Inflation or Employment

Inflation or Employment

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Macro Letter – No 95 – 20-04-2018

Inflation or Employment

  • Inflationary fears are growing and US rates continue to rise
  • Employment has become more flexible since the crisis of 2008/2009
  • Commodity prices have risen but from multi-year lows
  • During the next recession job losses will rapidly temper inflationary pressures

Given the official policy response to the Great Financial Recession – a mixture of central bank balance sheet expansion, lower for longer interest rates and a general lack of fiscal rectitude on the part of developed nation governments – I believe there are two factors which are key for stock markets over the next few years, inflation and employment. The fact that these also happen to be the two mandated targets of the Federal Reserve – full employment and price stability – is more than coincidental. My struggle is in attempting to decide whether demand-pull inflation can survive the impact of a rapid rise in unemployment come the next recession.

Inflation and the Central Bankers response is clearly the new narrative of the financial markets. In his latest essay, Ben Hunt of Salient Partners makes some fascinating observations – Epsilon Theory: The Narrative Giveth and The Narrative Taketh Away:-

This market, like all markets, cares about two things and two things only — the price of money and the real return on invested capital. Or, as they are typically represented in cartoon form, interest rates and growth.

…This market, like all markets, needs a positive narrative on risk (the price of money) or reward (the real return on capital) to go up. Any narrative will do! But when neither risk nor reward is represented with a positive narrative, this market, like all markets, will go down. And that’s where we are today. 

Does the Fed have our back? No, they do not. They’ve told us and told us that they’re going to keep raising rates. And they will. The market still doesn’t fully believe them, and that’s going to be a constant source of market disappointment over the next few years. In the same way that markets go up as they climb a wall of worry, so do markets go down as they descend a wall of hope. The belief that central bankers care more about the stock market than the price stability of money is that wall of hope. It’s a forlorn hope.

The author goes on to discuss the way that inflation and the war on trade has derailed the global synchronized growth narrative. Dr Hunt writes at length about narratives; those who have been reading my letters for a while will know I regularly quote from his excellent Epsilon Theory.

The narrative has not yet become flesh, to coin a phrase, but in the author’s opinion it will:-

My view: the inflation narrative will surge again, as wage inflation is, in truth, not contained at all.

The trade war narrative hit markets in force in late February with the White House announcement on steel and aluminum tariffs. It subsided through mid-March as hope grew that Trump’s bark was worse than his bite, then resurfaced in late March with direct tariff threats against China, then subsided again on hopes that direct negotiations would contain the conflict, and has now resurfaced this past week with still more direct tariff threats against and from China. Already this weekend you’ve got Kudlow and other market missionaries trying to rekindle the hope of easy negotiations. But being “tough on trade” is a winning domestic political position for both Trump and Xi, and domestic politics ALWAYS trumps (no pun intended) international economics. 

My view: the trade war narrative will be spurred on by BOTH sides, and is, in truth, not contained at all.

The two charts below employ natural language processing techniques. They show how the inflation narrative has rapidly increased during the last 12 months. I shall leave Dr Hunt to elucidate:-

… analysis of a large set of market relevant articles — in this case everything Bloomberg has published that talks about inflation — where linguistic similarities create clusters of articles with similar meaning (essentially a linguistic “gravity model”), and where the dynamic relationships between and within these clusters can be measured over time.

epsilon-theory-the-narrative-giveth-and-the-narrative-taketh-away-april-10-2018-chart-one

Source: Quid.inc

What this chart shows is the clustering of content in 1,400 Bloomberg articles, which mention US inflation, between April 2016 and March 2017. The graduated colouring – blue earlier and red later in the year – enriches the analysis.

The next chart is for the period April 2017 to March 2018:-

epsilon-theory-the-narrative-giveth-and-the-narrative-taketh-away-april-10-2018-chart-two

Source: Quid.Inc

During this period there were 2,400 articles (a 75% increase) but, of more relevance is the dramatic increase in clustering.

What is clear from these charts is the rising importance of inflation as a potential driver of market direction. Yet there are contrary signals that suggest that economic and employment growth are already beginning to weaken. Can inflation continue to rise in the face of these headwinds. Writing in The Telegraph, Ambrose Evans-Pritchard has his doubts (this transcript is care of Mauldin Economics) – JP Morgan fears Fed “policy mistake” as US yield curve inverts:-

US jobs growth fizzled to stall-speed levels of 103,000 in March. The worldwide PMI gauge of manufacturing and services has dropped to a 14-month low. The average “Nowcast” tracker of global growth has slid suddenly to a quarterly rate of 3.2pc from 4.1pc as recently as early February.

