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Summary of My Post-CPI Tweets

April 17, 2015 3 comments

Below you can find a recap and extension of my post-CPI tweets. You can follow me @inflation_guy or sign up for email updates to my occasional articles here. Investors with interests in this area be sure to stop by Enduring Investments.

  • Core CPI+0.23% m/m is the story, with y/y upticking to 1.754% (rounded to +1.8%). This was higher than expected, by a smidge.
  • Core services +2.4% y/y down from 2.5%. But core goods -0.2%, up from -0.5% last mo and -0.8% two months ago. Despite dollar strength!
  • Core ex-housing rose to 0.91% y/y from 0.69% at the end of 2014. Another sign core inflation has bottomed and is heading back to median.
  • The m/m rise of 0.20% in core ex-shelter was the highest since Jan 2013.
  • Primary rents 3.53% y/y from 3.54%; OER 2.693% from 2.687%. Zzzzz…story today is outside of housing, which is significant.
  • Accelerating major groups: Apparel, Transport, Med Care, Recreation (32.1% of index). Decel: Food/Bev, Housing, Educ/Comm, Other (67.9%)
  • …but again, in housing the shelter component (32.7% of overall CPI) was unch at ~3% while fuels/utilities plunged to -2.26% from flat.
  • [in response to a question “Michael we have been scratching our heads on this one… is it some impact of port strike do you think?”] @econhedge I don’t think so. But core goods was just too low. Our proxy says this is about right.
  • @econhedge w/in core goods, Medical commodities went to 4.2% from 3.9%, new cars from 0.1% to 0.3%, and Apparel to -0.5% from -0.8%.
  • @econhedge so you can argue Obamacare effect having as much impact as port strike. But it’s one month in any case. Don’t overanalyze. 🙂
  • Medicinal drugs at 4.46% y/y. In mid-2013 it was flat. That was a big reason core CPI initially diverged from median. Sequester effect.
  • @econhedge Drugs 1.70%, med equip/supplies 0.08% (that’s percentage of overall CPI). 8.7% and 0.4% of core goods, respectively.
  • Median should be roughly 0.2%. I have it up 0.21% m/m and 2.22% y/y, but I don’t have the right seasonals for the regional OERs.
  • Further breakdown of medical care commodities: the biggest piece was prescription drugs, +5.74% y/y vs 5.19%. The other parts were lower.

The main headline of the story is that core inflation rose the most month-over-month since May. After a long string of sub-0.2% prints (that sometimes rounded up), this was a clean print that would annualize to 2.7% or so. And it is no fluke. The rise was broad-based, with 63% of the components at least 2% above deflation (see chart, source Enduring Investments, and keep in mind that anything energy-related is not part of that 63%) and nearly a quarter of the basket above 3%.

abovezero

This is no real surprise. Median has consistently been well above core CPI, which implied some “tail categories” were dragging down core CPI. These tail categories are still there (see chart, source Enduring Investments), but less than they had been (compare to chart here). Ergo, core is converging upward to median CPI. As predicted.

distrib

The next important step in the evolution of inflation will be when median inflation turns decisively higher, which we think will happen soon. But that being said, a few more months of core inflation accelerating on a year/year basis will get the attention of the moderates on the Federal Reserve Board. I don’t think it will matter until the doves also take notice, and this is unlikely to happen when the economy is slowing, as it appears to be doing. I don’t think we will see a Fed hike this year.

Forecasting Cold to Continue Into Summer?

We are a people of language. The way we talk about a thing affects how we think about it. This is something that behavioral economists are very aware of; and even more so, marketers. There is a reason that portfolio “insurance” was such a popular strategy. Language matters. When we call a market decline a “correction,” we tend to want to buy it; when we call it a “crash” or a “bear market”, we tend to want to sell it.

And so as the “arctic vortex” reaches its cold fingers down from the frozen northland, it is really hard for us to think about economic “overheating.” Even though economic overheating doesn’t lead to inflation, I really believe that it is hard for investors to worry about inflation (the “fire” in the traditional “fire versus ice” economic tightrope that central bankers walk) when it is so. Darn. Cold.

