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Setting Up For a CPI Surprise?

Heading into the CPI print tomorrow, the market is firmly in “we don’t believe it” mode. Since the CPI report last month – which showed a third straight month of a surprising and surprisingly-broad uptick in prices – commodity prices are actually down 4% (basis the Bloomberg Commodity Index, formerly known as the DJ-UBS Commodity Index). Ten-year breakeven inflation is up 1-2bps since then, but there is still scant sign of alarm in global markets about the chances that the inflation upswing has arrived.

Essentially, no one believes that inflation is about to take root. Few people believe that inflation can take root. Indeed, our measure of inflation angst is near all-time lows (see chart, source Enduring Investments).

inflangst

…which, of course, is exactly the reason you ought to be worried: because no one else is, and that’s precisely the time that often offers the most risk to being with the crowd, and the most reward from bucking it. And, with 10-year breakevens around 2.22%, the cost of protecting against that risk is quite low.

I suspect that one reason some investors are less concerned about this month’s CPI is that some short-term indicators are indicating that a correction in prices may be due. For example, the Billion Prices Project (which is now Price Stats, but still makes a daily series available at http://bpp.mit.edu/usa/) monthly inflation chart (shown below) suggests that inflation should retreat this month.

monthlybpp

However, hold your horses: the BPP is forecasting non-seasonally-adjusted headline CPI. The June seasonals do have the tendency to subtract a bit less than 0.1% from the seasonally-adjusted number, which means that it’s not a bad bet that the non-seasonally-adjusted figure will show a smaller rise from May to June than we saw April to May, or March to April. Moreover, the BPP and other short-term ‘nowcasts’ of headline inflation are partly ebbing due to the recent sogginess in gasoline prices, which are 10 cents lower (and unseasonally so) than they were a month ago.

But that does not inform on core inflation. The last three months’ prints of seasonally-adjusted core CPI have been 0.204%, 0.236%, and 0.258%, which is a 2.8% annualized pace for the last quarter…and accelerating. Moreover, as I have previously documented the breadth of the inflation uptick is something that is different from the last few times we have seen mild acceleration of inflation.

None of that means that monthly core CPI will continue to accelerate this month. The consensus forecast of 0.19% implies year/year core CPI will accelerate, but will still round to 2.0%. But remember that the Cleveland Fed’s Median CPI, to which core CPI should be converging as the sequester/Medical Care effect fades, is at 2.3% and rising. We should not be at all surprised with a second 0.3% increase tomorrow.

But, judging from markets, we would be.

This is not to say I am forecasting it, because forecasting one month’s CPI is like forecasting a random number generator, but I think the odds of 0.3% are considerably higher than 0.1%. I am on record as saying that core or median inflation will get to nearly 3% by year-end, and I remain in that camp.

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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