Analysts at JP Morgan say the forward curve for the one-month Overnight Index Swap rate (OIS) – a market proxy for the Fed policy rate – has flattened and “inverted” two years ahead. This is a collective bet by big institutional investors and fund managers that interest rates may be falling by then.

…The OIS yield curve has inverted three times over the last two decades. In 1998 it proved to be a false alarm because the Greenspan Fed did a pirouette and flooded the system with liquidity. In 2000 it was a clear precursor of recession. In 2005 it signaled that the US housing boom was already starting to deflate.

…Growth of the “broad” M3 money supply in the US has slowed to a 2pc rate over the last three months (annualised)…pointing to a “growth recession” by early 2019. Narrow real M1 money has actually contracted slightly since November.

…RBC Capital Markets says this will drain M3 money by roughly $300bn a year…

…Three-month Libor rates – used to set the cost of borrowing on $9 trillion of US and global loans, and $200 trillion of derivatives – have surged 60 basis points since January.

…The signs of a slowdown are even clearer in Europe…Citigroup’s economic surprise index for the region has seen the worst four-month deterioration since 2008.  A reduction in the pace of QE from $80bn to $30bn a month has removed a key prop. The European Central Bank’s bond purchase programme expires altogether in September.

…The global money supply has been slowing since last September. The Baltic Dry Index measuring freight rates for dry goods peaked in mid-December and has since dropped 45pc.

Which brings us neatly to the commodity markets. Are real assets a safe place to hide in the coming inflationary (or perhaps stagflationary) environment? Will the lack of capital investment, resulting from the weakness in commodity prices following the financial crisis, feed through to cost-push inflation?

The trouble with commodities

Commodities are an excellent portfolio diversifier because they tend to be uncorrelated with stock, bonds or real estate. They have a weakness, however, since to invest in commodities one needs to accept that over the long run they have a negative real-expected return. Why? Because of man’s ingenuity. We improve our processes and invest in new technologies which reduce our production costs. We improve extraction techniques and enhance acreage yields. You cannot simply buy and hold commodities: they are trading assets.

Demand and supply of commodities globally is a complex challenge to measure; for grains, oilseeds and cotton the USDA World Agricultural Supply and Demand Estimates for March offers a fairly balanced picture:-

World 2017/18 wheat supplies increased this month by nearly 3.0 million tons as production is raised to a new record of 759.8 million

Global coarse grain production for 2017/18 is forecast 7.0 million tons lower than last month to 1,315.0 million

Global 2017/18 rice production is raised 1.2 million tons to a new record led by 0.3- million-ton increases each for Brazil, Burma, Pakistan, and the Philippines. Global rice exports are raised 0.8 million tons with a 0.3-million-ton increase for Thailand and 0.2- million-ton increases each for Burma, India, and Pakistan. Imports are raised 0.5 million tons for Indonesia and 0.3 million tons for Bangladesh. Global domestic use is reduced fractionally. With supplies increasing and total use decreasing, world ending stocks are raised 1.4 million tons to 144.4 million and are the second highest stocks on record.

Global oilseed production is lowered 5.7 million tons to 568.8 million, with a 6.1-million-ton reduction for soybean production and slightly higher projections for rapeseed, sunflower seed, copra, and palm kernel. Lower soybean production for Argentina, India, and Uruguay is partly offset by higher production for Brazil.

Cotton – Lower global beginning stocks this month result in lower projected 2017/18 ending stocks despite higher world production and lower consumption. World beginning stocks are 900,000 bales lower this month, largely attributable to historical revisions for Brazil and Australia. World production is about 250,000 bales higher as a larger Brazilian crop more than offsets a decline for Sudan. Consumption is about 400,000 bales lower as lower consumption in India, Indonesia, and some smaller countries more than offsets Vietnam’s increase. Ending stocks for 2017/18 are nearly 600,000 bales lower in total this month as reductions for Brazil, Sudan, the United States, and Australia more than offset an increase for Pakistan.

It is worth remembering that local market prices can be dramatically influenced by small changes in regional supply or demand and the vagaries of supply chain logistics. Added to which, for US grains there is heightened anxiety regarding tariffs: they are expected to be the main target of the Chinese retaliation.