But nevertheless, we can take executive notice of certain details that may suggest, overheating or not, inflation pressures really are building. I have been writing for some time about how the recent rapid rise in housing prices was eventually going to pass through to rents, and although the lag was a couple of months longer than it has historically been, it seems to be finally happening as an article in today’s Wall Street Journal suggests. This is significant for at least two reasons. The first is that housing costs are a very large part of the consumption basket for the average consumer, so any acceleration in those prices can move the otherwise-ponderous core CPI comparatively quickly. The second reason, though, is more important. Over the last couple of years, as housing prices have improbably spiked again and inventories have declined sharply, many observers have pointed out the presence of an institutional element among home purchasers. That is to say that homes have been bought in large numbers not only by individuals, but by investors who saw an inexpensive asset (they sure solved that problem!). And some analysts reasoned that the prevalence of these investors might break the historical connection between rents and home prices, at least in the short run, in the same way that a sudden influx of pension fund money could change the relationship between equity prices and earnings (that is, P/Es).

In the long run, of course, this is unlikely, but to the extent it happens in the short run it could delay the upturn in core inflation for a long time. But recent indications, such as that article referred to above, are that this effect is not as large as some had thought. The substitution effect does work. Higher home prices do cause rents to rise as more potential buyers choose to rent instead. It is a question for econometricians in the next decade whether the institutions had a large and lasting effect, or a short and ephemeral effect, or no effect at all. But what we can begin to say with a bit more confidence is that this influx of investors did not remove the tendency of home prices and rents to move together, with a lag.

On to other matters. The market curve for inflation has remained remarkably static for a long time. It is relatively steep, and perennially seems to forecast benign inflation for the next couple of years before headline inflation becomes slightly less-benign (but still not high) a few years down the road. The chart below (Source: Enduring Investments) shows the first eight years of the inflation swaps curve from today, and one year ago.

zc20132014If that was the only story, I probably wouldn’t bother mentioning it. But inflation swaps settle to headline CPI, like TIPS and other inflation-linked bonds do; however, a fair amount of the volatility in headline inflation comes from movements in energy. This is why policymakers and prognosticators look at core inflation. You cannot directly trade core inflation yet, but we can extract expected energy inflation (implied by other markets) from the implied headline inflation rates and derive “implied core inflation swaps” curves. And here, we find that the relatively static yield curves seen above hide a more interesting story. The chart below (Source: Enduring Investments) shows these two curves as of today, and one year ago.

core20132014At the beginning of 2013, investors has just experienced a 1.94% rise in core prices (November to November, which is the data they would have had at the time), yet anticipated that core inflation would plunge to only 1.22% in 2013. They actually got 1.72% (as of the latest report, so still Nov/Nov). Now, investors are anticipating about 1.8% over the next 12 months – I am abstracting from some lags – but expect that inflation will ultimately not rise as much as they had feared at this time last year.

Another way to look at this change is to map the implied forward core inflation rates onto the years they would apply to. The chart below (Source: Enduring Investments) does that.

calcore20132014The blue line shows the market’s forecast of core inflation as of January 7th, 2013, year by year. So investors were implicitly saying that core CPI would be 1.22% in 2013, 2.36% in 2014, 2.68% in 2015, 2.87% in 2016, and so on. One year later, the forecast (in red) for 2014 has come down to 1.80%, the forecast for 2015 has declined to 2.20%, the forecast for 2016 has dropped to 2.41%, etcetera.

Has this happened because inflation surprised to the downside in 2013? Hardly. As I just noted, the market “expected” core inflation of 1.22% in 2013 and actually got 1.72%. And yet, investors are pricing higher confidence that inflation will stay low – remaining basically unchanged in 2014 before rising very slowly thereafter – and in fact won’t seriously threaten the Fed’s core mission basically ever.

As I wrote yesterday, we need to tread carefully around consensus. Now, some investors might prefer to be non-consensus by anticipating and investing for deflation in the out years, but taking the whole of the information I look at and model I think the more dangerous break with consensus would be a more-rapid and more-extreme rise in core inflation. I do not think that this economically-cold pricing environment will continue into what is essentially a monetary summer.

