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A Generous Fed Isn’t Really the Good News it Sounds Like

October 31, 2019 10 comments

I understand why people are delighted about Powell’s remarks yesterday, about how the Fed would need to see a significant and sustained increase in inflation before hiking rates again. This generation, and the last, does not see inflation as a significant threat, nor a significant cost should it get going, and believes firmly that the Fed can easily squelch it if it gets going. (They believe this because, after all, the Fed told them so).

Older investors might be more reticent to believe that there’s a pony in there somewhere, since the evidence suggests that not only does inflation erode purchasing power (thereby demanding even more nominal return be provided by portfolios that are already overstretched valuation-wise) but it also ruins the diversification effect of bonds relative to stocks. The main reason that 60:40 is a dramatically lower risk portfolio (and more efficient in an investing sense) than 100% stocks is that stock and bond returns have tended to be inversely correlated for a long time. When stocks go up, bonds go down, in general (and vice-versa). But that’s because they have inverse sensitivities to the economic growth factor. In recent years, that has been the only factor that matters, but stocks and bonds have the same sensitivity to the inflation factor: when inflation goes up, both stocks and bonds tend to decline (and vice-versa). Consequently, when inflation becomes an important element in investors’ calculations the correlation of stocks and bonds tends to be positive and in the immortal words of Billy Joel in “Goodnight Saigon,” “We would all go down together.” Along these lines I recently prepared this chart for Real Asset Strategies,[1] illustrating that when inflation is over about 2.5%, correlations tend to flip. This is a 3-year average of y/y inflation (and shown on the chart as inflation minus 2.5% so the zero line is what matters, not the line at 2.5%) versus 3-year correlations; the point is that you don’t need 4% inflation to drastically change the value of the 60:40 portfolio.

I also think that people give the Fed much more credit for their ability to squelch inflation – which after all they haven’t had to do for more than 30 years after spending 15 years squelching the last round – than they deserve. But that’s a ‘show me’ situation and it’s hard to prove my suspicion that they won’t be so successful when push comes to shove.

So, I understand why people are partying about a Fed that is even looser than it had been. I don’t think that’s the correct response, but I understand it.

I also understand why people are somewhat morose about trade frictions. It isn’t for the right reason, that in the long run it will hurt real growth a smidge and increase inflation a smidge-and-a-half, but because they think it will have a drastic effect on near-term growth. That’s why everyone gets so excited about any inkling the US and China are nearing a trade détente and so depressed when it looks like they aren’t. We are told that the current global slowdown is being caused largely by the trade war.

In my view that’s nonsense. The global economy has been expanding for a decade on exceptionally loose liquidity but no tree grows to the sky. The global economy was slowing well before the trade frictions could possibly have had any impact. But it is hard to convince people of that, because everyone knows that:

GDP = C + I + G + (X-M),

or consumption plus investment plus government spending plus trade. And we learned in school about Ricardian comparative advantage and how trade enriches (or anyway, can enrich) both parties at the same time. So if China doesn’t import anything from the US and doesn’t export anything to the US, growth is going to be crushed, right?

But that’s not how trade works. Frankly, that’s not how anything in the GDP equation works. If you remove the final term, you don’t reduce GDP by (X-M). Sure, if this was an algebra problem you would, but it’s not. In the real world, what you lose from trade gets partially replaced by an increase in consumption, investment, or government. Just as I pointed out last year with soybeans, if China buys zero from us it means they have to buy them from someone else, which means that supplier doesn’t have them to sell to one of their traditional customers…who then buys them from us. Incidentally, neither beans nor corn went to zero after mid-2018 (see chart, source Bloomberg, normalized to December 2017=100).

The rest of trade works the same way if the two parties are “internal customers” and “external customers.” Though there will always be winners and losers, if we don’t have international trade then we won’t have a destination for our merchandise overseas…but we will also have consumers who don’t have Chinese goods to buy and so need to buy something from a domestic producer instead. This is not a zero sum game; it clearly results in a loss for all players. But the order of magnitude of this loss in the short run is not very big at all, especially for a country with a large fraction of its domestic production going to domestic consumption, as in the US but not even for the world at large. The world economy has lots of reasons to slow and go into recession, and trade frictions are one of those reasons, but certainly not the only one and not even the largest reason.