Here is the price of US Wheat since 2007:-

Wheat since 2007

Source: Trading Economics

Crisis? What crisis? It is still near to multi-year lows, although above the nadir of the financial crisis in 2009.

The broader CRB Index shows a more pronounced recovery, it has been rising since the beginning of 2016:-

CRB Index since 2007 Core Commodity Indexes

Source: Reuters, Core Commodity Indexes

Neither of these charts suggest that price momentum is that robust.

Another (and, perhaps, more global) measure of economic activity is the Baltic Dry Freight Index. This chart shows a very different reaction to the synchronised increase in world economic growth:-

Baltic Dry Index - Quandl since 2007

Source: Quandl

In absolute terms the index has more than tripled in price from the 2016 low, nonetheless, it is still in the lower half of the range of the past decade.

Global economic growth may have encouraged a rebound in Copper, another industrial bellwether, but it appears to have lost some momentum of late:-

Copper Since 2007

Source: Trading Economics

Brent Crude Oil also appears to be benefitting from the increase in economic activity. It has doubled from its low of two years ago. The US rig count has increased in response but at 800 it remains at half the level of a few years ago:-

Brent Oil Since 2007

Source: Trading Economics

US Natural Gas, which might still manage an upward price spike on account of the unseasonably cold weather in the US, provides a less compelling argument:-

US Nat Gas Since 2007

Source: Trading Economics

Commodity markets are clearly off their multi-year lows, but the strength of momentum looks mixed and, in grains and oil seeds, global supply and demand look fairly balanced. Cost push inflation may be a factor in certain markets, but, without price-pull demand, inflation pressures are likely to be short-lived. Late cycle increases in commodity prices are quite common, however, so we may experience a short-run stagflationary squeeze on incomes.

Conclusions and investment opportunities

When ever I write about commodities in a collective way, I remind readers that each market is unique, pretending they are homogenous is often misleading. The recent rise in Cocoa, after a two-year downtrend resulting from an increase in global supply, is a classic example. The time it takes to grow a Cocoa plant governs the length of the cycle. Similarly, the lead time for producing a new ship is a major factor in determining the length of the freight rate cycle. Nonetheless, at the risk of contradicting myself, what may keep a bid under commodity markets is the low level of capital investment which has been a hall-mark of the long, listless recovery from the great financial recession. I believe an economic downturn is likely and job losses will occur rapidly in response.  

I entitled this letter ‘Inflation or Employment’, these are the factors which will dominate Central Bank policy. Currently commentators view inflation as the greater concern, as Dr Hunt’s research indicates, but I believe those Central Bankers who can (by which I mean the Federal Reserve) will attempt to insure they have raised interest rates to a level from which they can be cut, rather than having to rely on ever more unorthodox monetary policies.

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Are we nearly there yet? Employment, interest rates and inflation

In the Long Run - small colour logo

Macro Letter – No 92 – 09-03-2018

Are we nearly there yet? Employment, interest rates and inflation

  • Rising interest rates and inflation are spooking financial markets
  • Unemployment data suggests that labour markets are tight
  • Central Banks will have to respond to a collapse in the three asset bubbles

There are two factors, above all others, which are spooking asset markets at present, inflation and interest rates. The former is impossible to measure with any degree of certainty – for inflation is in the eye of the beholder – and the latter is divergent depending on whether you look at the US or Japan – with Europe caught somewhere between the two extremes. In this Macro Letter I want to investigate the long term, demand-pull, inflation risk and consider what might happen if stocks, bonds and real estate all collapse in tandem.

It is reasonable to assume that US rates will rise this year, that UK rates might follow and that the ECB (probably) and BoJ (almost certainly) will remain on the side-lines. An additional worry for export oriented countries, such as Japan and Germany, is the protectionist agenda of the current US administration. If their exports collapse, GDP growth is likely to slow in its wake. The rhetoric of retaliation will be in the air.

For international asset markets, the prospect of higher US interest rates and protectionism, spells lower growth, weakness in employment and a lowering of demand-pull inflationary pressure. Although protectionism will cause prices of certain goods to rise – use that aluminium foil sparingly, baste instead – the overall effect on employment is likely to be swift.

