Thursday, May 26, 2016

R.I.P. Deflation?

Amey Stone of Barron's reports, Deflation Is Dead, Buy TIPS over Treasuries:
BlackRock’s global chief investment strategist Richard Turnhill is worrying a lot more about inflation lately. His weekly commentary is titled, “Why deflation is dead,” and argues investors should own Treasury Inflation-Protected Securities (TIPS) as a hedge and also because they are likely to do better than Treasuries.

Higher energy prices is a big reason why he thinks more inflation is coming. But he has a lot of additional reasons, too. He explains:
Our analysis suggests rising U.S. inflation pressures will persist, as factory-gate price increases are passed on to consumers. It is not just the rebound in energy prices pushing inflation higher. An appreciating U.S. dollar is abating as a headwind. Prices of more stable service-based components of the CPI are also rising. Wages, too, are moderately increasing, as are survey-based consumer inflation expectations.
TIPS price in inflation of just 1.4% over the next 10 years. An exchange-traded fund that tracks the TIPS market, iShares TIPS Bond ETF (TIP), is up 4% year-to-date. It fell in the past week, however, as investors judged that if the Fed raises rates this summer, it would lower the risk of inflation and might even cause deflation.

Turnhill’s view is very different. He concludes:
The odds of the Fed increasing rates this summer have increased, although we see only one to two rate increases this year amid slow U.S. growth. We are cautious on duration, but rising inflation means owning TIPS in lieu of nominal Treasuries can be an important hedge for fixed income portfolios.
ValueWalk also reports, A Chart Showing Why Deflation Is Dead:
U.S. deflation is no longer an imminent risk. Global Chief Investment Strategist Richard Turnill’s chart of the week helps illustrate why.

U.S. deflation is no longer an imminent risk. This week’s chart helps illustrate why (click on image).

U.S. inflation has been picking up, following a prolonged period of subdued price rises, as evident in the chart above. The U.S. Consumer Price Index (CPI) in April posted its largest increase since February 2013. The inflation upturn is even more pronounced in forward-looking prices-paid surveys, such as the Institute for Supply Management’s Price Index, our analysis suggests. A greater number of purchasing manager survey respondents reported paying more for products and services in March and April, as the chart above shows.

We see the inflation upturn continuing over the near term. Energy supply-demand fundamentals are turning from a headwind into a tailwind for inflation. Oil supply has tightened, and demand is picking up, primarily out of China and India. This suggests current prices look increasingly sustainable, unless we get a significant reopening of idled shale-oil production. It points to energy’s downward pressures on inflation beginning to subside, in line with the view expressed in hawkish Federal Reserve (Fed) meeting minutes released last week.

Our analysis suggests rising U.S. inflation pressures will persist, as factory-gate price increases are passed on to consumers. It is not just the rebound in energy prices pushing inflation higher. An appreciating U.S. dollar is abating as a headwind. Prices of more stable service-based components of the CPI are also rising. Wages, too, are moderately increasing, as are survey-based consumer inflation expectations.

Bottom line: The odds of the Fed increasing rates this summer have increased, although we see only one to two rate increases this year amid slow U.S. growth. We are cautious on duration, but rising inflation means owning Treasury Inflation Protected Securities (TIPS) in lieu of nominal Treasuries can be an important hedge for fixed income portfolios. Read more market insights in my weekly commentary.
So is Richard Turnhill right? Is deflation dead? Have policymakers succeeded in resurrecting global inflation? Is deflation the dog which has not barked? Has the deflation tsunami receded into oblivion?

Of course not, deflation is very much alive everywhere outside the United States and the Fed and other central bankers are desperately worried that if it becomes entrenched, the global economy is going to fall into a long deflationary slump.

I know, everyone is getting excited as US crude breaks above $50 for first time in seven months and some are even worried the Fed could be blindsided by 1970s style stagflation. Some geopolitical analysts are even claiming that China thinks the US will default via inflation.

