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Spinning Economic Stories

January 4, 2019 5 comments

As economists[1] we do two sorts of things. We do quantitative work, and we tell stories.

One of the problems with economics is that we aren’t particularly regimented about how we convert data into stories and about how we look at stories to decide how to interrogate the data. So what tends to happen is that we have a phenomenon and then we look at what story we like and decide if that’s a reasonable way to explain the data…without asking if there isn’t a more reasonable way to explain the data, or at least another way that’s equally consistent with the data. I’m not saying that everyone does this, just that it’s disturbingly common especially among people being paid to be storytellers and for whom a good story is really important.

So for example, there is a well -known phenomenon that inflation tends to accelerate after the Fed begins raising interest rates.[2] Purporting to explain this phenomenon, here is a popular story that the Fed is just really smart, so they’re ahead of inflation, and when they seeing it moving up just a little bit they can jump on it real quick and get ahead of it and so inflation goes up…but the apparent causality is there because we just knew it was going to go up and acted before the observation of the higher inflation happened. This is basically Keynesian theory combined with “brilliant person” theory.

There is another theory that is consistent with this, of course: monetarism, which explains that increasing interest rates actually causes inflation to move higher, by causing velocity to increase. But, because this isn’t the popular story, this doesn’t get matched up to the data very frequently. In my mind it’s a better theory, because it doesn’t require us to believe that the Fed is super brilliant to make it work. (And, not to get snarky, but the countervailing evidence versus Fed staff economist genius is pretty mountainous). Of course, economists – and the Fed economists in particular – like theories that make them look like geniuses, so they prefer the prior explanation.

But again, as economists we don’t have a good and rigorous way to say that one way is the ‘preferred’ story or to look at other stories that are consistent with our data. We tend to look at what part of the data supports our story – in other words, confirmation bias.

Why this is relevant now is that the Fed is in fact tightening and inflation is in fact heading higher, and the story being pushed by the Fed and some economists is “good thing the Fed is tightening, because it looks like inflation was going up!” The story on the other hand that I have been telling for quite some time (and which I write about in my book) is that it’s partly because the Fed is tightening and interest rates are going up that that inflation is rising, in a feedback loop that is missed in our popular stories. The important part is the next chapter in the story. In the “Fed is getting ahead of it” story, inflation comes down and the Fed is able to stop tightening, achieving a soft landing. In the “rate increase is causing velocity to rise and inflation to rise” story, the Fed keeps chasing the dog which is only running because the Fed is chasing it.

There is another alternative, which really excites the stock market as evidenced by today’s massive – although disturbingly low-volume – rally. That story is that the Fed is going to become more “data dependent” (Chairman Powell suggested something along these lines today), which is great because the Fed has already won on inflation and growth is still okay. So the Fed can stop the autopilot rate hikes. This story unfortunately does require a little suspension of disbelief. For one thing, today’s strong Employment report (Payrolls 370k, including revisions, compared to 184k expectations) is unfortunately a December figure which means it has huge error bars. Moreover, the Unemployment Rate rose to 3.9% from 3.7%, and while a higher Unemployment Rate doesn’t mean the economy is definitely slowing (it could just be that more people are looking for jobs because the job market is so robust – another fun story), it is certainly more consistent with the notion that the economy is slowing at the margin. The fact that the Unemployment Rate went up, while Hourly Earnings rose more than expected and Jobs rose more than expected, should make you suspect that year-end quirkiness might have something to do with the figures. For the decades I’ve watched economic data, I always advise ignoring the January and February Employment Reports since the December/January changes in payroll are so large that the noise swamps the signal. But professional storytellers aren’t really content to say “this doesn’t really mean anything,” even if that’s the quantitative reality. They get paid to spin yarns, so spin yarns they do.

Yeah, about those wages: I’m not really sure why economists were expecting hourly earnings to decelerate this month. All of the anecdotal data, along with other wage measures, are suggesting that wages are rising apace (see chart, source Bloomberg, showing the Atlanta Fed Wage Tracker vs AHE). Not really a surprise, even given its compositional challenges, that AHE is also rising.

The thing about all of these stories is that while they can’t change the actual reality, they can change how reality is priced. This is one of the reasons that we get bubbles. The stories are so powerful that trading against them, with a ‘value’ mindset for example, is quixotic. Ultimately, in the long run, the value of the equity market is limited by fundamentals. But in the short run, it is virtually unlimited because of valuation multiples (price as a speculative multiple of fundamental earnings, e.g.) and those valuation multiples are driven by stories. And that’s a big reason that bullish stories are so popular.

But consider this bearish footnote on today’s 3.4% S&P rally: volume in the S&P constituents today was lower than the volume was on December 26! To be fair, the volume yesterday, when the S&P declined 2.5%, was even a bit lower than today’s volume. It’s typical thin and whippy first-week-of-the-year trading. Let’s see what next week brings.