Near-term impact

Whilst US bond yields rise, European bond yields may fail to follow, or even decline, if export growth collapses. Stocks in the US, by contrast, may be buoyed by tax cuts and the short-term windfall effect of tariff barriers. The high correlation between equity markets and the international nature of multinational corporations, means global stocks may remain levitated a while longer. The momentum of recent economic growth may lead to increased employment and higher wages in the near-term – and this might even spur demand for a while – but the spectre of inflation at the feast, will loom like a hawk.

Longer-term effects

But is inflation really going to be a structural problem? In an attempt to answer this we must delve into the murky waters of the employment data. As a starting point, at what juncture can we be confident that the US and other countries at or near to full-employment? Let us start by looking at the labour force participation rate. It is a difficult measure to interpret. As the table below shows, in the US and Japan the trend has been downward whilst the UK and the EU are hitting record highs:-

Labor_Force_Participation_Rates

Source: Trading Economics

One possible reason for this divergence between the EU and the US/Japan is that the upward trend in European labour participation has been, at least partially, the result of an inexorable reduction in the scope and scale of the social safety net throughout the region.

More generally, since the Great Recession of 2008/2009 a number of employment trends have been evident across most developed countries. Firstly, many people have moved from full-time to part-time employment. Others have switched from employment to self-employment. In both cases these trends have exerted downward pressure on earnings. What little growth in earnings there has been, has mainly emanated from the public sector, but rising government deficits make this source of wage growth unsustainable in the long run.

The Record of Meeting of the CAC and Federal Reserve Board of Governors – published last November, stated the following in relation to US employment:-

The data indicate that despite the drop in unemployment, there has not been an increase in the number of quality jobs—those that pay enough to cover expenses and enable workers to save for the future. The 2017 Scorecard reports that one in four jobs in the U.S. is in a low-wage occupation, which means that at the median salary, these jobs pay below the poverty threshold for a family of four. For the first time, the 2017 Scorecard includes a measure of income volatility that shows that one in five households has significant income fluctuations from month to month. The percentage varies by state, from a low of 14.7 percent of households in Virginia to a stunning 29.8 percent of households in Wyoming. In addition, 40 percent of those experiencing volatility reported struggling to pay their bills at least once in the last year because of these income fluctuations. These two factors contribute significantly to the fact that almost 37 percent of U.S. households, and 51 percent of households of color, live in the financial red zone of “liquid asset poverty.” This means that they do not have enough liquid savings to replace income at the poverty level for three months if their main source of income is disrupted, such as from job loss or illness. This level of financial insecurity has profound implications for the security of households, and for the overall economic growth of the nation.

Another trend that has been evident is the increase in the number of people no longer seeking employment. Setting aside those who, for health related reasons, have exited the employment pool, early retirement has been one of the main factors swelling the ranks of the previously employable. For this growing cohort, inflation never went away. In particular, inflation in healthcare has been one of the main sources of increases in the price level over the past decade.

At the opposite end of the working age spectrum, education is another factor which has reduced the participation rate. It has also exerted downward pressure on wages; as more students enrol in higher education in order to gain, hopefully, better paid employment, the increased supply of graduates insures that the economic value of a degree diminishes. Whilst a number of corporations have begun to offer apprenticeships or in-work degree qualifications, in order to address the skill gap between what is being taught and what these firms require from their employees, the overall impact of increased demand for higher education has been to reduce the participation rate.

For a detailed assessment of the situation in the US, this paper from the Kansas City Federal Reserve – Why Are Prime-Age Men Vanishing from the Labor Force? provides some additional and fascinating insights. Here is the author’s conclusion:-

Over the past two decades, the nonparticipation rate among primeage men rose from 8.2 percent to 11.4 percent. This article shows that the nonparticipation rate increased the most for men in the 25–34 age group and for men with a high school degree, some college, or an associate’s degree. In 1996, the most common situation prime-age men reported during their nonparticipation was a disability or illness, while the least common situation was retirement. While the share of primeage men reporting a disability or illness as their situation during nonparticipation declined by 2016, this share still accounted for nearly half of all nonparticipating prime-age men. This result is in line with Krueger’s (2016) finding, as many of these men with a disability or illness are likely suffering from daily pain and using prescription painkillers.