I'm afraid to rain on the inflation parade but the global reality is deflationary headwinds are picking up steam. Paul Hannon of the Wall Street Journal reports, Eurozone Slides Back Into Deflation:
The eurozone slipped back into deflation in April despite a stabilization in energy prices, underlining the difficulties the European Central Bank faces as it struggles to boost consumer prices.

The European Union’s statistics agency on Wednesday confirmed a preliminary estimate that showed consumer prices were 0.2% below their year-earlier levels in April, making it the second month this year in which the eurozone was in deflation.

The decline in consumer prices won’t have come as a surprise to the ECB, which had expected such an outcome during the first half of this year. But the reasons for the slide back into deflation have caused some fresh anxiety among policy makers.

“I am more worried about deflation,” ECB governing council member Ignazio Visco said in an interview with German business daily Handelsblatt published Tuesday. “With this come bankruptcies and very negative effects on the real economy. I believe we still face a concrete deflation risk.”

For much of the three years during which inflation has remained stubbornly below the central bank’s target of just under 2%, falling energy prices have been the main culprit. But energy prices have rebounded after sharp falls in the first two months of the year, and indeed rose slightly during April.

Instead, the main driver of the decline in consumer prices during April was a sharp drop in the rate at which prices for services rose, to 0.9% from 1.4% in March. Some of that likely reflects the timing of Easter, which this year pushed up prices of package holidays and other services in March.

But it may also be a sign of what central bankers call “second-round effects,” when businesses outside the energy sector start cutting their prices to reflect lower costs or falling inflation expectations among consumers. The core rate of inflation—excluding items such as food and energy, the prices of which are set mainly in world markets—fell to 0.7% from 1% in March, hitting its lowest level in a year.

“It will clearly be a very long, hard slog to get eurozone consumer-price inflation back up to the ECB’s target rate,” said Howard Archer, an economist at IHS Global Insight.

The ECB has launched a series of stimulus packages since mid-2014, all in an effort to achieve its inflation target. The most recent, announced in March, included cuts to all its main interest rates, a series of ultracheap loans for banks and an acceleration of its bond purchases to €80 billion ($91 billion) a month.

But the bank’s efforts have been frustrated by lower energy prices that partly reflect weaker growth in a number of large developing economies, as well as the modest pace of the eurozone’s recovery from its debt crisis, now in its fourth year.

“The stabilization in global energy prices since early 2016 raises the bar for additional easing at the next release of the ECB’s macroeconomic projections on June 2, but another rate cut is not out of the question,” said Bill Adams, an economist at PNC Financial Services.

One obstacle to the announcement of new measures is the U.K.’s referendum on whether to remain in the EU or leave, which will be held in June. Either outcome could have significant implications for the eurozone economy.

In an interview with The Wall Street Journal published Wednesday, ECB council member Vitas Vasiliauskas said he favors waiting until autumn before considering any additional policy moves.

“If there will be a need, we will of course do additional measures,” Mr. Vasiliauskas, who also heads Lithuania’s central bank. But “if there will be no need, we will do nothing.”
The Financial Times also reports, Spain PPI deflation worst since financial crisis:
Producer prices in Spain continued to deflate in April, with the biggest drop in almost seven years.

The PPI index fell 6.1 per cent year-on-year in April, the 22nd consecutive month of decline. They had fallen 5.6 per cent in March, but April marks the sharpest pace of contraction since July 2009, in the depths of the financial crisis.

Month on month, prices fell 0.1 per cent, after rising 0.6 per cent in March.

Consumer and producer prices around the world have generally been deflating for the past 18 months, with low oil prices a big driver. However over the long term, deflation erodes corporate profits, leading to layoffs and tighter investment, curbing economic growth.
In Asia, things are going from bad to worse. The Hindu Business Line reports that slowing or declining producer prices are haunting the two major Asian economies, China and India, signalling that the deflation contagion has spread to the developing world as well.

In Japan, Prime Minister Shinzo Abe has decided to postpone a consumption tax increase that was planned for next April, judging it to threaten efforts to pull the world's third-largest economy out of deflation:
Abe conceded earlier in the month that raising the consumption tax to 8% had a bigger-than-expected impact on consumer spending. He has argued repeatedly in parliament that Japan would be worse off after an increase that failed to generate higher revenue. Abe cited the threat to his campaign against deflation as grounds for postponing the rise to 10% the first time.

