Monday, August 7, 2017

The Mystery of Inflation Deflation?

Kopin Tan of Barron's reports, The Baffling Mystery of Inflation Deflation:
The stock market has gone more than a year without a 5% pullback, but a correction isn’t the only thing missing in action. What’s also baffling is the mystery of disappearing inflation.

A correction, like your misplaced car keys, will turn up sooner or later. But inflation’s absence has become especially glaring after the long, loud drum roll anticipating its appearance—what with our economic expansion entering its ninth year, a well-publicized synchronized global recovery, the Trump administration’s promise of fiscal fireworks, and tightening policies by central banks from the U.S. to China. Yet the core consumer price index eked out a year-over-year increase of just 1.7% in June, the slowest in two years. Stripping out shelter costs, core inflation grew just 0.6%, the most sluggish rate since 2004. Personal-consumption expenditures are growing at a 1.4% pace, shy of the Federal Reserve’s 2% target.

You may think it’s perverse to wish for inflation, and life’s necessities—a nice house, stiff drinks, Orlebar Brown swim trunks—seem only to get more expensive, not less. But stable inflation lets businesses hike prices of the goods and services they sell, and raise wages. It’s no coincidence the labor market is tight and unemployment is down to 4.4%, but wages are growing at a glacial pace of about 2.5%.

For a stock market braving new peaks—the Standard & Poor’s 500 index just snagged its 27th record high of 2017—weak inflation reinforces concerns that the Fed is tightening even when our slow-growth, low-interest-rate economy is going nowhere fast.

Why does inflation keep falling short of expectations? For one thing, “excess debt encourages saving, not spending,” notes Michael Hartnett, Bank of America Merrill Lynch’s chief investment strategist, who cites data from the Institute of International Finance showing global debt hitting an all-time high this year of $217 trillion, roughly 327% of global gross domestic product. Next, he adds, aging populations also tend to save more and spend less, and even though demographic trends here are sprightly compared with, say, Japan and Europe, over the past decade the annual growth in the U.S. working population has shrunk from 1.3% to just 0.5%.

On top of that, automation, robots, and artificial intelligence are pressuring human wage expectations. Technology disruption may one day prompt policy changes that could include, for example, taxing robots or levying higher taxes on Silicon Valley profits, Hartnett notes. For now, he says, “corporations continue to emphasize cost-cutting over risk-taking, and wide swaths of the labor market see that their ability to maintain wages and incomes are under enormous threat from technology.”

The worrisome thing is how inflation seems to have befuddled central bankers. Fed chair Janet Yellen has said that weak recent inflation readings are merely “transitory,” and she pointed to a price war in mobile phone services and a decline in prescription drug prices as momentary inflation depressants. But the Fed has brushed aside feeble inflation as transient year after year after year, and still inflation has yet to catch up to the Fed’s 2% goal. Back in 2015, for example, Yellen said inflation was held back by collapsing oil prices and weakening imports in the face of our strong dollar. Well, energy prices have since rebounded from early-2016 depths, and the dollar just declined to a 30-month low against the euro. But there’s always something else, and new culprits springing forth to hold inflation hostage.

IN THE COMING MONTHS, expect the Fed to be extra sensitive to any whiff of faltering growth. With inflation already below target, the Fed has less cover to continue its painstakingly telegraphed plan to raise rates and shrink its balance sheet. At first, this will cheer a market accustomed to the addictive fix of easy money. But the Fed has fewer tools at its disposal if growth starts to flag, what with interest rates already low. On the other hand, if inflation were to start climbing, financial markets—which are pricing in only a 39% chance of one more rate hike through year end—just might be startled.

It’s a good thing the economy is growing, but how much of that growth is already factored into rising stock prices? Companies are on track to report second-quarter profit growth of 9.6%, compared to 15.3% in the first quarter. So far this earnings season, companies that beat targets have eked out average gains of 0.6% in the first session after reporting, notes Bespoke Investment Group. But companies merely meeting their forecasts slipped 2.7%, while those missing their marks were drubbed 4.6%.