I argue that a decline in the demand for middle-skill workers accounts for most of the decline in participation among prime-age men. In addition, I find that the decline in participation is unlikely to reverse if current conditions hold. In 2016, the share of nonparticipating prime-age men who stayed out of the labor force in the subsequent month was 83.8 percent. Moreover, less than 15 percent of nonparticipating prime-age men reported that they wanted a job. Together, this evidence suggests nonparticipating prime-age men are less likely to return to the labor force at the moment.

The stark increase in prime-age men’s nonparticipation may be the result of a vicious cycle. Skills demanded in the labor market are rapidly changing, and automation has rendered the skills of many less-educated workers obsolete. This lack of job opportunities, in turn, may lead to depression and illness among displaced workers, and these health conditions may become further barriers to their employment. Ending this vicious cycle—and avoiding further increases in the nonparticipation rate among prime-age men—may require equipping workers with the new skills employers are demanding in the face of rapid technological advancements.

For an even more nuanced interpretation of the disconnect between corporate profits and worker compensation this essay by Jonathan Tepper of Varient Perception – Why American Workers Aren’t Getting A Raise: An Economic Detective Story – is even more compelling:-

Rising industrial concentration is a powerful reason why profits don’t mean revert and a powerful explanation for the imbalance between corporations and workers. Workers in many industries have fewer choices of employer, and when industries are monopolists or oligopolists, they have significant market power versus their employees.

The role of high industrial concentration on inequality is now becoming clear from dozens recent academic studies. Work by The Economist found that over the fifteen-year period from 1997 to 2012 two-thirds of American industries were more concentrated in the hands of a few firms. In 2015, Jonathan Baker and Steven Salop found that “market power contributes to the development and perpetuation of inequality.”

One of the most comprehensive overviews available of increasing industrial concentration shows that we have seen a collapse in the number of publicly listed companies and a shift in power towards big companies. Gustavo Grullon, Yelena Larkin, and Roni Michaely have documented how despite a much larger economy, we have seen the number of listed firms fall by half, and many industries now have only a few big players. There is a strong and direct correlation between how few players there are in an industry and how high corporate profits are.

Tepper goes on to discuss monopolies and monopsonies. At the heart of the issue is the zombie company phenomenon. With interest rates at artificially low levels, companies which should have been liquidated have survived. Others have used their access to finance, gained from many years of negotiation with their bankers, to buy out their competitors. If interest rates were correctly priced this would not have been possible – these zombie corporations would have gone to the wall. I wrote a rather long two part essay on this subject in 2016 for the Cobden Centre – A history of Fractional Reserve Banking – or why interest rates are the most important influence on stock market valuations? This is about the long-run even by my standards but I commend it to those of you with an interest in economic history. Here is a brief quote from part 2:-

…This might seem incendiary but, let us assume that the rate of interest at which the UK government has been able to borrow is a mere 300bp below the rate it should have been for the last 322 years – around 4% rather than 7%. What does this mean for corporate financing?

There are two forces at work: a lower than “natural” risk free rate, which should make it possible for corporates to borrow more cheaply than under unfettered conditions. They can take on new projects which would be unprofitable under normal conditions, artificially prolonging economic booms. The other effect is to allow the government to crowd out private sector borrowing, especially during economic downturns, where government borrowing increases at the same time that corporate profitability suffers. The impact on corporate interest rates of these two effects is, to some extent, self-negating. In the long run, excessive government borrowing permanently reduces the economic capacity of the country, by the degree to which government investment is less economically productive than private investment.

To recap, more people are remaining in education, more people are working freelance or part-time and more people are choosing to retire early. The appreciation of the stock, bond and property markets has certainly helped those who are asset rich, choose to exit the ranks of the employable, but, I suspect, in many cases this is only because asset prices have been rising for the past decade. Pension annuity rates appear to have hit all-time lows, a reckoning for asset markets is overdue.

What happens come the next bust and beyond?

If inflation rises and Central Banks respond by raising interest rates, bond prices will fall and stocks will have difficulty avoiding the force of gravity. Once bond and stock markets fall, property prices are likely to follow, as the cost of financing mortgages increases. With all the major asset classes in decline, economic growth will slow and unemployment will rise. Meanwhile, the need to work, in order to supplement the reduction in income derived from a, no longer appreciating, pool of assets, will increase, putting downward pressure on average earnings. Here is the most recent wage, inflation and real wage data. For France, Germany and the UK, wages continue to lag behind prices. A 2% inflation target is all very well, just so long as wages can keep up:-

Wages_and_Inflation

Source: Trading Economics

The first place where this trend in lower earnings will become evident is likely to be among freelance and part-time workers – at least they will still have employment. The next casualty will be the fully employed. Corporations will lay-off staff as corporate profit warnings force their hands. Governments will be beseeched to create jobs and, regardless of whether the inflation rate is still rising or not, Central Banks will be implored, cajoled (whatever it takes) to cut interest rates and renew their quest to purchase every asset under the sun.