An overreaction by markets to anything in a stream of economic news is not unique or new, of course; those overreactions won Robert Shiller a Nobel Prize after all for his work pointing out the “excess volatility puzzle” as an early highlight of the nascent field of behavioral economics. But there’s a good reason to ignore most of these wiggles and focus on the long-term effect of these developments. Which, in the case of both the general climate of trade and the Fed’s reaction function to inflation, are negatives for both stocks and bonds.


[1] As part of Enduring Intellectual Properties’ investment in Real Asset Strategies, I serve as Director of Research for the firm. Real Asset Strategies LLC offers liquid real asset strategies focused on diversification benefits and inflation protection at reasonable fees.

Tariffs Don’t Hurt Domestic Growth

August 28, 2019 7 comments

I really wish that economics was an educational requirement in high school. It doesn’t have to be advanced economics – just a class covering the basics of micro- and macroeconomics so that everyone has at least a basic understanding of how an economy works.

If we had that, perhaps the pernicious confusion about the impact of tariffs wouldn’t be so widespread. It has really gotten ridiculous: on virtually any news program today, as well as quite a few opinion programs (and sometimes, it is hard to tell the difference), one can hear about how “the trade war is hurting the economy and could cause a recession.” But that’s ridiculous, and betrays a fundamental misunderstanding about what tariffs and trade barriers do, and what they don’t do.

Because to the extent that people remember anything they were taught about tariffs (and here perhaps we run into the main problem – not that we weren’t taught economics, but that people didn’t think it was important enough to remember the fine points), they remember “tariffs = bad.” Therefore, when tariffs are implemented or raised, and something bad happens, the unsophisticated observer concludes “that must be because of the tariffs, because tariffs are bad.” In the category of “unsophisticated observer” here I unfortunately have to include almost all journalists, most politicians, and most alarmingly a fair number of economists and members of the Fed. Although, to be fair, I don’t think the latter two groups are making the same error as the former groups; they’re probably just confusing the short-term and the long-term or thinking globally rather than locally.

In any event, this reached a high enough level of annoyance for me that I felt the need to write this short column about the effects of tariffs. I actually wrote some of this back in June but needed to let it out again.

The effect of free trade, per Ricardo, is to enlarge the global economic pie. (Ricardo didn’t speak in terms of pie, but if he did then maybe people would understand this better.) However, in choosing free trade to enlarge the pie, each participating country surrenders its ability to claim a larger slice of the pie, or a slice with particular toppings (in this analogy, choosing a particular slice means selecting the particular industries that you want your country to specialize in). Clearly, this is good in the long run – the size of your slice, and what you produce, is determined by your relative advantage in producing it and so the entire system produces the maximum possible output and the system collectively is better off.

However, that does not mean that this is an outcome that each participant will like. Indeed, even in the comparative free trade of the late 1990s and 2000s, companies carefully protected their champion companies and industries. Even though the US went through a period of truly sucking at automobile manufacturing, we still have the big three automakers. On the other hand, the US no longer produces any apparel to speak of. In fact, I would suggest that the only way that free trade works at all in a non-theoretical world is if (a) all of the participants are roughly equal in total capability or (b) the dominant participant is willing to concede its dominant position in order to enrich the whole system, rather than using that dominant position to secure its preferred slices for itself. Many would argue that (b) is what happened, as the US was willing to let its manufacturing be ‘hollowed out’ in order to make the world a happier place on average. Enter President Trump, who suggested that as US President, it was sort of his job to look out for US interests. And so we have tariffs and a trade war.

What is the effect of tariffs?