In June, retail sales grew 1.2% year over year, down from 2.1% in May, and it remains to be seen if Washington can deliver the promised tax cuts and fiscal stimulus before growth slows further. In a July survey of global fund managers conducted by BofA Merrill Lynch, the percentage who expect faster global growth over the next 12 months shrank to 38%, down from 62% back in January. Profit expectations are rolling over as well. Only 41% see profits improving over the next 12 months, the lowest since the election and down from 58% in January.

Against this backdrop, we’re crowding back into what we fear could become scarce. Big tech stocks, after a brief bout of profit-taking in late June, have regained their swagger and market leadership and are up 23% this year. Growth stocks in the S&P 500 nudged back ahead of their value counterparts to reach another all-time high and are up 15.8% this year, compared with 4.5% for value stocks. Inflation may be in retreat, but in the stock market, prices seem only to march higher.
There is no baffling mystery of inflation to me, global deflation is coming our way and those who aren't prepared, like the lambs who think stock markets are headed higher and those shorting volatility thinking it will remain low forever, will get slaughtered (credit investors get it).

Last week, I discussed why Alan Greenspan and others are wrong on bonds, alluding to six structural factors that lead me to believe we are headed for a prolonged period of debt deflation:

  1. The global jobs crisis: High structural unemployment, especially youth unemployment, and less and less good paying jobs with benefits.
  2. Demographic time bomb: A rapidly aging population means a lot more older people with little savings spending less.
  3. The global pension crisis: As more and more people retire in poverty, they will spend less to stimulate economic activity. Moreover, the shift out of defined-benefit plans to defined-contribution plans is exacerbating pension poverty and is deflationary. Read more about this in my comments on the $400 trillion pension time bomb and the pension storm cometh. Any way you slice it, the global pension crisis is deflationary and bond friendly.
  4. Excessive private and public debt: Rising government and consumer debt levels are constraining public finances and consumer spending.
  5. Rising inequality: Hedge fund gurus cannot appreciate this because they live in an alternate universe, but widespread and rising inequality is deflationary as it constrains aggregate demand. The pension crisis will exacerbate inequality and keep a lid on inflationary pressures for a very long time.
  6. Technological shifts: Think about Amazon, Uber, Priceline, AI, robotics, and other technological shifts that lower prices and destroy more jobs than they create.
These are the six structural factors I keep referring to when I warn investors to temper their growth forecasts and to prepare for global deflation.

Now, let me take a little detour here to teach people some very basic macro points which everyone seems to get wrong:
  • First, in an ultra low interest rate world, currency swings matter a lot. Why? When the US dollar takes a hit relative to the euro and yen, like it did since December, this means the euro and yen strengthen, which means tighter financial conditions and lower import prices in these regions as they are effectively importing deflation. The problem is Japan is stuck in deflation and the Eurozone isn't far behind (never mind the rosy headlines proclaiming deflation risk is removed in Europe, that's utter nonsense). In other words, given the deflationary headwinds in Japan and the Eurozone, they can't afford to see their currencies appreciate for a long period, it only reinforces more deflation at a time when they're desperately trying to escape it.
  • Second, and more importantly, the US leads the world. When the US economy is slowing -- and make no mistake, despite Friday's good jobs report, it is slowing -- it leads the rest of the world by six to nine months. So expect the US dollar (UUP) to rally relative to other currencies even if the Fed takes a pause from raising rates. Why? Because as the world ex-US slows, real rate differentials widen, making the US dollar that much more attractive. And if there is a full-blown financial crisis, then the flight-to-liquidity will support US bonds (TLT) and the dollar.
  • Third, as the US dollar gains relative to other currencies, US import prices will fall as the US imports global deflation. The threat then becomes a full-blown dollar crisis which I warned of late last year (it hasn't happened yet) and deflation coming to America which I discussed three years ago. 
  • Lastly, and equally important, talk of a bond bubble is just silly in a deflationary environment. Legions of hedge funds shorting JGBs in the 90s got wiped off the planet and legions of hedge funds shorting US Treasurys now and in the future will suffer the same fate.
In a deflationary environment, I remain long US long bonds (TLT) and the US dollar (UUP) and short cyclical risk assets, including energy, commodities, emerging market stocks, bonds and currencies and commodity currencies.

