Friday, March 23, 2018

Market Phishing For Inflation Phools?

Desmond Lachman of the American Enterprise Institute wrote a comment, Behind the curve at the Federal Reserve:
History will not judge Janet Yellen’s Federal Reserve kindly should U.S. inflation accelerate in the months ahead as is all too likely to occur. At a time when there was every reason last year for the Fed to be accelerating the pace at which it was raising interest rates, Janet Yellen’s Fed effectively sat on its hands. As a result, Jerome Powell has inherited a Fed that is substantially behind the curve in terms of its efforts to prevent a return in U.S. inflation.

One reason that in 2017 Mrs. Yellen’s Fed should have been adjusting upward its path of planned interest rate increases was because of the substantial increase in household wealth during the year. Since the start of 2017, U.S. equity prices increased by 25 percent while U.S. home prices increased by 6 percent. This constitutes approximately a US$8 trillion increase in household wealth or the equivalent of around 40 percent of U.S. GDP. On the assumption that households are likely to spend 4 cents on every dollar of increased wealth as the Fed itself estimates, this alone constitutes a boost to U.S. aggregate demand of more than 1 ½ percent of GDP.

A second reason why in 2017 the Fed should have been more aggressive was because of the U.S. dollar’s sharp fall. Since the start of 2017, the U.S. dollar is estimated to have depreciated by around 10 percent. Past experience with dollar depreciations of that order of magnitude would suggest that over the next year or two the weaker dollar could boost U.S. aggregate demand by more than 1 percent of GDP. In addition, it could increase U.S. core inflation directly by around ¼ percent.

Yet another reason why the Fed should have adjusted upward its path of interest rate increases was to neutralize the effect of a more expansionary U.S. fiscal policy. Over the past year, not only did President Trump succeed in securing Congressional passage of an unfunded tax cut that would increase the U.S. budget deficit by around US$1 ½ trillion over the next decade, he also went along with Congress’ US$300 billion increase in public expenditures over the next two years.

According to IMF estimates, the net effect of the Trump tax cut and public spending increases will be to boost U.S. aggregate demand by around ¾ percent of GDP in both 2018 and 2019. That alone should have been reason for Mrs. Yellen’s Fed to have been more aggressive than it was in its interest rate policy.

Mrs. Yellen’s failure to pursue a more aggressive monetary policy certainly must heighten the risk that the U.S. economy will soon overheat. At a time that U.S. unemployment is already down to 4 percent, the U.S. economy is now being boosted by extraordinarily easy financial conditions as evidenced by still very low interest rates, buoyant equity prices, and a weak dollar. In addition, at this late stage in the economic cycle, it is receiving additional support from the Trump fiscal stimulus.

It should be little wonder then that the U.S. economy is now humming along at an unsustainable 3 percent pace, which is much faster than its potential growth rate. It would also seem that it is only a matter of time before the U.S. labor market tightens further and inflation starts rising. As if to underline this point, one would think that it should be of concern to the Fed that five-year inflation expectations as measured in the bond market are already significantly above the Fed’s 2 percent inflation target.

There will be those who will be advising Jerome Powell to let the economy run faster and to wait until inflation starts to accelerate before making any upward to its interest rate path. Mr. Powell would do well to disregard that counsel. Rather, he should be mindful that monetary policy operates with long and variable lags and that once the inflation genie is out of the bottle it is difficult to get it back in.

He should also be mindful of the likelihood that any further sign that the Fed is being too easy on inflation will invite the wrath of the bond market vigilantes. At a time when there are asset and credit market bubbles around the globe that are waiting on a trigger to burst, the last thing that Mr. Powell needs is a disorderly rout in the U.S. bond market.
I like Desmond Lachman of the American Enterprise Institute, think he's a first-rate economist who writes and covers markets and the economy extremely well.

The only problem is I don't agree with him, hence the title of this comment which is a word play on a book I'm currently reading, Phishing For Phools. Written by two Nobel-prize winning economists, George A, Akerlof and Robert J. Shiller, this is a very readable great little book which is all about the economics of manipulation and deception.