[1] People occasionally ask me why I didn’t go on for my MA or PhD in Economics. I reply that it’s because I learned my Intermediate Microeconomics very well: I stopped going for a higher degree when the marginal costs outweighed the marginal benefits. When you look at it that way, it makes you wonder whether the PhD economists aren’t just the bad students who didn’t absorb that lesson.

[2] It’s referred to as the “price puzzle”; see Martin Eichenbaum, “Interpreting Macroeconomic Time Series Facts: The Effects of Monetary Policy: Comments.” European Economic Review, June 1992. And Michael Hanson, “The ‘Price Puzzle’ Reconsidered,” Journal of Monetary Economics, October 2004.

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Inflation-Related Impressions from Recent Events

September 10, 2018 2 comments

It has been a long time since I’ve posted, and in the meantime the topics to cover have been stacking up. My lack of writing has certainly not been for lack of topics but rather for a lack of time. So: heartfelt apologies that this article will feel a lot like a brain dump.

A lot of what I want to write about today was provoked/involves last week. But one item I wanted to quickly point out is more stale than that and yet worth pointing out. It seems astounding, but in early August Japan’s Ministry of Health, Labour, and Welfare reported the largest nominal wage increase in 1997. (See chart, source Bloomberg). This month there was a correction, but the trend does appear firmly upward. This is a good point for me to add the reminder that wages tend to follow inflation rather than lead it. But I believe Japanese JGBis are a tremendous long-tail opportunity, priced with almost no inflation implied in the price…but if there is any developed country with a potential long-tail inflation outcome that’s possible, it is Japan. I think, in fact, that if you asked me to pick one developed country that would be the first to have “uncomfortable” levels of inflation, it would be Japan. So dramatically out-of-consensus numbers like these wage figures ought to be filed away mentally.

While readers are still reeling from the fact that I just said that Japan is going to be the first country that has uncomfortable inflation, let me talk about last week. I had four inflation-related appearances on the holiday-shortened week (! is that an indicator? A contrary indicator?), but two that I want to take special note of. The first of these was a segment on Bloomberg in which we talked about how to hedge college tuition inflation and about the S&P Target Tuition Inflation Index (which my company Enduring Investments designed). I think the opportunity to hedge this specific risk, and to create products that help people hedge their exposure to higher tuition costs, is hugely important and my company continues to work to figure out the best way and the best partner with whom to deploy such an investment product. The Bloomberg piece is a very good segment.

I spent most of Wednesday at the Real Return XII conference organized by Euromoney Conferences (who also published one of my articles about real assets, in a nice glossy form). I think this is the longest continually-running inflation conference in the US and it’s always nice to see old friends from the inflation world. Here are a couple of quick impressions from the conference:

  • There were a couple of large hedge funds in attendance. But they seem to be looking at the inflation markets as a place they can make macro bets, not one where they can take advantage of the massive mispricings. That’s good news for the rest of us.
  • St. Louis Fed President James Bullard gave a speech about the outlook for inflation. What really stood out for me is that he, and the Fed in general, put enormous faith in market signals. The fact that inflation breakevens haven’t broken to new highs recently carried a lot of weight with Dr. Bullard, for example. I find it incredible that the Fed is actually looking to fixed-income markets for information – the same fixed-income markets that have been completely polluted by the Fed’s dominating of the float. In what way are breakevens being established in a free market when the Treasury owns trillions of the bonds??
  • Bullard is much more concerned about recession than inflation. The fact that they can both occur simultaneously is not something that carries any weight at the Fed – their models simply can’t produce such an outcome. Oddly, on the same day Neel Kashkari said in an interview “We say that we have a symmetric view of inflation. We don’t mind if it’s 2.1 or 1.9, but in our practice, in what we actually do, we are much more worried about high inflation than we are low inflation. And I think that that is the scar from the 1970s.” That’s ludicrous, by the way – there is no way in the world that the Fed would have done the second and third QEs, with the recession far in the rear view mirror, if the Fed was more concerned with high inflation. Certainly, Bullard showed no signs of even the slightest concern that inflation would poke much above 2%, much less 3%.
  • In general, the economists at the conference – remember, this is a conference for people involved in inflation markets – were uniform in their expectation that inflation is going nowhere fast. I heard demographics blamed (although current demographics, indicating a leftward shift of the supply curve, are actually inflationary it is a point of faith among some economists that inflation drops when the number of workers declines. It’s actually a Marxist view of the economic cycle but I don’t think they see it that way). I heard technology blamed, even though there’s nothing particularly modern about technological advance. Economists speaking at the conference were of the opinion that the current trade war would cause a one-time increase in inflation of between 0.2%-0.4% (depending on who was speaking), which would then pass out of the data, and thought the bigger effect was recessionary and would push inflation lower. Where did these people learn economics? “Comparative advantage” and the gain from trade is, I suppose, somewhat new…some guy named David Ricardo more than two centuries ago developed the idea, if I recall correctly…so perhaps they don’t understand that the loss from trade is a real thing, and not just a growth thing. Finally, a phrase I heard several times was “the Fed will not let inflation get out of hand.” This platitude was uttered without any apparent irony deriving from the fact that the Fed has been trying to push inflation up for a decade and has been unable to do so, but the speakers are assuming the same Fed can make inflation stick at the target like an arrow quivering in the bullseye once it reaches the target as if fired by some dead-eye monetary Robin Hood. Um, maybe.
  • I marveled at the apparent unanimity of this conclusion despite the fact that these economists were surely employing different models. But then I think I hit on the reason why. If you built any economic model in the last two decades, a key characteristic of the model had to be that it predicted inflation would be very low and very stable no matter what other characteristics it had. If it had that prediction as an output, then it perfectly predicted the last quarter-century. It’s like designing a technical trading model: if you design one that had you ‘out’ of the 1987 stock market crash, even if it was because of the phase of the moon or the number of times the word “chocolate” appeared in the New York Times, then your trading model looks better than one that doesn’t include that “factor.” I think all mainstream economists today are using models that have essentially been trained on dimensionless inflation data. That doesn’t make them good – it means they have almost no predictive power when it comes to inflation.