  1. Tariffs are good for the domestic growth of the country imposing them. There is no question about it in a static equilibrium world: if you raise the price of the overseas competitor, then your domestic product will be relatively more attractive and you will be asked to make more of it. If other countries respond, then the question of whether it is good or bad for growth depends on whether you are a net importer or exporter, and on the relative size of the Ex-Im sector of your economy. The US is a net importer, which means that even if other countries respond equally it is still a gain…but in any event, the US economy is relatively closed so retaliatory tariffs have a comparatively small effect. The effect is clearly uneven, as some industries benefit and some lose, but tariffs are a net gain to growth for the US in the short term (at least).
  2. Tariffs therefore are good for US employment. In terms of both growth and employment, recent weakness has been blamed on tariffs and the trade war. But this is nonsense. The US economy and the global economy have cycles whether or not there is a trade war, and we were long overdue for a slowdown. The fact that growth is slowing at roughly the same time tariffs have been imposed is a correlation without causality. The tariffs are supporting growth in the US, which is why Germany is in a recession and the US is not (yet). Anyone who is involved with a manufacturing enterprise is aware of this. (I work with one manufacturer which has suddenly started winning back business that had previously been lost to China in a big way).
  3. Tariffs are bad for global growth. The US-led trade war produces a shrinkage of the global pie (well, at least a slowing of its growth) even as the US slice gets relatively larger. But for countries with big export-import sectors, and for our trade partners who are net exporters to the US and have tariffs applied to their goods, this is an unalloyed negative. And as I said, more-fractious trade relationships reduce the Ricardian comparative advantage gain for the system as a whole. It’s just really important to remember that the gains accrue to the system as a whole. The question of whether a country imposing tariffs has a gain or a loss on net comes down to whether the growth of the relative slice outweighs the shrinkage of the overall pie. In the US case, it most certainly does.
  4. Trade wars are bad for inflation, everywhere. I’ve written about this at length since Trump was elected (see here for one example), and I’d speculated on the effect of slowing trade liberalization even before that. In short, the explosion of free trade agreements in the early 1990s is what allowed us to have strong growth and low inflation, even with a fairly profligate monetary policy, as a one-off that lasted for as long as trade continued to open up. That train was already slowing – partly because of the populism that helped elect Mr. Trump, and partly because the 100th free trade agreement is harder than the 10th free trade agreement – and it has gone into reverse. Going forward, the advent of the trade war era means we will have a worse tradeoff of growth and inflation for any given monetary policy. This was true anyway as the free-trade-agreement spigot slowed, but it is much more true with a hot trade war.
  5. Trade wars are bad for equity markets, including in the US. A smaller pie means smaller profits, and a worse growth/inflation tradeoff means lower growth assumptions need to be baked into equity prices going forward. Trade wars are of course especially bad for multinationals, whose exported products are the ones subject to retaliation.

In the long run, trade wars mean worse growth/inflation tradeoffs for everyone – but that doesn’t mean that every country is a net loser from tariffs. In the short run, the effect on the US of the imposition of tariffs on goods imported to the US is clearly positive. Moreover, because the pain of the trade war is asymmetric – a country that relies on exports, such as China, is hurt much more when the US imposes tariffs than the US is hurt when China does – it is not at all crazy to think that trade wars in fact are winnable in the sense of one country enlarging its slice at the expense of another country or countries’ slices. To the extent that the trade war is “won,” and the tariffs are not permanent, then they are even beneficial (to the US) in the long run! If the trade war becomes a permanent feature, it is less clear since slower global growth probably constrains the growth of the US economy too. Permanent trade frictions would also produce a higher inflation equilibrium globally.

In this context, you can see that the challenge for monetary policy is quite large. If the US economy were not weakening anyway, for reasons exogenous to trade, then the response to a trade war should be to tighten policy since tariffs lead to higher prices and stronger domestic growth. However, the US economy is weakening, and so looser policy may be called for. My worry is that the when the Federal Reserve refers to the uncertainty around trade as a reason for easing, they either misapprehend the problem or they are acting as a global central bank trying to soften the global impact of a trade war. I think a decent case can be made for looser monetary policy – but it doesn’t involve trade. (As an aside: if central bankers really think that “anchored inflation expectations” are the reason we haven’t had higher inflation, then why are they being so alarmist about the inflationary effects of tariffs? Shouldn’t they be downplaying that effect, since as long as expectations remain anchored there’s no real threat? I wonder if even they believe the malarkey about anchoring inflation expectations.)

Do I like tariffs? Well, I don’t hate them. I don’t think the real economy is the clean, frictionless world of the economic theorists; since it is not, we need to consider how real people, real industries, real companies, and real regimes behave – and play the game with an understanding that it may be partially and occasionally adversarial, rather than treating it like one big cooperative game. There are valid reasons for tariffs (I actually first enumerated one of these in 1992). I won’t make any claims about the particular skill of the Trump Administration at playing this game, but I will say that I hope they’re good at it. Because if they are, it is an unalloyed positive for my home country…whatever the pundits on TV think about the big bad tariffs.

The Downside of Balancing US-China Trade

January 18, 2019 Leave a comment

The rumor today is that China is going to resolve the trade standoff by agreeing to balance its trade with the US by buying a trillion dollars of goods and services over the next four years. The Administration, so the rumor goes, is holding out for two years since that will look better for the election. They should agree to four, because otherwise they’re going to have to explain why it’s not working.