Portfolio Projections from 2013

December 13, 2013 14 comments

This will be my last “live” post of 2013. As such, I want to thank all of you who have taken the time to read my articles, recommend them, re-tweet them, and re-blog them. Thanks, too, for your generous and insightful comments and reactions to my writing. One of the key reasons for writing this column (other than for the greater glory of Enduring Investments and to evangelize for the thoughtful use of inflation products by individual and institutional investors alike) is to force me to crystallize my thinking, and to test that thinking in the marketplace of ideas to find obvious flaws and blind spots. Those weaknesses are legion, and it’s only by knowing where they are that I can avoid being hurt by them.

In my writing, I try to propose the ‘right questions,’ and I don’t claim to have all the right answers. I am especially flattered by those readers who frequently disagree with my conclusions, but keep reading anyway – that suggests to me that I am at least asking good questions.

So thank you all. May you have a blessed holiday season and a happy new year. And, if you find yourself with time to spare over the next few weeks, stop by this blog or check your email (if you have signed up) as I will be re-blogging some of my (subjectively considered) “best” articles from the last four years. Included in that list is an article on long-run returns to equities, one on Yellen’s defense of large-scale asset purchases, an article on the Phillips Curve, one on why CPI isn’t a bogus construct of a vast governmental conspiracy, and so on. Because I don’t expect some of the places where this column is ‘syndicated’ to post the re-blogs, you should consider going to the source site to sign up for these post, or follow me @inflation_guy on Twitter.

And now, on to my portfolio projections as of December 13th, 2013.

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Last year, I said “it seems likely…that 2013 will be a better year in terms of economic growth.” It seems that will probably end up being the case, marginally, but it is less likely that 2014 improves measurably in terms of most economic variables on 2013 and there is probably a better chance that it falls short. This expansion is at least four years old. Initial Claims have fallen from 650k per week in early 2009 to a pace of just barely more than half that (335k) in the most-recent 26 weeks. About the best that we can hope for, plausibly, is for the current pace of improvement to continue. The table below illustrates the regularity of this improvement over the last four years, using the widely-followed metric of the Unemployment Rate:

‘Rate (change)
12/31/2009 9.90%
12/31/2010 9.30% -0.60%
12/31/2011 8.50% -0.80%
12/31/2012 7.80% -0.70%
11/30/2013 7.00% -0.80%

Sure, I know that there are arguments to be made about whether the Unemployment Rate captures the actual degree of pain in the jobs market. It plainly does not. But you can pick any one of a dozen other indicators and they all will show roughly the same pattern – slow, steady improvement. There is no doubt that things are better now than they were four years ago, and no doubt that they are still worse than four years before that. My point is simply that we have been on the mend for four years.

Now, perhaps this expansion will last much longer than the typical expansion. But I don’t find terribly compelling the notion that the expansion will last longer because the recession was deeper. Was this recession deeper because the previous expansion was longer? If so, then the argument is circular. If not, then why would that connection only work in one direction? What I know is that the Treasury has spent the last four years running up large deficits to support the economy, and the Fed has nailed interest rates at zero and flooded the economy with liquidity. Those two things will at best be repeated in 2014, not increased; and there is a decent chance that one or the other is reversed. Another 0.8% improvement in the Unemployment Rate would put it at 6.2%, and I expect inflation to head higher as well. A taper will be called for; indeed, it should never have been necessary because policy is far too loose as it is. Whether or not an extremely dovish Fed Chairman will actually acquiesce to taper is an open question, but economically speaking it is already overdue and certainly will appear that way by the middle of the year, absent a crack-up somewhere.

Global threats to growth do abound. European growth is sluggish because of the condition of the financial system and the pressures on the Euro (but they think growth is sluggish because money isn’t free enough). UK growth has been improving, but much of that – as in the U.S. – has been on the back of housing markets that are improving too quickly to make me comfortable. Chinese growth has recently been downshifting. Japanese growth has been irregularly improving but enormous challenges persist there. Globally, the bright spot is a modest retreat in Brent Crude prices and lower prices of refined products (although Natural Gas prices seem to be on the rise again despite what was supposed to be a domestic glut). Some observers think that a lessening of tensions with Iran and recovery of capacity in Libya, along with increasing US production of crude, could push these prices lower and provide a following wind to global growth, but I am less sanguine that geopolitical tensions will remain relaxed for long and, in any event, depending on a calm Iran as the linchpin of 2014 optimism seems pretty cavalier to me.