Wage deflation will, of course, continue, harming those who have no alternative but to work; those who lack sufficient unearned income to survive. Government debt will accelerate, Central Bank balance sheets will balloon and asset prices will eventually recover. Bond yields may even reach new record lows, prompting assets to flow into stocks – the ones Central Banks have not yet purchased as part of their QQE programmes – despite their inflated valuations. Corporate executives will no doubt take the view that interest rates are artificially low and conclude that they can best serve their shareholders by buying back their own stock – accompanied by the occasional special dividend to avoid accusations for impropriety.

As economic growth takes a nose drive, inflation will moderate, providing justification for the pre-emptive rate cutting and balance sheet expanding actions of the Central Banks. Articles will begin to appear, in esteemed journals, talking of a new era of low economic trend growth. Finally, after several years of QE, QQE and whatever the stage beyond that may be – helicopter money anyone? – the world economy will start to grow more rapidly and the labour force participation rate, increase once more. Inflation will start to rise, interest rates will be tightened, bond yields, increase. At this point, stocks will fall and the next downward leg of the economic cycle will have to be averted by renewed QQE and fiscal stimulus. If this is reminiscent of a scene from Groundhog Day, I regret to inform you, it is.

There will be a point at which the financialisation of the global economy and the nationalisation of the stock market can no longer deliver the markets from the deleterious curse of debt, but, sadly, I do not believe that moment has yet arrived. Are we nearly there yet? Not even close.

 

What are the bond markets telling us about inflation, recession and the path of central bank policy?

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Macro Letter – No 41 – 11-09-2015

What are the bond markets telling us about inflation, recession and the path of central bank policy?

  • Since January US Government bond yields have risen across the yield curve
  • Corporate bond yields have risen more rapidly as stock markets have retreated
  • China, Canada and Mexico have seen their currencies weaken against the US$

For several years some commentators have been concerned that the Federal Reserve is behind the curve and needs to tighten interest rates before inflation returns. To date, inflation – by which I refer narrowly to CPI – has remained subdued. The recent recovery in the US economy and improvement in the condition of the labour market has seen expectations of rate increases grow and bond market yields have risen in response. In this letter I want to examine whether the rise in yields is in expectation of a Fed rate increase, fears about the return of inflation or the potential onset of a recession for which the Federal Reserve and its acolytes around the globe are ill-equipped to manage.

Below is a table showing the change in yields since the beginning of February. Moody Baa rating is the lowest investment grade bond. Whilst the widening of spreads is consistent with the general increase in T-Bond yields, the yield on Baa bonds has risen by 30bp more than Moody BB – High Yield, sub-investment grade. This could be the beginning of an institutional reallocation of risk away from the corporate sector.

Bond       Spread over T-Bonds    
08-Sep 02-Feb Change 08-Sep 02-Feb Change
10yr US T-Bond 2.19 1.65 0.54 N/A N/A N/A
Baa Corporate 5.28 4.29 0.99 3.09 2.64 0.45
BB Corporate 5.55 4.86 0.69 3.36 3.21 0.15

 

Source: Ycharts and Investing.com

The chart below shows the evolution of Baa bond yields over the last two years:-

FRED Baa Corporate bond yield 2013-2015

Source: St Louis Federal Reserve

The increase in the cost of financing for the corporate sector is slight but the trend, especially since May, is clear.

Another measure of the state of the economy is the breakeven expected inflation rate. This metric is derived from the differential between 10-Year Treasury Constant Maturity Securities and 10-Year Treasury Inflation-Indexed Constant Maturity Securities:-

FRED Breakeven Inflation rate 2007-2015

Source: St Louis Federal Reserve

By this measure inflation expectations are near their lowest levels since 2010. It looks as if the bond markets are doing the Federal Reserve’s work for it. Added to which the July minutes of the FOMC stated:-

The risks to the forecast for real GDP and inflation were seen as tilted to the downside, reflecting the staff’s assessment that neither monetary nor fiscal policy was well positioned to help the economy withstand substantial adverse shocks.

