Prepare For a Deflationary Boom?
"Deflation" and "boom" are not two words that normally go together. They are almost like "sad happiness," "low-cal donut." But in their very unlikely pairing they appear to do a good job of explaining the unusual economic and market environment that may lie ahead.I'm glad I read this article because it's been a while since I last received research insights from Francois Trahan at Cornerstone Macro. I agree with the thrust of his arguments, the U.S. will experience a "deflationary boom" next year and investors should emphasize cyclicals over defensives in their portfolios.
It’s a term discussed this week by Cornerstone Macro analyst Francois Trahan to describe a rare condition in which a country’s economic activity rises but inflation falls. He believes that is the right interpretation of the Philadelphia Fed data released on Tuesday that showed output in the region up but prices paid falling, as shown in the chart below.
The improvement of the Philly Fed can be seen in part as a result of the stimulative effect of falling crude oil prices, and their ripple effect on the broad economy. The chart below, created by Cornerstone, shows the Philly Fed Index (green line) charted against the six-month percent change in the price of Brent Oil, advanced four months (gray) and inverted.
The oil price is advanced four months to show the lagged effect that oil has on economic activity. In other words, when oil falls in price it takes about four months for the change to have an effect on end users’ decisions.
You can already start to see the effect of lower oil and interest rate stimulus in the fact that the last four major economic data releases — Empire Manufacturing, NAHB Housing, Philly Fed and Kansas City Fed — have been better than expected, the first time that has happened in quite a while.
What we are starting to see, Trahan argues, is news that demonstrates we are in an “all stimulus, all the time” backdrop, with more boosts to global economic activity coming every day. The latest of course were the monetary policy announcements by the Chinese and Japanese, and the wink to suggest sovereign bond QE in the eurozone. The chart below shows a checklist: The Fed is still stimulating with super-low rates and not trimming its balance sheet of all the bonds bought during three years of QE; oil prices are dropping; long term interest rates are still falling; and the U.S. dollar is rising.
A “deflationary boom” in the United States occurs when the prices of raw materials — ranging from crude oil and precious metals to grains and cotton — fall, stimulating consumers to buy more, lifting demand from factories and service providers.
This is all pretty weird because we are used to seeing a stronger U.S. economy generate higher inflation, particularly as a result of wage growth and greater demand for raw materials. But companies are managing to keep wages relatively low through productivity increases, and commodity prices are sinking because of lower demand from emerging markets and the eurozone.
In short, a deflationary boom is not supposed to be able to happen, but it appears to be a byproduct of globalization.
In this environment, which was last seen in the 1990s, the shares of “early cyclical” companies like airlines, railroads and specialty retailers should go up, while late-stage cyclicals like miners, metal producers and energy producers should go down — pretty much what has been happening in the second half of this year.
Falling inflation boosts consumers’ free cash flow, or disposable income, which leads them to spend more on clothing, travel, cars and the like. For a variety of reasons, Trahan observes, the Phlly Fed tends to be one of the first indexes to respond and rise dramatically, and then activity in other Fed regions — Chicago, Richmond and Dallas — then to follow.
Cornerstone argues that investors who wish to position themselves for these conditions in 2015 should overweight the following “risk-on” industries and sectors: Financials, semiconductors, communications equipment, computer hardware, computer storage, electronic components, machinery, airlines, autos and steel. And they should underweight the “risk off” industries: utilities, food, staples, groceries, health care equipment, consumer services, insurance and software.
No wonder we’re seeing the odd pairs trade of long Apple, short oil work out so well in the past five months, as shown above.
Summing it up into a single point of view, the Cornerstone team is looking for stronger growth and lower inflation to result in higher P/E multiples next year to go along with higher profit growth. If it’s true that risk-on will surpass risk-off next year, then investors should simply emphasize cyclicals over defensives in their portfolios.
Source: Markman Capital Insight
In fact, as I wrote back in August, the real risk in the stock market is a melt-up, not a meltdown, unlike anything you've ever seen before. This is why I used the big unwind earlier this year and the October selloff to plunge into stocks and add to my biotech positions.
But I've also warned my readers to be very selective, paying attention to what top funds are buying and selling, and steering clear of energy (XLE), materials (XLB) and commodities (GSG) and going overweight small caps (IWM), technology (QQQ or XLK) and especially biotech shares (IBB or XBI).
In particular, I specifically mentioned to keep an eye on companies like Acadia Pharmaceuticals (ACAD), Avanir Pharmaceuticals (AVNR), Idera Pharmaceuticals (IDRA), Biocryst Pharmaceuticals (BCRX), Progenics Pharmaceuticals (PGNX), Seattle Genetics (SGEN), Threshold Pharmaceuticals (THLD), TG Therapeutics (TGTX), XOMA Corp (XOMA) and told you to buy the dip on Twitter (TWTR) which is my favorite social media stock.