Note that the muddled growth picture contains some elements of risk to price inflation. The ECB has been kicking around the idea of doing true QE or experimenting with negative deposit rates. The UK housing boom, like ours, keeps the upward pressure on measures of core inflation. There is no sign of an end to Japanese QE, and the PBOC seems willing to let the renmimbi rise more rapidly than it has in the past. And all of these global risks to domestic price inflation are in addition to the internally-generated pressures from rapid housing price growth in the United States.

The good news on inflation domestically is that M2 money growth has slackened from the 8%-10% pace of last year to more like 6%-8% (see chart, source Bloomberg). This is still too fast unless money velocity continues to slide, but it is certainly an improvement. But the bad news is that money growth remains rapid in the UK and is accelerating in Japan. The only place it is flagging, in Europe, has a central bank that is anxious not to be last place on the global inflation scale. I expect core inflation (and median inflation) in the U.S. to rise throughout 2014 and for core inflation to end up above 3% for the year.

allemsNow, I have just made a number of near-term forecasts but I need to change gears when looking at the long-term projections. In what follows, I make no effort to predict the 3-month, 6-month, or 12-month returns of any market. Indeed, although I will present long-term risk and return outlooks, and they are presented as point estimates, I want to make it very clear that these are not predictions but rather statements of relative risk and return possibilities. For many types of instruments, the error bars around the average annual performance are so large as to make point estimates (in my view) nearly useless. The numbers come from models of how markets behave when they are priced “like they are now” in terms of several important metrics. They are not prescient. However, that is what investing is really all about: not making the “right” bet in terms of whether you can call the next card off the deck, but making the “right” bet with respect to the odds offered by the game, and betting the right amount given the odds and the edge.

I also will not make portfolio allocation recommendations here. The optimal portfolio allocation for you depends on more variables than I have at my disposal: your age, your career opportunities, your lifestyle, your goals, any insurance portfolio and your risk tolerance, to name just a few.

What I will do here, though, is to give top-down estimates of the long-run returns and risks of some broad asset classes, and make some general observations. I don’t analyze every possible asset class. For this exercise, I limit the universe to stocks, TIPS, nominal bonds (both long Treasury and corporate bonds), commodity indices and (since many of us already own it) residential real estate. My estimates and some notations about the calculations are in the table below.

Inflation 2.50% Current 10y CPI Swaps
TIPS 0.68% Current 10y TIPS. This is not at equilibrium, but it is what we can lock in today. It is the highest rate available at year-end since 2010.
Treasuries 0.37% Nominal bonds and inflation-linked bonds ought to have the same a priori expectation, but Treasuries trade rich to TIPS because of their value as repo collateral. Current 10y nominal rate is 2.87%, implying 0.37% real.
T-Bills -0.50% Is less than for longer Treasuries because of liquidity preference.
Corp Bonds -0.69% Corporate bonds earn a spread that should compensate for expected credit losses.  A simple regression of Moody’s “A”-Rated Corporate yields versus Treasury yields suggests the former are about 45bps rich to what they should be for this level of Treasury yields.
Stocks 1.54% 2.25% long-term real growth + 1.83% dividend yield – 2.54% per annum valuation convergence 2/3 of the way from current 24.3 Shiller P/E to the long-run mean. Note that I am using long-run growth at equilibrium, not what TIPS are implying. This is the worst prospective 10 year real return we have seen in stocks since December 2007. Now, to be fair in 1999 we did get to almost -2%, which would imply up to another 35-40% upside to stocks before we reached an equivalent height of bubbliness. That is a 35-40% that I am happy to miss.
Commodity Index 6.26% Various researchers have found that commodity futures indices have a long-run diversification return of about 3.5%. To this we add 1-month LIBOR to represent the return on the collateral behind the futures, and a ‘relative value’ factor to reflect the performance (relative to the expected model) of hard assets relative to currency.
Real Estate (Residential) -0.19% The long-run real return of residential real estate is around +0.50%. Current metrics have Existing Home Sales median prices at 3.79x median income, versus a long-term average of 3.55x. Converging to the mean over 10 years would imply an 0.69% per annum drag to the real return. This is the first time since 2008 that housing prices have offered a negative real return on a forward-looking basis.