In fact, read the PDF introduction of this book here just to get a flavor for the subject they cover. There is a passage in the intro I particularly Ioved on the alleged optimality of free-market equilibrium:
There is a perhaps surprising result that, indisputably, lies at the very heart of economics. Back in 1776, the father of the field, Adam Smith, in The Wealth of Nations, wrote that, with free markets, as if “by an invisible hand ... [each person] pursuing his own interest” also promotes the general good.

It took a bit more than a century for Smith’s statement to be precisely understood. According to the modern version, commonly taught even in introductory economics, a competitive free-market equilibrium is “Pareto optimal.” That means that once such an economy is in equilibrium, it is impossible to improve the economic welfare of everyone. Any interference will make someone worse off. For graduate students, this conclusion is presented as a mathematical theorem of some elegance—elevating the notion of free-market optimality into a high scientific achievement.

The theory, of course, recognizes some factors that might blemish such an equilibrium of free markets. These factors include economic activities of one person that directly affect another (called “externalities”); they also include bad distributions of income. Thus it is common for economists to believe that, those two blemishes aside, only a fool would interfere with the workings of free markets. And, of course, economists have also long recognized that firms that are large in size may keep markets from being wholly competitive.

But that conclusion ignores the considerations that are central to this book. When there are completely free markets, there is not only freedom to choose; there is also freedom to phish. It will still be true, following Adam Smith, that the equilibrium will be optimal. But it will be an equilibrium that is optimal, not in terms of what we really want; but an equilibrium that is optimal, instead, in terms of our monkey-on-our-shoulder tastes. And that, for ourselves, as for the monkeys, will lead to manifold problems.

Standard economics has ignored this difference because most economists have thought that, for the most part, people do know what they want. That means that there is nothing much to be gained from examining the differences between what we really want and what those monkeys on our shoulders are, instead, telling us. But that ignores the field of psychology, which is, largely, about the effects of those monkeys.

As exceptions, behavioral economists, especially for the past forty years, have been studying the relationship between psychology and economics. That means that they have brought the consequences of the monkeys to center stage. But, curiously, to the best of our knowledge, they have never interpreted their results in the context of Adam Smith’s fundamental idea regarding the invisible hand. Perhaps it was just too obvious. Only a child, or an idiot, would make an observation like that and expect anyone to notice. But we will see that this observation, simple as it may be, has real consequences. Especially so, because, as Adam Smith might say, as if by an invisible hand, others out of their own self-interest will satisfy those monkey-on-the-shoulder tastes.

Thus we may be making only a small tweak to the usual economics (by noticing the difference between optimality in terms of our real tastes and optimality in terms of our monkey-on-the-shoulder tastes). But that small tweak for economics makes a great difference to our lives. It’s a major reason why just letting people be Free to Choose — which Milton and Rose Friedman, for example, consider the sine qua non of good public policy — leads to serious economic problems.
What does this book and passage have to do with what Desmond Lachman covered in his comment above on the Fed being behind the inflation curve? Is Lachman trying to deceive us?

Of course not but I believe the market is phishing for inflation phools. Lachman, the Maestro, and a few hedge fund gurus like Paul Tudor Jones, Ken Griffin, Paul Singer, and others warning of inflation have completely misunderstood the ongoing inflation disconnect because they don't understand the deflationary structural factors weighing down the economy (or aren't willing to discuss them publicly).

Last September, I wrote a comment on why I still fear deflation is headed to America where I brought up seven 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. Lots of discussion how more and more people are leaving the ranks of long-term unemployed and re-entering the workforce but in reality, these are just young people who couldn't find work after the 2008 crisis hit and are now only catching up. Hysterisis (long-term structural unemployment) remains a big problem for the US and all developed economies.
  2. Demographic time bomb: A rapidly aging population means a lot more older people with little savings, living longer and spending less. Meanwhile, the younger Millenials are more frugal and better savers which they need to be to meet their retirement needs.
  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. In essence, too much private and public debt constrains long-term growth.
  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. This means rates will stay lower for a lot longer.
  6. Globalization: Capital is free to move around the world in search of better opportunties but labor isn't. Offshoring manufacturing and service sector jobs to countries with lower wages increases corporate profits but exacerbates inequality.
  7. 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 seven structural factors I keep referring to when I warn investors to temper their growth forecasts and to prepare for a long bout of debt deflation.