This article is already getting long, so I am going to leave out for now the idea I mentioned to someone who works for the Fed’s Open Market Desk. But it’s really cool and I’ll write about it at some point soon. It’s an idea that would simultaneously be really helpful for investors and help the Fed reduce a balance sheet that they claim to be happy with but we all really know they wish they could reduce.

So I’ll move past last week and close with one final off-the-wall observation. I was poking around in Chinese commodity futures markets today because someone asked me to design a trading strategy for them (don’t ask). I didn’t even know there was such a thing as PVC futures! And Hot Rolled Coils! But one chart really struck me:

This is a chart of PTA, or Purified Terephthalic Acid. What the heck is that? PTA is an organic commodity chemical, mainly used to make polyester PET, which is in turn used to make clothing and plastic bottles. Yeah, I didn’t know that either. Here’s what else I don’t know: I don’t know why the price of PTA rose 50% in less than two months. And I don’t know whether it is used in large enough quantities to affect the end price of apparel or plastic bottles. But it’s a pretty interesting chart, and something to file away just in case we start to see something odd in apparel prices.

Let me conclude by apologizing again for the disjointed nature of this article. But I feel better for having burped some of these thoughts out there and I hope you enjoyed the burp as well.

The Important Trade Effects Are Longer-Term

The question about the impact of trade wars is really two questions, and I suppose they get conflated a lot these days. First, there’s the near-term market impact; second is the longer-term price/growth impact.

The near-term market impact is interesting. When the market is in a bad mood (forgive the anthropomorphization), then trade frictions are simply an excuse to sell – both stocks and bonds, but mostly stocks. When the market is feeling cheerful, and especially around earnings season, trade wars get interpreted as having very narrow effects on certain companies and consequently there is no large market impact. That is what seems to have happened over the last few weeks – although trade conflicts are escalating and having very concentrated effects in some cases (including on markets, such as in commodities, where they really oughtn’t), it hasn’t dampened the mood of the overall market.

In fact, the risk in these circumstances is that a “happy” market will take any sign of a reduction in these tensions as broadly bullish. So you get concentrated selloffs in single names that don’t affect the market as a whole, and when there’s any sign of thawing you see a sharp market rally. We saw a bit of that in the last day or so as Mexico’s President-elect and US President Trump both expressed optimism about a ‘quick’ NAFTA deal. Honestly, the broad market risk to trade in the near-term is probably upwards, since any increase in tensions will have a minor and concentrated effect while any thawing (especially with China) at all will cause a rally.

But beware in case the mood changes!

As an inflation guy, I’m far more interested in the longer-term impact. And there, the impact is unambiguous and bad. I’ve written about this in the past, in detail (see this article, which is probably my best on the subject and first appeared in our private quarterly), but the salient point is that you don’t need a trade war to get worse inflation outcomes than we have seen in the last 20 years. You only need for progress on advancing global trade to stop. And it seems as though it has.

Not all of the forces pressing on inflation right now are bullish, although most are. Apartment rents have slowed their ascent, and the delayed effect of the dollar’s rally will have a dampening effect next year (arrayed against that, however, are the specific effects of tariffs on particular goods) although globally, FX movements are roughly zero-sum in terms of global inflation. Money growth has slowed, to levels that would tend to contain inflation if velocity were also to remain stable at all-time lows. But velocity recently started to uptick (we will find out on Friday if this uptick continued in Q2) and as interest rates gradually increase around the globe money velocity should also quicken. The chart below (source: Enduring Investments) shows our proprietary model for money velocity.