This is hardly hiking rhetoric.

The International perspective

The table below looks at the largest importers into the US and their contribution to the US trade deficit as at December 2014:-

Country/Region Imports Deficit
China $467bln $343bln
EU $418bln $142bln
Canada $348bln $35bln
Mexico $294bln $54bln
Japan $134bln $68bln

Source: US Census Bureau

The TWI US$ Index shows a rather different picture to the US$ Index chart I posted last month, it has strengthened against its major trading partners steadily since it lows in July 2011; after a brief correction, during the first half of 2015, the trend has been re-established and shows no signs of abating:-

FRED USD TWI 2008-2015

Source: St Louis Federal Reserve

A closer inspection of the performance of the Loonie (CAD) and Peso (MXN) reveals an additional source of disinflation:-

CAD and MXN vs USD 2yr

Source: Yahoo Finance

Focus Economics – After dismal performance in May, exports and imports increase in June – investigates the bifurcated impact of lower oil prices and a weaker currency on the prospects for the Mexican economy:-

Looking at the headline numbers, exports increased 1.2% year-on-year in June, which pushed overseas sales to USD 33.8 billion. The monthly expansion contrasted the dismal 8.8% contraction registered in May. June’s expansion stemmed mainly from a solid increase in non-oil exports (+6.8% yoy). Conversely, oil exports registered another bleak plunge (-41.0% yoy).

Should the U.S. economy continue to recover and the Mexican peso weaken, growth in Mexico’s overseas sales is likely to continue improving in the coming months.

Mexico’s gains have to some extent been at the expense of Canada as this August 2015 article from the Fraser Institute – Canada faces increased competition in U.S. market – explains:-

There are several possible explanations of the cessation of real export growth to the U.S. One is the slow growth of the U.S. economy over much of the period from 2000-2014, particularly during and following the Great Recession of 2008. Slower real growth of U.S. incomes can be expected to reduce the growth of demand for all types of goods including imports from Canada.

A second possible explanation is the appreciation of the Canadian dollar over much of the time period. For example, the Canadian dollar increased from an all-time low value of US$.6179 on Jan. 21, 2002 to an all-time high value of US$1.1030 on Nov. 7, 2007. It then depreciated modestly to a value of US$.9414 by Jan. 1, 2014.

A third possible explanation is the higher costs to shippers (and ultimately to U.S. importers) associated with tighter border security procedures implemented by U.S. authorities after 9/11.

Perhaps a more troubling and longer-lasting explanation is Canada’s loss of U.S. market share to rival exporters. For example, Canada’s share of total U.S. imports of motor vehicles and parts decreased by almost 12 percentage points from 2000 through 2013, while Mexico’s share increased by eight percentage points. Canada lost market share (particularly to China) in electrical machinery and even in its traditionally strong wood and paper products sectors.

There is fundamentally only one robust way for Canadian exporters to reverse the recent trend of market share loss to rivals. Namely, Canadian manufacturers must improve upon their very disappointing productivity performance over the past few decades—both absolutely and relatively to producers in other countries. Labour productivity in Canada grew by only 1.4 per cent annually over the period 1980-2011. By contrast, it grew at a 2.2 per cent annual rate in the U.S. Even worse, multifactor productivity—basically a measure of technological change in an economy—did not grow at all over that period in Canada.

With an election due on 19th October, the Canadian election campaign is focused on the weakness of the domestic economy and measures to stimulate growth. While energy prices struggle to rise, non-energy exports are likely to be a policy priority. After rate cuts in January and July, the Bank of Canada left rates unchanged this week, but with an election looming this is hardly a surprise.

China, as I mentioned in my last post here, unpegged its currency last month. Official economic forecasts remain robust but, as economic consultants Fathom Consulting pointed out in this July article for Thomson Reuters – Alpha Now – China a tale of two economies – there are many signs of a slowing of economic activity, except in the data:-

With its usual efficiency, China’s National Bureau of Statistics released its 2015 Q2 growth estimate earlier this week. Reportedly, GDP rose by 7.0% in the four quarters to Q2. We remain sceptical about the accuracy of China’s GDP data, and the speed with which they are compiled. Our own measure of economic activity — the China Momentum Indicator — suggests the current pace of growth is nearer 3.0%.