I ascribe approximately a 10% chance that the trade balance with China will be at zero in four years. (I’m adjusting for overconfidence bias, since I think the real probability is approximately zero.) But if it does happen, it is very bad for our financial markets. Here’s why.

If China buys an extra trillion dollars’ worth of US product, where do they get the dollars to do so? There are only a few options:

  1. They can sell us a lot more stuff, for which they take in dollars. But that doesn’t solve the trade deficit.
  2. They can buy dollars from other dollar-holders who want yuan, weakening the yuan and strengthening the dollar, making US product less competitive and Chinese product more competitive globally. This means our trade deficit with China would be replaced by trade deficits with other countries, again not really solving the problem.
  3. They can use the dollars that they are otherwise using to buy financial securities denominated in dollars, such as our stocks and bonds.

The reality is that it is really hard to make a trade deficit go away. Blame the accountants, but this equation must balance:

Budget deficit = trade deficit + domestic savings

If the budget deficit is very large, which it is, then it must be financed either by running a trade deficit – buying more goods and services from other countries than they buy from us, stuffing them with dollars that they have no choice but to recycle into financial assets – or by increased domestic savings. So, let’s play this out and think about where the $500bln per year (the US trade deficit, roughly, with the rest of the world) is going to come from. With the Democrats in charge of Congress and an Administration that is liberal on spending matters, it seems to me unlikely that we will see an abrupt move into budget balance, especially with global growth slowing. The other option is to induce more domestic savings, which reduces domestic consumption (and incidentally, that’s a counterbalance to the stimulative growth effect of an improving trade balance). But the Fed is no longer helping us out by “saving” huge amounts – in fact, they are dis-saving. Inducing higher domestic savings would require higher market interest rates.

The mechanism is pretty clear, right? China currently holds roughly $1.1 trillion in US Treasury securities (see chart, source US Treasury via Bloomberg).

China also holds, collectively, lots of other things: common equities, corporate bonds, private equity, US real estate, commodities, cash balances. Somewhere in there, they’ll need to divest about a trillion dollars’ worth to get a trillion dollars to buy US product with.

The effect of such a trade-balancing deal would obviously be salutatory for US corporate earnings, which is why the stock market is so ebullient. But it would be bad for US interest rates, and bad for earnings multiples. One of the reasons that financial assets are so expensive is that we are force-feeding dollars to non-US entities. To the extent that we take away that financial inflow by balancing trade and budget deficits, we lower earnings multiples and raise interest rates. This also has the effect of inducing further domestic savings. Is this good or bad? In the long run, I feel reasonably confident that having lower multiples and more-balanced budget and trade arrangements is better, since it lowers a source of economic leverage that also (by the way) tends to increase the frequency and severity of financial crack-ups. But in the short run…meaning over the next few years, if China is really going to work hard to balance the trade deficit with the US…it means rough sledding.

As I said, I give this next-to-no chance of China actually balancing its trade deficit with us. But it’s important to realize that steps in that direction have offsetting effects that are not all good.

Tariffs Do Not Cause Price Declines

July 5, 2018 7 comments

Adding to a good’s price does not make its price decline.

It’s worth repeating that a couple of times, because it seems to be getting lost in the discussion about tariffs – in particular, in the discussion about tariffs levied on US commodities. Grains prices have been plummeting, as the chart below showing front corn and soybean prices (source: Bloomberg) illustrates.

There are many reasons that grains prices may be declining, but if “tariffs have been levied on US production” is one of them then there is some really weird economics happening. Corn and soybeans are commodities. Specifically, this means that they are essentially fungible – corn from site “A” is essentially the same as corn from site “B.” So what does this mean for the results of a tariff?

If China stops buying soybeans from the US altogether, it means that unless they’re going to stop eating soybeans they will buy soybeans from Brazil. But if Brazil sells all of their soybeans to China, it means that Germany can no longer soybeans from Brazil. So where does Germany buy its soybeans from? Well, it seems that the US has beans that are not spoken for in this scenario…in other words, when we are talking about commodities a tariff mostly just reorganizes the list of who is buying from whom. If soybean prices are falling because China isn’t buying our soybeans, it means a great deal for Russia or Germany or whoever else is going to buy beans from us instead of from China’s new supplier. More than that, if global soybeans prices are falling because of tariffs then it means that everyone is getting cheaper soybeans because China is changing who they’re buying from. If that’s the case, then we really need to slap tariffs on everything and watch prices decline!