At this point, trade is pushing inflation higher in two ways. The first is that arresting the multi-decade trend towards more-open markets and more-numerous trade agreements fundamentally changes the inflation/growth tradeoff that central banks globally will face. Rather than having a following wind that made monetary policy relatively simple (although policymakers still found a way to louse it up, potentially beyond repair, largely as a result of believing their own fables about the powerful role that central banks played in saving the world first from inflation, and then from deflation), there will be a headwind that will make monetary much more difficult – more like the 1960s and 1970s than the 1980s, 1990s, and 2000s. The second way that trade conflict is pushing inflation higher is mechanical, by causing higher prices of recorded goods as a direct result of tariff implementation.

But this second way, while it gets all the ink and causes near-term knee-jerk effects in markets, is much less important in the long run.

Signs of a Top, OR that I am a Grumpy Old Man

June 20, 2018 4 comments

I was at an alternative investments conference last week. I always go to this conference to hear what strategies are in vogue – mostly for amusement, since the strategies that are in vogue this year are ones they will spit on next year. Two years ago, everyone loved CTAs; last year the general feeling was “why in the world would anyone invest in CTAs?” Last year, the buzzword was AI strategies. One comment by a fund-of-funds manager really stuck in my head, and that was that this fund-of-funds was looking for managers with quantitative PhDs but specifically ones with no market experience so that “they don’t have preconceived notions.” So, you can tell how that worked out, and this year there was no discussion of “AI” or “machine learning” strategies.

This year, credit strategies were in vogue and the key panel discussion involved three managers of levered credit portfolios. Not surprisingly, all three thought that credit is a great investment right now. One audience question triggered answers that were striking. The question was (paraphrasing) ‘this expansion is getting into the late innings. How much longer do you think we have until the next recession or crisis?” The most bearish of the managers thought we could enter into recession two years from now; the other two were in the 3-4 year camp.

That’s borderline crazy.

It’s possible that the developing trade war, the wobbling of Deutsche Bank, the increase in interest rates from the Fed, higher energy prices, Italy’s problems, Brexit, the European migrant crisis, the state pension crisis in the US, Elon Musk’s increasingly erratic behavior, the fact that the FANG+ index is trading with a 59 P/E, and other imbalances might not unravel in the next 3 years. Or 5 years. Or 100 years. It’s just increasingly unlikely. Trees don’t grow to the sky, and so betting on that is usually a bad idea. But, while the tree still grows, it looks like a good bet. Until it doesn’t.

There are, though, starting to be a few peripheral signs that the expansion and markets are experiencing some fatigue. I was aghast that venerable GE was dropped from the Dow Jones to be replaced by Walgreens. Longtime observers of the market are aware that these index changes are less a measure of the composition of the economy (which is what they tell you) and more a measure of investors’ animal spirits – because the index committee is, after all, made up of humans:

  • In February 2008 Honeywell and Altria were replaced in the Dow by Bank of America (right before the largest banking crisis in a century) and Chevron (oil prices peaked over $140/bbl in July 2008).
  • In November 1999, Chevron (with oil at $22) had been replaced in the Dow (along with Sears, Union Carbide, and Goodyear) by Home Depot, Intel, Microsoft, and SBC Communications at the height of the tech bubble, just 5 months before the final melt-up ended.

It isn’t that GE is in serious financial distress (as AIG was when it was dropped in September 2008, or as Citigroup and GM were when they were dropped in June 2009). This is simply a bet by the index committee that Walgreens is more representative of the US economy than GE and coincidentally a bet that the index will perform better with Walgreens than with GE. And perhaps it will. But I suspect it is more about replacing a stodgy old company with something sexier, which is something that happens when “sexy” is well-bid. And that doesn’t always end well.

After the credit-is-awesome discussion, I also noted that credit itself is starting to send out signals that perhaps not all is well underneath the surface. The chart below (Source: Bloomberg) shows the S&P 500 in orange, inverted, against one measure of corporate credit spreads in white.

Remember, equity is a call on the value of the firm. This chart shows that the call is getting more valuable even as the first-loss piece (the debt) is getting riskier – or, in other words, the cost to bet on bankruptcy, which is what a credit spread really is, is rising. Well, that can happen if overall volatility increases (if implied volatility rises, both a call and a put can rise in value which is what is happening here), so these markets are at best saying that underlying volatility/risk is rising. But it’s also possible that the credit market is merely leading the stock market. It is more normal for these markets to correlate (inverted) over time – see the chart below, which shows the same two series for 2007-2009.