I tell all my friends and family to use the strength in the loonie to buy US assets now, particularly US long bonds (TLT) which will rally as long bond yields make a new secular low. Moreover, they will gain more as the US dollar gains on the Canadian dollar over the next year(s).

Why US bonds? Why not US or Canadian dividend stocks? Because their valuations are high and there's too much beta embedded in them.

More importantly, if a crisis hits us, only US long bonds will offer you the ultimate diversification and protect your portfolio from being obliterated.

I'm astounded at how many financial advisors and institutional investors just don't get it and buy the garbage that global growth is strong and inflation will roar back.

This morning, Bloomberg reported that investors just made a big bet on global growth and a soft dollar, loading up on industrials (XLI). Bad move, I'm short industrials and while they have made impressive gains over the last year, now is the time to take your profits, underweight and/ or short them (click on image):


Once again, let me show you my number one macro conviction trade on a risk-adjusted basis going forward, long US long bonds (TLT) and stay long over the next year and possibly longer (click on image):


Let me also take this opportunity to once again plug the research of Francois Trahan and Michael Kantrowitz at Cornerstone Macro. Earlier today, they wrote a great report on what they're watching which is a must read for all investors, especially institutional investors (click here to subscribe to their research).

In an email to me on July 21st when I shared my macro conviction calls, Francois shared this with me: "We put a 1.5% target on the 10-year in our outlook piece back in January ... all 51 forecasts on Factset are calling for higher yields." I replied "Yup, I remember you in Montreal (in January), agree completely and yields might even go lower than your forecast."

In fact, let me make a bold forecast here: Yields on the 10-year Treasury note are headed below 1% and might touch 0.5% or head even lower if a global deflationary crisis develops.

Am I sounding too bearish, discounting the possibility of another 1999-2000 melt-up rally in risk assets where they go parabolic? Maybe, but I recently put all my money in US long bonds (TLT) because while I made great money trading biotech (XBI) stocks in the first half of the year, I fear these high-beta high-flyers will get killed too when the next beta tsunami hits us (plus I've been sleeping like a baby ever since I stopped trading biotechs).

Let me end this comment by plugging a family friend of mine, Nicolas Papageorgiou, professor of finance at HEC Montreal, who is also a VP at Fiera Capital, a Montreal-based asset manager founded by Jean-Guy Desjardins, a legend in the industry.

Jean-Guy and I have very different views on the energy sector and the S&P/TSX (he is bullish on both, I am short) but there's no denying he's an astute businessman who isn't afraid to take risks, grow by acquisition and he hires very smart people like Nicolas and Nadim Rizk, one of the best Canadian portfolio managers you probably never heard of and a nice guy to boot (just like Nicolas).

In fact, Nicolas and Nadim are my two favorite people at Fiera Capital and are living proof that it pays to diversify and hire some ethnics along the way (don't be scared, even though our names sound different, we won't hurt you). Fiera also hired Heather Cooke away from Unigestion and she's now the Deputy CIO (another example that it pays to diversify).

Below, Fiera Capital Vice President Nicolas Papageorgiou discusses how the Defensive Global Equity Fund has performed year-to-date, the strategy's key differentiators against peers, as well as the fund's current level of risk overlay.

To all the big pensions and other large institutional investors who regularly read this blog, take the time to meet Nicolas, not only does he really know his stuff, he's also extremely nice and will help you manage your asset allocation decisions in what will prove to be a very challenging time for markets in the years ahead as global deflation takes over, crushing risk assets across the spectrum.

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