The results, using historical volatilities calculated over the last 10 years (and put in terms of ‘real annuitized income,’ a term that means essentially the variance compared to a fixed 10-year real annuity, which in this analysis would be the risk-free instrument), are plotted below. (Source: Enduring Investments).

portproj2013

Return as a function of risk is, as one would expect, positive. For each 0.33% additional real return expectation, an investor must accept a 1% higher standard deviation of annuitized real income. However, note that this is only such a positive trade-off because of the effect of commodities and TIPS. If you remove those two asset classes, which are the cheap high-risk and the cheap low-risk asset classes, respectively, then the tradeoff is worse. The other assets lie much more closely to the resulting line, which is flatter: you only gain 0.19% in additional real return for each 1% increment of real risk. Accordingly, I think that the best overall investment portfolio using public securities – which has inflation protection as an added benefit – is a barbell of broad-based commodity indices and TIPS.

TIPS by themselves are not particularly cheap; it is only in the context of other low-risk asset classes that they appear so. Our Fisher model is long inflation expectations and flat real rates, which merely says that TIPS are strongly preferable to nominal rates but not a fabulous investment in themselves (although 10-year TIPS yields are better now than they have been for a couple of years). Our four-asset model remains heavily weighted towards commodity indices; and our metals and miners model is skewed heavily towards industrial metals (50%, e.g. DBB) with a neutral weight in precious metals (24%, e.g. GLD) and underweight positions in gold miners (8%, e.g. GDX) and industrial miners (17%, e.g. PICK). (Disclosure: We have long positions in each of the ETFs mentioned.)

Feel free to send me a message (best through the Enduring website http://www.enduringinvestments.com ) or tweet (@inflation_guy) to ask about any of these models and strategies. In the new year, I plan to offer an email “course”, tentatively entitled “Characteristics of Inflation-Protecting Asset Classes,” that will discuss how these different assets behave with respect to inflation and give some thoughts on how to put an arm’s-length valuation on them. Keep an eye out for the announcement of that course. And in the meantime, have a happy holiday season and a merry new year!

Wrapping Up – And Some Portfolio Projections

December 20, 2012 7 comments

Whether it’s with a bang or with a whimper, the year is drawing to a close. So too is this author’s year; I expect that this will be my last post for 2012. Let me take a quick moment to thank all of you who have taken the time to read my articles, recommend them, and re-tweet them. Thanks, too, for your generous and insightful comments and reactions to my writing. One of the key reasons for writing this column (other than for the greater glory of Enduring Investments and to evangelize for the thoughtful use of inflation products by individual and institutional investors alike) is to force me to crystallize my thinking, and to test that thinking in the marketplace of ideas to find obvious flaws and blind spots. Those weaknesses are legion, and it’s only by knowing where they are that I can avoid being hurt by them.

In my writing, I try to propose the ‘right questions,’ and I don’t claim to have all the right answers. I am especially flattered by those readers who frequently disagree with my conclusions, but keep reading anyway – that suggests to me that I am at least asking good questions.

So thank you all, and I hope you have a blessed holiday season and a happy new year. And now, back to our regularly-scheduled article.

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It seems likely, although not a sure thing, that 2013 will be a better year in terms of economic growth. Certainly, we are ending 2012 in better shape than we entered it. One way or the other, the budget deficit will come down – at least partly because the prospective rise in tax rates has moved forward some realization of taxable gains – and, although that is a negative from a classical C+I+G+(X-M) perspective, I believe a smaller deficit will help assuage some business and consumer fears and be no worse than neutral … if, in fact, we get a smaller deficit! A bigger point is that while Europe is far from out of the woods, a near-term exit of Greece from the Euro finally seems unlikely. Stay tuned for Italian and Spanish dramas in 2013, and plenty of other pressures on the continent, but the worst case that we feared a year ago has been at least kicked down the road a piece.