However, I warned you to prepare for more volatility in these crazy markets and beware of "high dividend traps," specifically alluding to companies like SeaDrill (SDRL) in my October comment which I knew was going to get slaughtered once it cut its dividend.
And what happened? Earlier this week, SeaDrill cut its dividend and the stock got hammered, now down over 30% in a couple of trading days -- and that's after a sharp selloff over the last few months. The stock keeps making new 52-week lows and I wouldn't touch it or others that are going to suffer the same fate.
In fact, the oil services sector got clobbered this week by the plunge in SeaDrill's stock as everyone is worried about who's next to cut their dividend. As shown below, these oil service stocks are very weak and vulnerable to further weakness (click on image).
OPEC's decision to hold production unchanged just added to the woes of an already weak energy sector and risks pushing Canada's TSX much lower.
So far, most people are focusing on the benefits of lower oil and commodity prices, viewing it as a gift to consumers that will lift aggregate demand. And while lower oil prices will boost consumption, the question is for how long and are these lower prices a harbinger of more pain ahead?
I'm not in the camp that believes we're in a prolonged deflationary boom and the fall in oil and commodity prices is unambiguously good for the world economy.
Importantly, the big danger here is that everyone will focus on the "oil dividend" and the U.S. economy, underestimating the risk of deflation spreading throughout the world and eventually coming to America. Moreover, the surge in the mighty greenback risks reinforcing U.S. deflationary pressures, raising concerns at the Fed.
Sure, the liquidity party will last, we will see P/E multiple expansion taking stocks much higher but if inflation expectations keep dropping, you'll see more central banks panicking, including the Fed and even the Bank of Canada which rightly ignored the OECD's call to hike rates.
That's when a deflationary boom can easily turn into a deflationary bust so don't get carried away thinking the drop in oil and commodity prices is benign and will lead to a huge global economic recovery. It won't, it will lull investors into a false sense of security, ripping them apart when deflation becomes entrenched and serious.
It's worth noting that long-dated U.S. Treasury yields hit their lowest level in over a month for a third straight session and benchmark yields also touched more than one-month lows on Friday, pushed down by signs of disinflation and month-end buying. Is the bond market worried about a major slowdown despite the fall in oil prices? It sure looks that way which is another reason not to sour on debt.
Finally, Jonathan Nitzan sent me the latest research which he co-authored with Shimshon Bichler, Still About Oil?. This is the type of research George Soros would devour and even though it's not an easy and fast read, it's excellent and well worth reading.
Before joining academia, Jonathan used to be an associate editor of emerging markets at BCA Research. He's an intellectual tour de force and his thinking is way ahead of anything BCA publishes. I asked him about his thoughts on whether we're in the midst of a deflationary boom and he shared this with me:
1. The nineteenth century was characterized by falling prices and rising output (in England, consumer prices are estimated to have fallen by 30%); I doubt that this "deflationary boom" will be repeated any time soon.Again, I will leave it up to you to read their latest research paper on oil to gain a better understanding of his comments above.
2. The future of course is unknowable. But if oil prices and overall inflation continue to drop, that might be symptomatic of dominant capital approaching its asymptotes of power. During the 1980s and 1990s, oil prices and inflation trended downward (Figure 7), but mergers and acquisitions boomed, fueling the differential earnings and capitalization of dominant capital. These days, inflation AND amalgamation are on a downtrend, which makes it difficult for dominant capital to meet the average, let alone beat it.
Finally, Leo de Bever, CEO & CIO of AIMCo, was interviewed on BNN's "The Close" yesterday (fast forward to minute 15), once again saying lower oil prices are here to stay and Canadian energy firms need to do 20 years of tech development in 5 years to stay competitive.
Last December, I wrote a comment on why it's time to short Canada where Leo predicted oil prices would drop to $70 a barrel "over the next five years." He was laughed at but right on the money even if it happened a lot quicker than he anticipated.
I'm still short Canada and think oil prices will fall below $60 a barrel. This means the TSX and especially the loonie are heading much lower. Canadian banks aren't exposed to the drop in oil in their loan portfolios (only 6% exposure to energy companies) but energy companies generated 30% of underwriting fees in the last few years. The drop in those fees will hurt them.
Below, an interview with Cornerstone Macro’s Investment Strategist, Francois Trahan, who has once again been named the number one ranked strategist on Wall Street by Institutional Investor magazine.
Francois has been a market bull since the fall of 2011 when the markets looked dicey and is still bullish. This interview took place back in October on Consuela Mack's Wealthtrack.
Good interview, take the time to listen to his comments but keep in mind my warning above, a deflationary boom can easily turn into a deflationary bust so enjoy the liquidity party while it lasts because once deflation comes to America, the hangover will last for decades.
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