It's important to differentiate between structural (long-term) factors and cyclical (short-term) factors when discussing inflation trends. As I've repeatedly stated, the decline in the US dollar last year was a cyclical inflationary headwind because it will temporarily raise US import prices this year and raise US core inflation which seems tame but is rising fast (click on image):


Now, here is where I want you to pay close attention because many investors are currently positioned for the wrong type of inflation and they will feel the pain in the second half of the year as the US and global economy slow.

Importantly, while core inflation is set to accelerate which might cause the Fed to overshoot and hike rates more than anticipated, headline inflation will continue declining in the coming months as global leading indicators decelerate from peak levels.

On Thursday, I listened to François Trahan and Michael Kantrowitz of Cornerstone Macro where they painstakingly went over The Big Inflation Trap of 2018.

Now, keep in mind, after leaving BCA Research in 2000 to join the Caisse, I was working in a small team which was literally in charge of reading external research from brokers and independent firms and filtering the very best ideas to the Caisse's senior portfolio managers. I read everything and still read tons of market related sites to learn and try to get a grasp on what's going on.

When I tell you François Trahan and Michael Kantrowitz killed it yesterday, they really killed it, to the point where I emailed François late last night after viewing the replay to tell him this was their best presentation ever, if people don't walk away really thinking hard about The Big Inflation Trap of 2018, then it's not François or Michael's fault.

If you ever wondered why top institutions pay big money to read research insights from Cornerstone Macro then stop and ask to listen to this presentation and pay very close attention. It's truly worth an hour of your time.

François is sick with the flu but he was kind enough to allow me to share a couple of charts with my readers. There were so many of them so it was hard to choose and I still want you to take the time to listen to their entire presentation (if your company desn't subscribe to Cornerstone Macro, make sure you do so, it's well worth it).

Anyway, François and Michael began by explaining why we are now entering a different phase of the market (click on image, do not redistribute or you will be prosecuted):


The focus of their conference call was the slide below, namely, past peak leading indicators, it's not uncommon to see headline inflation wane while core inflation picks up (click on image, do not redistribute or you will be prosecuted):


And it's the pickup in core inflation which will complicate the backdrop because this is the measure the Fed and investors pay attention to (click on image, do not redistribute or you will be prosecuted):


The problem is investors are positioned for the wrong type of inflation, namely, headline not core inflation (click on image, do not redistribute or you will be prosecuted):


I've shared more than enough, make sure you watch the replay of The Big Inflation Trap of 2018 where François Trahan and Michael Kantrowitz do a masterful job in explaining how core and headline inflation move in opposite directions after leading indicators peak and what this means for your portfolio and what risk lie ahead.

You'll recall François Trahan helped me write my Outlook 2018: Return to Stability, where we explained why it's important to shift to a more defensive stance this year. And this despite the real threat of a trade war going forward (still not convinced it will happen but watching Trump surround himself with hawks makes me nervous).

Another thing I can share with you is François still thinks the yield curve is the most important indicator and it will likely invert over the next year as short rates remain high but long rates decline fast as global PMIs decline. If the Fed hikes too aggressively, he sees a real risk of another recession over the next year or year and a half.

In terms of where to invest, François still likes US long bonds (TLT), the US dollar (UUP) and is positioned more defensively in equities focusing on stable sectors like healthcare (XLV) and consumer staples (XLP) and interest-rate sensitive sectors like utilities (XLU), telecoms (IYZ) and REITs (IYR).

Given his defensive stance, François is underweight cyclicals like energy (XLE), financials (XLF), metals and mining (XME) and industrials (XLI). 

I'm going to go a step further in this comment and tell you I'm short tech (XLK) and semiconductors (SMH) and would steer clear of value traps like oil service stocks (OIH) which remain cheap despite the rise in oil prices (click on image):



I know, some energy stocks are really cheap and are due for a nice bounce but given my long-term inflation views, they will remain cheap for a very long time. Be careful of inflation and value traps!