Domestic growth to end 2012 is looking better, too. Today the Philly Fed index showed its highest print since March (8.1 versus -10.7 last month and expectations for -3.0). Existing Home Sales came in at 5.04mm, the first time above 5mm (without a government program, such as got Existing Home Sales up there briefly at the end of 2009) since 2007. The inventory of existing homes fell to the lowest level since 2002 (see chart, source Bloomberg).

housesforsale

Yes, there is additional “shadow inventory,” and so this isn’t the “true” inventory once you include bank REO property and other wannabe sellers who are waiting for the market to pick up, but that shadow inventory will clear a lot faster now that prices are rising. The monthly Home Price Index from the FHFA was released today, showing that nominal home prices in October rose 5.5% over last October (see chart, source Bloomberg).

monthlyHPI

Even in real terms, home prices are rising. Over time, residential real estate has roughly appreciated at the rate of inflation plus 0.5% (so that in real terms, home prices tend to just tread water). Between 1997 and 2007, however, real home prices rose some 50% before collapsing 28% between 2007 and 2011. But this latest bounce is real (see chart, source Bloomberg; I’ve merely divided the HPI by the NSA CPI price level and multiplied by 100), and it comes thanks to profligate monetary policy. To the extent that tax rates rise but the mortgage deduction persists, fiscal policy too will probably support home prices going forward. It isn’t a sustainable rise in real prices, but if it is merely sustainable in nominal prices it will heal a lot of upside-down borrowers.

realHPI

On the topic of profligate monetary policy, I ought to note that M2 growth has been reaccelerating, and has grown at a 9.8% pace over the last 13 weeks. Over the last 52 weeks, M2 is +7.6%. Assuredly, it isn’t the sustained 10% pace we saw at the beginning of 2012, but it is still far more than is needed to keep prices stable with a 2-3% real growth rate…as long as velocity stabilizes or heads higher. So, while the unemployment part of the “misery index” has been improving, the inflation part of the index is likely to continue to worsen. That will be the story in 2013, I suspect, as quantitative easing continues by central banks around the globe (and continues to accelerate in places: the Bank of Japan last night increased its purchasing program by another ¥10trln) and prices or real assets are not only no longer falling, but rather starting to rise.

Where to invest in this environment? Nominal bonds are the worst of all worlds; Treasuries are priced for a -1% real return over the next 10 years, and corporate bonds are even worse with a -2.1% expected real return. (Incidentally, you can compare these estimates to those I produced in 2010 and 2011 via these links. They’re mostly worse, following a better year from asset markets than we had a right to expect!) TIPS produce a -0.74% real return for the next 10 years. Stocks are at +2.44%, which looks good by comparison but is only fair given the risk, and low compared to historical norms – and also more expensive than they were at the end of 2011 (2.57% expected 10 year real return) and 2010 (2.58%). Commodities are cheaper: by my metric, diversified commodity indices are now expected to return 5.43% per year, after inflation, over the next decade (2010: 4.30%, 2011: 4.78%, so you can see this is not an exercise in forecasting the next year’s returns!). Residential real estate has richened slightly but is priced roughly at the long-run average, so I expect returns to be around 0.2% per year for the next decade. The chart below summarizes these estimates (source: Enduring Investments).

projrets

Our Fisher model is flat inflation expectations and short real rates; our four-asset model remains heavily weighted towards commodity indices; and our new metals and miners model is skewed heavily towards industrial metals (53%, e.g. DBB) and precious metals (43%, e.g. GLD) with negligible weights in gold miners (2%, e.g. GDX) and industrial miners (2%, e.g. PICK). (Disclosure: We have long positions in each of the ETFs mentioned.)

Feel free to send me a message (best through the Enduring website) or tweet (@inflation_guy) to ask about any of these models and strategies. And otherwise, have a happy holiday season and a merry new year! I look forward to a great 2013, a robust inflation market that continues to grow (the CME is likely to list both TIPS and CPI futures in the coming year), and no small amount of volatility to navigate. This column will return circa January 3rd or 4th.

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