I’m not good at picking the precise turning points of markets, especially when values start to get really bubbly and irrational – as they have been for some time. It’s impossible to tell when something that is irrational will suddenly become rational. You can’t tell when the sleepwalker will wake up. But they always do. As interest rates, real interest rates, and credit spreads have risen and equity yields have fallen, it is getting increasingly difficult for me to see why buying equities makes sense. But it will, until it doesn’t.

I don’t know whether the expansion will end within the next 2, 3, or 4 years. I am thinking it’s more likely to be 6 months once the tax-cut sugar high has truly worn off. And I think the market peak, if it isn’t already in, will be in within the next 6 months for those same reasons as companies face more difficult comps for earnings growth. But it could really happen much more quickly than that.

However, I recognize that this might really just mean that I am a grumpy old man and you’re all whippersnappers who should get off my lawn.

You Haven’t Missed It

April 26, 2018 2 comments

A question I always enjoy hearing in the context of markets is, “Have I missed it?” That simple question betrays everything about the questioner’s assumptions and about the balance of fear and greed. It is a question which, normally, can be answered “no” almost without any thought to the situation, if the questioner is a ‘normal’ investor (that is, not a natural contrarian, of which there are few).

That is because if you are asking the question, it means you are far more concerned with missing the bus than you are concerned about the bus missing you.

It usually means you are chasing returns and are not terribly concerned about the risks; that, in turn – keeping in mind our assumption that you are not naturally contrary to the market’s animal spirits, so we can reasonably aggregate your impulses – means that the market move or correction is probably underappreciated and you are likely to have more “chances” before the greed/fear balance is restored.

Lately I have heard this question arise in two contexts. The first was related to the stock market “correction,” and on at least two separate occasions (you can probably find them on the chart) I have heard folks alarmed that they missed getting in on the correction. It’s possible, but if you’re worried about it…probably not. The volume on the bounces has diminished as the market moves away from the low points, which suggests that people concerned about missing the “bottom” are getting in but rather quickly are assuming they’ve “missed it.” I’d expect to see more volume, and another wave of concern, if stocks exceed the recent consolidation highs; otherwise, I expect we will chop around until earnings season is over and then, without a further bullish catalyst, the market will proceed to give people another opportunity to “buy the dip.”

The other time I have heard the angst over missing the market is in the context of inflation. In this, normal investors fall into two categories. They’re either watching 10-year inflation breakevens now 100bps off the 2016 lows and 50bps off the 2017 lows and at 4-year highs (see chart, source Bloomberg) and thinking ‘the market is no longer cheap’, or they just noticed the well-telegraphed rise in core inflation from 1.7% to 2.1% over the last several months and figuring that the rise in inflation is mostly over, now that the figure is around the Fed’s target and back at the top of the 9-year range.

Here again, the rule is “you didn’t miss it.” Yes, you may have missed buying TIPS 100bps cheap to fair (which they were, and we pointed it out in our 2015Q3 Quarterly Inflation Outlook to clients), but breakevens at 2.17% with median inflation at 2.48% and rising (see chart, source Bloomberg), and still 25bps below where breakevens averaged in the 5 years leading up to the Global Financial Crisis, says you aren’t buying expensive levels. Vis a vis commodities: I’ve written about this recently but the expectations for future real returns are still quite good. More to the point, inflation is one of those circumstances where the bus really can hit you, and concern should be less about whether you’ve missed the gain and more about whether you need the protection (people don’t usually lament that they missed buying fire insurance cheaper, if they need fire insurance!).

(In one way, these two ‘did I miss it’ moments are also opposites. People are afraid of missing the pullback in stocks because ‘the economy still looks pretty strong,’ but they’re afraid they missed the inflation rally because ‘the economy is going to slow soon and the Fed is tightening and will keep inflation under control.’ Ironically, those are both wrong.)

My market view is this:

  • For some time, TIPS have been very cheap to nominal bonds, but rich on an absolute Negative real yields do not a bargain make, even if they look better than other alternatives when lots of asset classes are even more expensive. But as real yields now approach 1% (70bps in 5y TIPS, 80bps in 10y TIPS), and with TIPS still about 35bps cheap to nominal bonds, they are beginning to be palatable to hold on their own right. And that’s without my macro view, which is that over the next decade, one way or the other, inflation protection will become an investment theme that people tout as a ‘new focus’ even though it’s really just an old focus that everyone has forgotten. But the days of <1% inflation are over, and we aren’t going to see very much <2% either. We may not see 4% often, or for long, but at 3% inflation is something that people need to take into account in optimizing a portfolio. I think we’re at that inflection point, but if not then we will be in a year or two. And TIPS are a key, and liquid, component of smart real assets portfolios.
  • Stocks have been outrageously expensive with very poor forward return expectations for a long time. However, these value issues have been overwhelmed by strong momentum (that, honestly, I never gave enough credit to) and the currently in-vogue view that momentum is somehow better than value. But perennially strong momentum is no longer a foregone conclusion. Momentum has stalled in the stock market – the S&P has broken the 50-day, 100-day, and (a couple of times, though only briefly so far) 200-day moving averages. The 50-day has now crossed below the 100-day. And the longer that the market chops sideways the weaker the momentum talisman becomes. Eventually, the value anchor will take over. There may be more chop to come but as I said above, I think another leg down is likely to come after earnings season.