What else? Both large (IBB) and small (XBI) biotech shares continue to do well but these high beta stocks are also toppish and I would proceed with extreme caution (click on images):




Don't get me wrong, I still see opportunities in biotech and love trading small biotech shares but I'm increasingly nimble, not overstaying my welcome, paying close attention every day to what is moving up and down on my watch list which doesn't just consist of biotechs (click on images):




What else? As I recently shared, I remain short Facebook (FB) / long Twitter (TWTR) as a pairs trade, I'm outright short Micron Technology (MU), think it's headed back to $40 a share or even lower, and I'm short US Steel (X) and Freeport-McMoran (FCX) and wouldn't touch any metal and mining or energy share with a ten foot pole, even for a bounce.

I'm also short Dow high-flyer Boeing (BA) which has defied my wildest predictions when I wrote about its huge pension gaffe a few months ago, rising to new highs before getting clobbered recently (click on image):



In fact, this may be the biggest short the market has to offer over the next year or two so pay attention if you're still bullish on Boeing (lighten up and take some profits).

My biggest LONG? That's easy, on a risk-adjusted basis, I continue to love US long bonds (TLT) over the next year or two (click on image):


As far as the overall market (SPY), it's been a terrible end of the week and we shall see what next week brings:





We'll see what happens next week but one analyst who called the correction now sees a bear market starting within a year:
The stock strategist who predicted the S&P 500's drop earlier this year now expects a big market decline within 12 months.

Barry Bannister, Stifel's head of institutional equity strategy, is telling clients to prepare for a bear market and buy defensive stocks that perform better during periods of market turmoil.

"Our models for the S&P 500 point to minimal price upside in 2018 and a bear market (-20%) in the coming year. What matters for investors is that any decline is likely to be unusually rapid and occur as a result of P/E compression, resulting from policy risks not weak GDP," Bannister wrote in a note to clients entitled "The Fed's 'forced error': It's time to start moving to more defensive positions."

Bannister said on Jan. 26, the day of the S&P's record high, that stocks will correct at least 5 percent this quarter as the Federal Reserve and other central banks tighten monetary policy. The S&P 500 subsequently dropped 10 percent through early February.

The strategist is still concerned about monetary policy. The Federal Reserve raised the benchmark funds rate Wednesday by 25 basis points to 1.75 percent. It was the sixth rate hike since December 2015.

In his note Wednesday, Bannister said the Fed's outlook for the economy points to more aggressive rate hikes.

"We're concerned the Fed's 2019-20 view grew more hawkish," he wrote. "We now expect deflationary policy errors to develop in 2018 to early 2019."

As a result, the strategist recommends investors buy stocks in "defensive" areas such as utilities, consumer household products and food companies.

Bannister reaffirmed his 2,800 S&P 500 price target, representing 3 percent upside to Wednesday's close. He cautioned the forecast may change on any sign of a sudden "break down" in the market.
Pretty much what François Trahan and I stated at the beginning of the year. The last correction didn't turn into something worse but the second half of the year will be challenging, that much you can count on.

A potential full-blown trade war with China will only add fuel to the fire which is why top economists are sounding the alarm, concerned about escalating tensions.

What else? I think I've rambled on enough here. I'm tired and remind all of you that it takes a lot of time and effort to write these comments, so if you take the time to read them and like my blog, take the time to donate and/ or subscribe on the right-hand side under my picture. 

I'm not phishing for blog phools, I'm asking people to do the right thing and donate to support this blog because let's be honest, there's nobody out there crazy enough to provide you with free great daily insights on pensions and markets. 

In fact, there are many financial blogs but there is no blog on earth which covers pensions and investments with the breadth and depth that I do. 

Lastly, take the time to listen to the latest MacroVoices podcast with Jeffrey Snider here and you can view the slides he discusses here. Great discussion, listen to Snider, he really understands the significance of the yield curve. You can also watch it here.

Below, Shawn Cruz, TD Ameritrade manager of trader strategy, discusses buying opportunities as the market sells off into the close.

How come they're always discussing "buying opportunities" on television and not a peep about shorting opportunities? I guess they're phishing for phools to unload their crap on. Be careful!

No comments:

Post a Comment