Japan's economy shrank an inflation-adjusted 0.3% in the fourth quarter of 2015 compared with the previous three months, revised figures show. The initial GDP reading for the first quarter of 2016 showed an annualized 1.7% expansion, but that meager growth was partly the result of an additional day in February due to a leap year. Consumer prices are sinking. And the impact of the Kyushu temblors on consumer and business activity will linger.

The rising yen is threatening corporate Japan's earnings and the stock market's performance. As for the global economy, growth prospects in China and other emerging markets are dimming amid unstable crude oil prices. Nobel laureate Paul Krugman, Joseph Stiglitz and other prominent economists have counseled Abe not to impose a higher tax burden on consumers under such conditions.
In Australia Bloomberg reports, Gloomy Aussie Rates Traders Win as Inflation Forces RBA Rethink:
Australian policy makers and economists are finally seeing the domestic economy through the dismal lens interest-rate traders have been using for the past year.

Swaps have been indicating for that long that the Reserve Bank of Australia would cut its benchmark rate at least once if not twice over 12 months, even as most economists saw the central bank sitting at a record-low 2 percent. Traders were proved right May 3 when Governor Glenn Stevens cut the policy rate to 1.75 percent. Now, markets and the majority of economists agree that a move to 1.5 percent is likely with JPMorgan Chase & Co., Commonwealth Bank of Australia and Morgan Stanley more bearish still.

Inflation was “a bit too low” Stevens said Tuesday, adding that and the central bank’s framework of targeting annual consumer-price gains of 2 percent to 3 percent had been a successful tool in deciding policy rates, though it wasn’t rigid. Swaps markets predict the low-point for the Australian benchmark will be about 1.4 percent in April next year, said Jarrod Kerr, a senior rates strategist at Commonwealth Bank, which is calling for a reduction to 1.25 percent by the end of 2016.

“The linkages between international and domestic inflation are a lot stronger these days and global inflation expectations are a lot lower,” Kerr said. “The fact that the RBA capitulated on its forecasts suggests to us that they are willing to do more to get inflation higher. The risk is more toward 1 percent than that they just do another cut and call it quits.”
In Canada, the inflation rate rose to an annual rate of 1.7 per cent in April as higher prices for food and shelter contributed to a higher cost of living but the Bank of Canada announced that it is maintaining its target for the overnight rate at 1/2 per cent, saying Alberta's wildfires will hurt the economy.

In her comment looking at why the Bank of Canada stood pat on rates, Sherry Cooper, Chief Economist of the Dominion Lending Centres, notes massive capital outflows from China are sustaining housing markets around the world, especially in Canada and the United States:
The media continue to put the spotlight on the Vancouver and Toronto housing booms and the role played by foreigners to drive up prices. Affordability issues are of great concern and questions continue to arise regarding the sustainability of the housing bubble.

I am currently researching the viability of continued housing demand by the Chinese given the government’s 2015 introduction of capital controls, which limits capital withdrawal to the equivalent of $50,000 (U.S. currency) per person. I will detail my findings in another report, but suffice it to  say China’s capital outflow has surged in recent months, notwithstanding these controls. There are a number of ways to circumvent the rules and the penalties are tiny. The Chinese government is simply not enforcing the controls and the continued devaluation of the Chinese yuan continues to trigger massive outflows (see Chart below). Much of that money is moving to housing in Toronto and Vancouver, as well as to Australia, New Zealand and the United States. The Chinese are now the number-one foreign purchaser of U.S. residential real estate, surpassing Canadian inflows this year. This is stimulating the housing markets especially in New York, Los Angeles, San Francisco and Seattle. Chicago, Miami and Las Vegas are also seeing significant investment.