Let’s go back to elementary microeconomics. Adding a tariff is reflected in our product market supply and demand curves as a shift in the supply curve to the left: the quantity that producers are willing to supply at any price declines, because the price to the producer declines. Put a different way, the market price required to induce any particular quantity supplied rises by the amount of the tariff. Now, whether that causes market prices to rise a lot or a little, or quantity supplied to fall by a lot or a little, depends on the elasticities of supply and demand. If demand if fairly inelastic (which seems reasonable – you may be able to substitute for “beans” but it’s hard to substitute for “grains”), then you will see more of a price response than a quantity response, at least in the short run where the supply of beans is fairly inelastic. But that price response is up, not down.

By the way, this gets a little hard to illustrate with supply and demand curves, because with a tariff what you have are now two separate markets and separate prices for the same good. This is what confuses some people – if China is no longer buying from the US, doesn’t that mean that demand for US beans has declined, and therefore prices should decline? The crucial point is that we are talking here about commodity goods, and supplies are fairly interchangeable. If we are talking about Harley Davidson motorcycles, the answer is different because if Europe stops buying Harleys, they have to buy a different product altogether. In that case, the global price of “motorcycles” might be relatively unaffected, but the price of Harleys will rise (and the output decline) relative to other motorcycles. So, a tariff on Harley-Davidson motorcycles definitely hurts the US, but a tariff on soybeans – or even “US soybeans” since that is not a universal distinction – should have virtually no effect on US producers. And certainly, no effect on the global price of soybeans.

There are other reasons that grains prices may be declining. Since Brazil is a major producer of beans, the sharp decline in the Brazilian Real has pushed the US dollar price of beans lower (see chart, source Bloomberg). In the chart below, the currency is shown in Reals per dollar, and inverted. This is a much more important factor explaining the decline in grains prices, as well as one that could easily get worse before it gets better.

I think the discussion of the effects of tariffs has gotten a bit polluted since the decline in grains seems to coincide with the announcement of tariffs from China. I think the price decline here has fed that story, but it’s bad economics. Piecemeal tariffs on commodity products are not likely to appreciably change the supply and demand outcome, although it will result in rearranging the sources of product for different countries. Tariffs on non-commodity product, especially branded products with few close substitutes, can have much larger effects – although we ought to remember that from the consumer’s perspective (and in the measurement of consumer inflation), tariffs never lower prices faced by consumers although they can lower prices received by producers. This is why tariffs are bad – they cause higher prices and lower output, and the best case is no real change.


DISCLOSURE: Quantitative/systematic funds managed by Enduring Investments have both long and short positions in grains, and in particular long positions in Beans and Corn, this month.

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.)

Little Trouble in Big China

It is obviously time for another update. I haven’t been an active poster recently, because as many of you know I am busy working on a book for the Wiley label. I am about 80% done; however, it is very time-consuming! The title of the book is (tentatively) What’s Wrong with Money?: The Biggest Bubble of All – and How to Invest with it in Mind, and if you would like to be on the notification list to receive an email when the book is published, simply send an email to WWWM@enduringinvestments.com. Even better, you can pre-order it already apparently, even though it’s not due out until later this year or early next year. (No pressure, huh?)

So, I have been embroiled in the writing and editing process, and not posting much. This will change soon, but China’s overnight move to (slightly) devalue the yuan is significant enough to warrant a post. There are also some other topics that need a quick mark-to-market, but I will save those for another day.

China’s move is possibly qualitatively significant, but I don’t believe it is yet quantitatively significant. A two-percent move in a currency is barely worth recording – it is almost within the daily standard deviation band of some currencies! So, when you have read about how this dramatically changes the inflationary concern of the Fed to a deflationary concern…that’s nonsense. The Swiss Franc strengthened by 20% against all currencies, in a single day, back in January. Since then, the core Swiss inflation rate has moved from +0.4% y/y to -0.6% y/y. Also note that Switzerland’s imports amount to about 50% of its GDP.

Let’s take that as a back-of-the-envelope scalar just to do a rationality check. A 20% change in exchange rate affecting about 50% of goods and services caused a 1% move in core CPI.