…although policymakers are reluctant to admit that China has slowed dramatically, the recent onslaught of measures aimed at stimulating the economy surely hints at their discomfort. While these measures may temporarily alleviate the downward pressure, they do very little to resolve China’s long standing problems of excess capacity, non-performing loans and perennially weak household consumption.

Accordingly, as China tries out the full range of its policy levers, we believe that eventually it will resort to exchange rate depreciation. Its recent heavy-handed intervention in the domestic stock market has demonstrated afresh its disregard for financial reform.

The chart below is the Fathom Consulting – China Momentum Indicator – note the increasing divergence with official GDP data:-

Fathom_Consulting_China_Momentum_Indicator

Source: Fathom Consulting/Thomson Reuters

A comparison between international government bonds also provides support for those who argue Fed policy should remain on hold:-

Government Bonds 2yr 2yr Change 5yr 5yr Change 10yr 10yr Change 30yr 30yr Change
08-Sep 02-Feb 08-Sep 02-Feb 08-Sep 02-Feb 08-Sep 02-Feb
US 0.74 0.47 0.27 1.52 1.17 0.35 2.19 1.65 0.54 2.96 2.23 0.73
Canada 0.45 0.39 0.06 0.79 0.61 0.18 1.48 1.25 0.23 2.24 1.83 0.41
Mexico 5.01* 4.13* 0.88 5.29 4.89 0.4 6.15 5.41 0.74 6.81 6.1 0.71
Germany -0.22 -0.19 -0.03 0.05 -0.04 0.09 0.68 0.32 0.36 1.44 0.9 0.54
Japan 0.02 0.04 -0.02 0.07 0.09 -0.02 0.37 0.34 0.03 1.41 1.31 0.1
China 2.59 3.22 -0.63 3.2 3.45 -0.25 3.37 3.53 -0.16 3.88 4.04 -0.16

*Mexico 3yr Bonds

Source: Investing.com

Canada and Mexico have both witnessed rising yields as their currencies declined, whilst Germany (a surrogate for the EU) and Japan have seen a marginal fall in shorter maturities but an increase for maturities of 10 years or more. China, with a still slowing economy and aided by PBoC policy, has lower yields across all maturities. Mexican inflation – the highest of these trading partners – was last recorded at 2.59% whilst core inflation was 2.31%. The 2yr/10yr curve for both Mexico and Canada, at just over 100bps, is flatter than the US at 145bp. The Chinese curve is flatter still.

A final, if somewhat tangential, article which provides evidence of a lack of inflationary pressure comes from this fascinating post by Stephen Duneier of Bija Advisors – Doctoring Deflation – in which he looks at the crisis in healthcare and predicts that computer power will radically reduce costs globally:-

The future of medical diagnosis is about to experience a radical shift. The same pocket sized computer which now holds the power to beat any human being at the game of chess, will soon be used to diagnose medical ailments and prescribe actions to follow, far more cheaply and with a whole lot more accuracy.

Conclusions and investment opportunities

The bond yield curves of America’s main import partners have steepened in train with the US – Canada being an exception – whilst stock markets are unchanged or lower over the same period – February to September. Corporate bond spreads have widened, especially the bottom of the investment grade category. Corporate earnings have exceeded expectations, as they so often do – see this paper by Jim Liew et al of John Hopkins for more on this topic – but by a negligible margin.

The FOMC has already expressed concern about the momentum of GDP growth, commodity prices remain under pressure, China has unpegged and the US$ TWI has reached new highs. This suggests to me, that inflation is not a risk, disinflationary forces are growing – especially driven by the commodity sector. Major central banks are unlikely to tighten but corporate bond yields may rise further.

Currencies

Remain long US$ especially against resource based currencies, but be careful of current account surplus countries which may see flight to quality flows in the event of “risk off” panic.

Stocks

At the risk of stating what any “value” investor should always look for, seek out firms with strong cash-flow, low leverage, earnings growth and comfortable dividend cover. In addition, in the current environment, avoid commodity sensitive stocks, especially in oil, coal, iron and steel.

Bonds

US T-Bonds will benefit from a strengthening US$, if the FOMC delay tightening this will favour shorter maturities. An early FOMC tightening, after initial weakness, will be a catalyst for capital repatriation – US T-Bonds will fare better in this scenario too. Bunds and JGBs are likely to witness similar reactions but, longer term, both their currencies and yields are less attractive.