And so, in neither case have you “missed it.”

Being Closer to the ‘Oh Darn’ Inflation Strike

April 19, 2018 5 comments

The time period between spikes of inflation angst seems to be shortening. I am not sure yet about the amplitude of those spikes of angst, but the concern seems to be quickening.

This is not without reason as it seems that concerning headlines are occurring with more frequency. This week the Bloomberg Commodity Index again challenged the 2016 and 2017 highs before backing off today (see chart, source Bloomberg).

Somewhat more alarming than that, to people who watch commodities, is how the commodity indices are rallying. The culprits are energy as well as industrial metals, and each has an interesting story to tell. Energy has been rallying partly because of global tensions, but also partly because US shale oil production appears to be running into some bottlenecks on production (wages, shortages of frack sand) as well as delivery (capacity constraints on pipelines), and part of what has kept a lid on energy prices over the last couple of years was the understanding that shale oil production was improving rapidly and becoming lots more efficient due to improved technology. If shale is limited, the ‘lid’ on prices is not as binding as we had thought. On industrial metals, some of the upward pressure has been due to fallout from US sanctions on Rusal, a major supplier of aluminum and alumina. Since those sanctions were announced, aluminum prices have risen around 25%, and alumina (a raw input to aluminum production) about 50%, with knock-on effects in other industrial metals.

Both of these items bear on the market’s recent fears about new pressures on inflation – capacity constraints (especially rising wages for long-haul truckers) and potential fracturing of the global trade détente.

And 10-year breakevens are at new 4-year highs, although it is worth remembering that this is nowhere near the 10-year highs (see chart, source Bloomberg).

Shorter inflation swaps look less alarming, and not at new four-year highs. However, even here the news is not really soothing. The reason that shorter inflation swaps are lower than they have been in the past is because the energy curves are in backwardation – meaning that the market is pricing in lower energy process in the future. In turn, this means that implied core inflation – once we strip out these energy effects – are, in fact, at 4-year highs (see chart, source Enduring Investments).

So there is legitimate cause to be concerned about upside risks to inflation, and that’s one reason the market is a bit jumpier in this regard. But there is also additional premium, volatility, and angst associated with the level of inflation itself. While as I have pointed out before much of the rise in core inflation to date due to optics arising from base effects, that doesn’t change the fact that the ‘oh, rats’ strike is closer now. That is to say that when core inflation is running at 1.5%, stuff can go wrong without hurting you if your pain threshold is at 3%. But when core inflation is at 2.5% (as it will be this summer), not as much “bad stuff” needs to happen to cause financial pain. In other words, both the ‘delta’ and the ‘gamma’ of the exposure is higher now – just as if one were short a call option struck at (say) 3% inflation. Because, implicitly, many investors are.

If inflation is low, then even if it is volatile in a range it can be consistent with high market valuations for stocks and bonds. But when inflation starts to creep above 3%, those markets tend to suffer in non-linear fashion.

And this, I believe, is why the market’s nervousness about inflation (and market volatility resulting from that nervousness) is unlikely to soon abate.

Summary of My Post-CPI Tweets (Apr 2018)

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

  • After a couple of weeks of relative quiet on the inflation theme, it seems people the last few days are talking about it again. Big coverage in the Daily Shot about the underlying pressures.
  • I don’t normally pay much attention to PPI, but it’s hard to ignore the momentum that has been building on that side of things. In particular, the medical care index that PCE uses has been rising rapidly in the PPI. Doesn’t affect us today w/ CPI but affects the Fed convo.
  • But back on CPI. Of course the main focus this month for the media will be the dropping off of the -0.073% m/m figure from March 2017, which will cause y/y CPI to jump to around 2.1% from 1.8%. It’s a known car wreck but the reporters are standing at the scene.
  • That year-ago number of course was caused by cell phone services, which dropped sharply because of the widespread introduction of ‘unlimited data’ plans which the BLS didn’t handle well although they stuck to their methodology.
  • Consensus expectations for this month are for 0.18% on core, which would cause y/y to round down to 2.1%. (Remember that last month, core y/y was very close to rounding up to 1.9%…that shortfall will make this month look even more dramatic.)
  • It would only take 0.22% on core to cause the y/y number to round UP to 2.2%, making the stories even more hyperventilated.
  • I don’t make point estimates of monthly numbers, because the noise swamps the signal. We could get an 0.1% or an 0.3% and it wouldn’t by itself mean much until we knew why. But I will say I think there are risks to a print of 0.22% or above.
  • First, remember the underlying trend to CPI is really about 0.2% anyway. Median inflation is 2.4% and after today core will be over 2%. So using the last 12 months as your base guess is biased lower.
  • Also, let’s look back at last month: Apparel was a big upside surprise for the second month in a row, while shelter was lower than expected. But…
  • But apparel was rebounding from two negative months before that. We’re so used to Apparel declining but really last month just brought it back up to trend. And with the trade tensions and weak dollar, am not really shocked it should be rising some.
  • Apparel is only +0.40% y/y, so it’s not like it needs to correct last month.
  • On the other hand, OER decelerated to 0.20 from 0.28 and primary rents decelerated to 0.20 from 0.34, m/m. But there’s really no reason yet to be looking for rent deceleration – housing prices, in fact, are continuing to accelerate.