The U.S. imports about $40bln in goods from China per month, out of an annual GDP of $16.3 trillion. So in this case, we have a 2% move in exchange rate affecting about 2.9% of domestic goods and services. So if the effect was linear, we would expect about 1/10th * 1/17th * 1% of a move in core CPI as a result of the Chinese action. Check my math, but that would seem to be about 0.006% movement in expected core inflation as a result of China’s revaluation. Negligible, in other words.

Now, qualitatively the effect might be higher if, for example, this presages a more-significant move by China. But even assuming that the exchange rate moved ten times as much, you are still talking about rounding error on inflation. Sure, the effect might not be linear but the essential guess is that from a price perspective we don’t care.

Certain companies and industries and goods, of course, will see a much bigger effect (it would be hard to have a much smaller effect), but it shouldn’t be a big deal – even if it is part of a larger move. From the standpoint of economic growth, it may matter more…but even so, a 2% change is unlikely to matter as much as a 10% change in shipping costs, and moves like that happen all the time.

China is a big economy, and a big trading counterparty of ours. But the U.S. is still a significantly-closed economy. While China represents about 20% of all of our imports, imports as a whole only amount to 14% of US GDP. So, in summary: this is an interesting moment politically, if China is signaling a willingness to float her currency. It is not a particularly interesting day macro-economically, at least from the standpoint of the effect on prices of this move.

The China Syndrome

The last month or two has provided a wonderful illustration of why a diversified commodity index is a better investment than an investment in any given commodity. Since mid-February, April Lean Hogs has rallied 23%. Since late January, May Wheat is up 23%. March Coffee is up 80%. Gold is up 9%. But Crude Oil is 6% off its highs. Copper is 12% off its highs (8% since Thursday). April Nat Gas was up 42% from November through late February, but has lost 10% since then.

This is great if you happened to be 100% in Coffee, and bad if you happened to be heavy into copper or RIO or BHP. But this sort of volatility and non-correlation is exactly where much of the return to commodity indices, over the long run, comes from. Later this month, commodity indices will sell coffee and buy copper, systematically buying low and selling high. This phenomenon is worth on average a couple of points of return per year.

Most commentators seem to be focusing on the precipitous decline in copper prices, supposedly because “Doc Copper” is supposed to be a good leading indicator of economic growth. But in this case, the behavior of copper is mostly due to quasi-panic over China’s recently flagging growth figures. Although China is not the only consumer of copper (although sometimes you might think so, from the news coverage), prices are set at the margin and if there was an actual recession in China as opposed to a modest slowdown, then this would push copper prices lower.

But that would be terrific for Europe and the U.S., because it would mean cheaper copper for us. Similarly, decreasing Chinese growth would relax some pressure on energy prices, which would also be a boon for the Western world. I think people forget that one of the key reasons the “Asian Contagion” from the 1997 Asian Financial Crisis never happened (U.S. growth “bottomed” at 4.1% in mid-1998 – a level it hasn’t reached since 2004) was not because of Federal Reserve action (from March 1997 until August 1998, the Fed Funds target never budged from 5.5%) but because commodity prices plunged from 1997 into 1999. The DJ-UBS index fell from around 128 one month before the Thai baht collapsed to 75 in the first quarter of 1999 (see chart, source Bloomberg).

djubsbaht

Even worse (or better, depending on your perspective) was the decline in energy. Crude oil dropped 55%, from the $25 area at the beginning of 1997 to $11 by late 1998. That remains the lowest real price of U.S. oil recorded since 1946 (see chart, source Enduring Investments using data from Dow Jones and the Bureau of Labor Statistics).

wtirealIt may be impolitic to say so, but probably the single best thing that could happen to U.S. growth would be for Chinese growth to slow, pushing the price of important commodity prices lower. As a nation, we consume far more commodities than we produce, so lower input prices is a net positive.

However, I suspect this is much ado about nothing. Chinese growth, even if it slows, is likely to remain plenty hot enough to keep commodity prices from falling very much, even in real terms. Real commodity prices have been falling steadily since 2011 (which is why all of the talk about the “end of the commodity supercycle” a year ago was so humorous) until early this year, even while the amount of currency in circulation has steadily increased. It certainly seems to me as if we have priced commodities fairly conservatively, and they can probably withstand a growth slowdown in China as long as the country doesn’t enter a bona fide crisis.

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