The Canadian government and regulatory response to this foreign inflow of money is evolving. The media have recently highlighted the potential for money laundering and the lax enforcement of of anti-money laundering initiatives in the real estate sector. But it appears that most of the Chinese purchase of Canadian housing is not for money laundering purposes, meaning garnered through illegal activity or to support terrorism.

More on this to come.
There is a lot of money laundering going on in Canada and elsewhere but Sherry Cooper is right, it's not the main driver of capital outflows out of China. Chinese are worried about their future and their currency depreciating, impacting their purchasing power.

And if Soros is right and a crash and deflation ravages China, there will be a lot less money available to propel housing markets in developed economies much higher and this will hit many bubble markets extremely hard.

If you ask me, it's the global deflationary wildfires that really worry Bank of Canada Governor Stephen Poloz and other central bankers around the world. 

But BlackRock’s global chief investment strategist Richard Turnhill says deflation is dead and he's not alone. I hear a lot of strategists claiming that there will be an inflationary pickup in the near term and some think it will possibly last years.

I think they are all wrong, confusing cyclical swings due to currency moves, and if you look at the US bond market, it's yawning too at all these foolish forecasts of a pickup in inflation. I know, oil just crossed the "psychologically important $50 mark," the "US housing market is on fire," everyone is getting ready for "the Fed to raise rates" at least once, but I remain highly skeptical as I see no clear evidence of a global recovery (quite the contrary) and still think the dumbest thing the Fed can do is raise rates (it will heighten global deflation).

The main reason why US inflation picked up in recent months was because of the weaker US dollar. That is it, nothing more fundamental. Outside the US, deflationary pressures are picking up and this will force central banks to do more stimulus to get their economies out of their deflation rut. This is bullish for the US dollar which is why I see it rallying in the second half of the year.

And as I stated in my comment looking at top funds' activity for Q1 2016:
The rising USD should provide relief in terms of deflationary pressures in Asia (except China which pegs the yuan to the USD) and Europe but it also means lower commodity and gold prices. It also means lower import prices for the US which will lower inflation expectations there, effectively importing deflation into that country.
My best advice remains to focus on the big picture which is DEFLATION. This is why I remain bullish bonds (TLT) and to a lesser extent high dividend sectors. The problem with the latter which are made up of utilities, REITS, telecoms and staples is that they ran up too much and have become very crowded. Also, any potential rise in rates will hurt these sectors as they are very interest rate sensitive.

In terms of risk trades, I still trade biotech shares (IBB and XBI) which got slaughtered this year and are coming back strong even if concerns over Valeant (VRX) continue to weigh on the sector.

So, when people ask me my Long/ Short macro trade for the second half of the year it's to go long biotechs (IBB and XBI) and short Metals & Mining (XME), Energy (XLE), and Emerging Markets (EEM).

Of course, if things get really bad, all sectors are going to get slammed hard, especially high beta biotechs, and the only thing that will save your portfolio are good old government bonds (TLT).
That is US nominal Treasury bonds, not TIPS! But if you believe in fairy tales on inflation and global economic growth, by all means, buy the garbage that Wall Street is feeding you about deflation being dead. I'm not buying it and neither is the US bond market.

Below, Chris Verrone, Strategas Research Partners, takes a look at crude oil charts and what stands out in the energy sector. He thinks investors should fade the oil rally and I agree, there may be a little more upside but there's plenty of downside and energy, metal and mining stocks are already diverging from oil prices.

Second,  with the Chinese yuan sliding, Rich Ross of Evercore ISI and Max Wolff of Manhattan Venture Partners discuss the Chinese currency’s importance to global markets with Brian Sullivan. They also discussed whether the market could be poised for a breakout (watch third clip).

Lastly, Gary Schilling, President of A. Gary Shilling & Co and author of The Age of Deleveraging, gave a very interesting presentation on how to make money in a world of deflation.

Deflation is looming and will enhance Shilling's investment strategies. They focus on first, owning Treasury bonds which are also the world's safe haven. Second, owning the US dollar which is also a refuge in troubled times and benefits from almost every other currency devaluing against it. Finally, shorting oil and other commodities that suffer from excess global supply and deficient demand.

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