  • No reason to think RENTAL costs should be decelerating while PURCHASE costs are still accelerating. Could happen of course, but a repeat of last month’s numbers is less likely.
  • Finally – this gets a little too quanty even for me, but I wonder if last month’s belly flop in CPI could perturb the monthly seasonal adjustments and (mistakenly) overcorrect and push this month higher. Wouldn’t be the first time seasonals bedeviled us.
  • I don’t put a lot of weight on that last speculation, to be clear.
  • Market consensus is clearly for weakness in this print. I’m just not so sure the ball breaks that way. But to repeat what I said up top: the monthly noise swamps the signal so don’t overreact. The devil is in the details. Back up in 5 minutes.
  • ok, m/m core 0.18%. Dang those economists are good. y/y to 2.12%.
  • After a couple of 0.18s, this chart looks less alarming.

  • OK, Apparel did drop again, -0.63% m/m, taking y/y to 0.27%. So still yawning there. Medical Care upticked to 1.99% from 1.76% y/y, reversing last month’s dip. Will dig more there.
  • In rents, OER rose again to 0.31% after 0.20% soft surprise last month, and primary rents 0.26% after a similar figure. y/y figures for OER and Primary Rents are 3.26% and 3.61% respectively. That primary rent y/y is still a deceleration from last mo.
  • Core services…jumped to 2.9% from 2.6%. Again not so surprising since cell phone services dropped out. So that’s the highest figure since…a year ago.
  • Core goods, though, accelerated to -0.3% from -0.5%. That’s a little more interesting. It hasn’t been above 0 for more than one month since 2013, but it’s headed that way.

  • Within Medical Care…Pharma again dragged, -0.16% after -0.44% last month…y/y down to 1.87% from 2.39% two months ago. So where did the acceleration come from?
  • Well, Hospital Services rose from 5.01% to 5.16% y/y, which is no big deal. But doctors’ services printed another positive and moved y/y to -0.83% from -1.27% last month and -1.51% two months ago. Still a long way to go there.

  • Oh wait, get ready for this because the inflation bears will be all about “OH LODGING AWAY FROM HOME HAD A CRAZY ONE-MONTH 2.31% INCREASE.” Which it did. Which isn’t unusual.

  • Interestingly those inflation bears who will tell us how Lodging Away from Home will reverse next month (it will, but hey folks it’s only 0.9% of the index) are the same folks always telling us that AirBnB is killing hotel pricing. MAYBE NOT.
  • Finally making it back to cars. CPI Used cars and trucks had another negative month, -0.33% after -0.26% last month. That really IS a surprise: we’ve never seen the post-hurricane surge that I expected.

  • Sure, used cars are out of deflation, now +0.37% y/y. New cars still deflating at -1.22% vs -1.47% y/y last month. But that really tells you how bad the inventory overhang is in autos. Gonna suck to be an auto manufacturer when the downturn hits. As usual.
  • Leased cars and trucks, interestingly (only 0.64% of CPI) are +5.26% y/y. Look at that trend. Maybe that’s where the demand for cars is going.

  • Oh, how could I forget the star of our show! Wireless telephone services went to -2.41% y/y from -9.43% y/y last month. Probably will go positive over next few months – a real rarity! But after “infinity” data where does the industry go on pricing? Gotta be in the actual price!
  • College tuition and fees: 1.75% y/y from 2.04%. Lowest in a long time. This is a lagged effect of the big stock and bond bull market, and that effect will fade. Tuition prices will reaccelerate.
  • Bigger picture. Core ex-housing rose to 1.23% from 0.92%. Again, a lot of that is cell phone services. But deflation is deep in the rear-view mirror.
  • While I’m waiting for my diffusion stuff to calculate let’s look ahead. We’re at 2.1% y/y core CPI now. The next m/m figures to “roll off” from last year are 0.09, 0.08, 0.14, and 0.14.
  • In other words, core is still going to be accelerating optically even if there’s no change in the underlying, modestly accelerating trend. Next month y/y core will be 2.2%, then 2.3%, then 2.4%. May even reach 2.5% in the summer.
  • This is also not in isolation. The Underlying Inflation Gauge is over 3% for the first time in a long time. Global inflation is on the rise and Chinese inflation just went to the highest level it has seen in a while.
  • One of the stories I’m keeping an eye on too is that long-haul trucker wages are accelerating quickly because new technology has been preventing drivers from exceeding their legal driving limits…which has the effect of restraining supply in trucking capacity.
  • …and that feeds into a lot of things. Until of course the self-driving cars or drone air force takes care of it.
  • The real question, of course, is whence inflation goes after the summer. I believe it will continue to rise as higher interest rates help to goose money velocity after a long time. But it takes time for that theme to play out.
  • time for four-pieces. Here’s Food & Energy.

