but this time against a measure of valuation. I’ve chosen, for simplicity, the Shiller Cyclically-Adjusted P/E (CAPE) (Source: http://www.econ.yale.edu/~shiller/data.htm)

capevsspread

Now, I should take pains to point out that I have not proven any causality here. It may turn out, in fact, that the causality runs the other way: overheated markets lead to tight US monetary policy that causes the interest rate spread to widen. I am skeptical of that, because I can’t recall many episodes in the last couple of decades where frothy markets led to tight monetary policy, but the point is that this chart is only suggestive of a relationship, not indicative of it. Still, it is highly suggestive!

The implication, if there is a causal relationship here, is interesting. It suggests that we need not fear these levels of valuation, as long as interest rates continue to suggest that the US is a good place to keep your money (that is, as long as you aren’t afraid of the dollar weakening). That, in turn, suggests that we ought to keep an eye on rates of change: if the ECB tightens more, or eases less, than is priced into European markets (which seems unlikely), or the Fed tightens less, or eases more, than is priced into US markets (which seems more likely, but not super likely since not much is presently priced in), or the dollar trend changes clearly. When one of those things happens, it will be a sign that not only are the future returns to equities looking unrewarding, but the more immediate returns as well.

Summary of My Post-CPI Tweets

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy or sign up for email updates to my occasional articles here. Investors with interests in this area be sure to stop by Enduring Investments. Plus…buy my book about money and inflation, just published! The title of the book is What’s Wrong with Money? The Biggest Bubble of All; order from Amazon here.

  • In prep for CPI: Econs forecasting about 0.15% core; Cleveland Fed’s Nowcast is 0.18%; avg of last 4 months is 0.20%.
  • So, econs which have been too bullish on econ for a year (see citi surprise index) are bearish on CPI.
  • If we get any m/m core less than 0.20% (even 0.19%), y/y will round to 2.1% b/c dropping off high 2015 April.
  • But after that, next 8 months from 2015 were <0.20% so any downtick wouldn’t be start of something new.
  • Hard to tell but the core CPI print was SLIGHTLY above expectations. 0.195%, so y/y was 2.147%.
  • In other words, if someone charged another nickel for a candy bar somewhere we would have had 2.2% again. <<hyperbole
  • That 0.195% m/m was lower than April 2015, but higher than May, June, July, Aug, Sep, Nov, and Dec.
  • Core services unch at 3.0%; core goods downticked to -0.5% y/y.
  • y/y Medical Care decelerated for second month in a row, down to 2.98% y/y; still looks to be in a broad uptrend from 2% in 2014. [ed note: chart added for clarity]

medcarecpi

  • Within Medical Care, medicinal drugs accelerated, prof svcs was flat. Hospital svcs dropped from 4.33 to 3.15% y/y
  • Hospital services oscillates – we’ll probably get that back to 4%-4.5% which will push med care back up.
  • Primary Rents 3.73% from 3.66%. OER 3.15% from 3.12%. Some were expecting deceleration there. Not us!
  • Lodging Away from Home dropped to 1.32% from 2.27%. That, and various home furnishings, is why Housing subcat went to 2.12 vs 2.14.
  • But Rents and OER are the stable measures…not Lodging, not furnishings.
  • Core ex-housing fell to 1.39% from 1.48%, but again that’s due to elements of med care and housing that are likely to rebound.
  • Lots of movement within Apparel but overall nothing. The February pop looks like a one-off.
  • Overall, a more buoyant number than expected and the stuff holding core CPI down are the transient things.
  • Biggest m/m declines: infants’/toddlers’ apparel (-26.5% annualized), fresh fruits & veggies; women’s apparel; Lodging away from home.
  • Biggest m/m outliers: Motor Fuel (+152.3% annualized), Fuel Oil, Processed Fruits & Veggies; Motor Vehicle Insurance.
  • My estimate of median CPI is actually 0.28% m/m and 2.46% y/y. But…
  • …but the median category this month may be affected by regional housing, and I don’t have the BLS factors. So grain of salt needed.
  • This summarizes the inflation story. Rents and Services ex-rents both rising ~3%. Core goods is the anchor.

threecat

Discussion: after last month’s surprising m/m core CPI print of +0.07%, many were questioning whether that was the outlier, or whether the +0.29% and +0.28% of January and February were the outliers. The answer might be that they are all outliers, as this month’s print was very close to the 4-month average. But even so, +0.2% m/m would produce a 2.4% core inflation number by the year’s end. That’s consistent with what we are being told by Median inflation. Both figures would suggest core PCE, after all of the temporary effects are removed, is essentially at or slightly above the Fed’s 2% target.

There are two pertinent questions at this juncture. The first is whether the Fed will feel any urgency to raise rates more quickly because of this data. The answer to that, I think, is clearly “no.” This Federal Reserve’s reaction function seems to be overly (and overtly) tilted towards growth indicators – and even more than that, their forecast of growth indicators. The majority of the Committee also believes that inflation expectations are “anchored” and so inflation can’t really move higher very quickly. They only pay lip service to inflation concerns, and honestly they aren’t even very good at the lip service.

The second question is where inflation goes next. Whether the Federal Reserve raises the target overnight rate or not, the question of inflation is relevant for markets. And the indicators seem to be fairly clear: the larger and more persistent categories are seeing price increases of around 3% or more, while the main drag comes from a “core goods” component that is highly influenced by the lagged effect of dollar strength (see chart, source Bloomberg).

coregoodsvsusd

Recently, the dollar has been weakening marginally but still is in a broad uptrend (looking at the broad, trade-weighted dollar). But if the buck merely goes flat, core goods will start to move higher. And that means even if core services remain steady, core inflation should push towards 3% later this year.

This doesn’t sound like much but it would be highly significant (and surprising) for many observers, investors, and consumers. Core inflation has not been above 3% for two decades (see chart, source Bloomberg).

coreCPIunder3

This means – incredibly – that many students in college today have never seen core inflation above 3%, and more importantly many investors have not seen core inflation above 3% during their investment lives. When core inflation breaches that level, it will feel like hyperinflation to some people! And I do not think markets will like it.

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