What's Next, Inflation or Deflation?

Isn't the 'winner' clear by now? Given the behavior of the commodity market as of late it appears that there is considerable confusion out there. Let us revisit the inflation/deflation debate again and be careful not to overlook the evidence that has been in place for the last 6 months at least.

Before we look at the evidence being put forward by the market let us look at what Jim Grant has been saying in his latest issue of Grant's Interest Rate Observer. He makes the following points that we find very interesting.

Grant starts off by quoting the Bureau of Labor Statistics regarding the fact that May's 1.3% drop in the Consumer Price Index was the largest decline since April 1950:

It's a funny deflation, though. Deflation, to us, is too much debt chasing too little income. One symptom of deflation is falling prices. In a proper deflation, prices fall broadly, not narrowly. Seventeen months into the Great Depression, the CPI had fallen by a cumulative 8.1%. This time around, December 2000 to date, it's risen by 1.8%.

Grant then notes that although the steel industry is operating at a capacity utilization rate of below 50%, AK Steel was raising prices for the second time since May. "If deflation it be, it's deflation light," he says. Grant's colleague Ian McCulley points out, "If we are truly in a sustained deflation, price decreases will eventually spread." Jim notes:

It hasn't happened yet. Core CPI, which includes food and energy, is 1.8% higher than it was last year. Though its rate of rise has slowed (a year ago, it was rising at an annual pace of 2.3%, it continues to hold above the level to which it sunk during the great deflation scare of 2002-2003.

McCulley proceeds to observe that the Cleveland Fed has its own alternative measure of CPI and that by virtue of its calculation methodology, "it is thus a less volatile price index than headline CPI, and is currently rising by 2.4% year-over-year." Yet there is more. Many believe that with the economy operating so far below its potential output and with high levels of unemployment, inflation can't possibly happen. Grant says:

that would be a perfect theory, if not for the existence of so many countervailing facts. Bolivia recorded a monthly inflation rate as high as 120% in 1984-86 with unemployment rates in the mid- to upper teens. Bulgaria recorded a monthly inflation rate as high as 242.7% in 1997 with unemployment rates ranging between 12.5% and 13.7%. The greatest hyperinflation of them all was not the 1920-23 German affair but the Hungarian calamity of 1945-46, which occurred in a war-ravaged economy operating well below pre-1939 levels of resource utilization.

So Jim Grant sees inflation as a very real threat.......what are markets telling us? The commodity market is certainly looking decisively weak with the broad based CRB CCI Index (an equally weighted index of 17 commodities) having fallen by 9% since the start of June. However, that 9% fall only takes the CCI back to early May levels. Significant support lies at the 375 level which is still some 3.4% away from current levels. We can't expect commodities to go up in a straight line as much as we would like them to do so. I guess the question is how much "slack" do we give them.....when do we stand up and say we are wrong? I would say that if the CCI falls below 350 (which would be a lower low) then we would have to stand up and eat humble pie! From a confirmation perspective we believe that one cannot get too bearish on commodities (by looking at the price charts of commodities in isolation) in general unless there is bearish confirmation from industrial metals. From the graph below it does not appear that industrial metals are in trouble....albeit they have got considerable room to fall before confirming a bear trend.

From a "fundamental" perspective what are bond and currency markets telling us? In terms of inflation expectations (inflation being a primary driver of commodity prices), the bond market is suggesting that the "inflation" trade is still on. Inflation protected treasuries are outperforming non inflation protected treasuries not only in the US but also in other developed markets. Although TIP has underperformed IEF since mid June it is not enough to warrant us getting concerned about a change in "trend" of outperformance. Notice how much TIP outperformed IEF in May (inflation expectations from the bond market perspective). We think that the weakness we are currently observing is merely a correction of this. Note that the inflation protected developed (ex-US) market treasury ETF WIP did not dramatically outperform its non inflation protected counterpart BWX in May and it has managed to hold onto all its gains (for now that is). We believe that the bond market is more efficient than the commodity market and place more emphasis on the signals generated.

Is the world "growth" or economic recovery story still on? From our observations it still appears that way. Highly economically sensitive emerging markets are continuing to outperform developed markets. In addition small caps are outperforming large caps.....which confirms the action of emerging markets relative to developed markets.

Economic growth conditions also suit the performance of junk bonds and emerging market debt relative to US investment grade debt. We do note some weakness in high yield and emerging market debt relative to US Investment grade. However, for the time being at least it is not "out of the ordinary" behavior. So for the time being at least we will have to give the bullish trends below the benefit of the doubt.

It is always hard to hold your positions when the enemy is coming straight towards you (and is rather fierce looking)........like right now in the commodity market. However, one can take "comfort" that so far at least none of the bulls' lines of defense have been breached. Until the bulls' lines are breached (and we are confident they won't be) we remain commodity bulls......and take the heat like a seasoned trader!

Comments

[bindlepete:]

Hey, get real - the deflation cry is propaganda and based on a shallow segment of human requirements if they are requirements at all. Yes, new housing is down, but any significant change in the rest of consumer expenditures?

Medical is up, food is up unless you buy the lies and distortions of substituting hamburger for sirloin, education is up, books are up, credit is up, entertainment is up, and as more and more retailers go broke and the competition is reduced the rises in prices will steepen.

Will the Fed have the gut to claw back tghe flood of new money it created? Not in my dreams as the economy will continue to descend with job losses and if we are lucky flatten out at a new level of long term no growth, as currently measured, somewhere out in 2112.

The Fed/Bernanke and Summers live in a dream world of a return to the " prosperity " of 2003-2006 without any manufacturing/exports that the remainder of the world markets want or can afford.

Forget it and choose a new metric of growth if you think you need one.

Jul 09 02:12 PM

[Gregman2:]

Nice post. See: www.economist.com/blog...

Jul 09 02:35 PM

[Rob A:]

"we remain commodity bulls"

What does that mean, inflation is coming?

Jul 09 04:25 PM

[Whitslack:]

"Core CPI, which includes food and energy, is 1.8% higher than it was last year."

Doesn't core CPI *exclude* food and energy?

Jul 09 09:23 PM

[Thomas MacLeod:]

Yes the market is certainly pricing in high inflation which will lead to much higher commodity prices. Great article!

Jul 09 10:23 PM

[johnbee:]

I live in Europe and some prices are up here too but overall expenditure is down a lot (20%+) on food and gas and vacations etc. So it looks as if those price rises are companies chancing their luck trying to keep margins intact. Lets hope they go bust.


On Jul 09 02:12 PM bindlepete wrote:

> Hey, get real - the deflation cry is propaganda and based on a shallow
> segment of human requirements if they are requirements at all. Yes,
> new housing is down, but any significant change in the rest of consumer
> expenditures?
>
> Medical is up, food is up unless you buy the lies and distortions
> of substituting hamburger for sirloin, education is up, books are
> up, credit is up, entertainment is up, and as more and more retailers
> go broke and the competition is reduced the rises in prices will
> steepen.
>
> Will the Fed have the gut to claw back tghe flood of new money it
> created? Not in my dreams as the economy will continue to descend
> with job losses and if we are lucky flatten out at a new level of
> long term no growth, as currently measured, somewhere out in 2112.
>
>
> The Fed/Bernanke and Summers live in a dream world of a return to
> the " prosperity " of 2003-2006 without any manufacturing/exports
> that the remainder of the world markets want or can afford.
>
> Forget it and choose a new metric of growth if you think you need
> one.

Jul 10 05:26 AM