  • Core goods. Consistent with our theme. it’s going higher.

  • OK, here’s where cell phone services come in: core services less rent of shelter. So the recent jump is taking us back to where we were a year ago. Real question here is whether medical rallies. Some signs in PPI it may be.

  • Rent of Shelter continues to be on our model. Some will look for a reversal in this little jump – not me.

  • Another month where one of the OER subindices will probably be the median category so my guess won’t be fabulous. It will probably either be 0.26% m/m on median (pushing y/y to 2.49%), or 0.20% (y/y to 2.44%). Either way it’s a y/y acceleration.
  • Oh, by the way…10y breakevens are unchanged on the day. This is the second month of data that was ‘on target,’ but surprised the real inflation bears. There isn’t anything really weird here or doomed to be reversed…at least, nothing large.
  • Bottom line for markets is core CPI will continue to climb; core PCE will continue to climb. For at least a few more months (and probably longer, but next 3-4 are baked into the cake). Even though this is known…I don’t know that the Fed and markets will react well to it.
  • That’s all for today, unless I think of something in 5 minutes as usually happens. Thanks for subscribing!!

As I said in the tweet series – this was at some level a ham-on-rye report, coming in right on consensus expectations. But some observers had looked for as low as 0.11% or 0.13% – some of them for the second month in a row – and those observers are either going to have to get religion or keep being wrong. There are a couple of takeaways here and one of them is that even ham-on-rye reports are going to cause y/y CPI to rise over the next four months. This is entirely predictable, as is the fact that core PCE will also be rising rapidly (and possibly more rapidly since medical care in the PCE seems to be turning up more quickly). But that doesn’t mean that the market won’t react to it.

There are all sorts of things that we do even though we know we shouldn’t. I would guess that most of us, noticing that our sports team won when we wore a particular shirt or a batter hit a home run when we pet the dog a certain way, have at some point in the past succumbed to the “well, maybe I should do it just in case” aspect of superstition. But there’s more to it than that. In the case of markets, it is well and good to say “I know this isn’t surprising to see year-on-year inflation numbers rising,” but there’s the second-level issue: “…but I don’t know that everyone else won’t be surprised or react, so maybe I should do something.”

By summertime, core CPI will have reached its highest level since the crisis. Core PCE will probably also have reached its highest level since the crisis. Median CPI has been giving us a steadier reading and so perhaps will not be at new highs, but it will be near the highest readings of the last decade. I believe that whether we think it should happen or not, the dot plots will move higher (unless growth stalls, which it may) and markets will have to deal with the notion that additional increases in inflation from there would be an unmitigated negative. So we will start to price that in.

Moreover, I am not saying that there aren’t underlying pressures that may, and indeed I think will, continue to push prices higher. In fact, I think that there is some non-zero chance of an inflationary accident. And, in the longer run, I am really, really concerned about trade. It doesn’t take a trade war to cause inflation to rise globally; it just takes a loss of momentum on the globalization front and I think we already have that. A bona fide trade war…well, it’s a really bad outcome.

I don’t think that just because China has been making concessionary noises that a trade spat with China has been averted. If I were China, then I too would have made those statements: because the last half-dozen Administrations would have been content to take that as a sign of victory, trumpet it, and move on. But the Trump Administration is different (as if you hadn’t noticed!). President Trump actually seems hell-bent on really delivering on his promises in substance, not in mere appearance. That can be good or bad, depending on whether you liked the promise! In this case, what I am saying is – the trade conflict is probably not over. Don’t make the mistake of thinking the usual political dance will play out when the newest dancer is treating it like a mosh pit.

And all of this is pointed the same direction. It’s time, if you haven’t yet done it, to get your inflation-protection house in order! (And, one more pitch: at least part of that should be to subscribe to my cheapo PremoSocial feed, to stay on top of inflation-related developments and especially the monthly CPI report! For those of you who have…I hope you feel you’re getting $10 of monthly value from it! Thanks very much for your support.)

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