The intention of this article is to examine the current economic environment as well as the future outlook in terms of inflation or deflation, and then suggest implications that would be imposed on the various assets classes. My conclusion is that we are in an inflationary environment, albeit one of low inflation (or disinflation). The threat of deflation looms, but so too does the threat of a significant increase in inflation. I believe the next year will foretell what can be expected over the next decade in terms of inflation or deflation and accordingly the performance of various asset classes. As of writing I believe there to be a higher probability of increased future inflation, rather than disinflation or deflation, and that commodities will outperform both equities and bonds.
One can measure inflation through a variety of ways; through asset prices such as commodities and real estate or through more conventional measures such as CPI, PPI, and PCE. Interestingly enough, all the above mentioned indicators are currently trending up and suggest that inflation is still taking place.
In the past I have considered the weakness in precious metals and the CRB as being indicative of a deflationary environment, but upon further reflection I believe that to be incorrect.
If one looks at precious metals, they are still in a long term uptrend. While the trend has been down for the past two years and many shorter term uptrends have been broken, the longest (and arguably most important) trend line is still up, as is the 200 week simple moving average. This suggests higher prices in the future. However a further move below recent lows could negate this outlook and be indicative of deflation.
Energy is also in a long term uptrend and is on the brink of putting in its first higher high since the series of lower highs began in 2008. Again, this is inflationary.
A consistent deflationary trend is that stocks become more correlated to commodities than bonds, as they did in the deflationary 1930s. Deflation did briefly emerge in 2008/2009 and the high correlation between stocks and commodities was experienced. Since 2012 however the correlation broke and equities have outperformed while commodities underperformed, a sign of deflationary threats subsiding. The recent outperformance of equities over commodities is typical of periods of low or disinflation. A return to higher levels of inflation however would likely see the two reverse courses. Until such an increase in inflation takes place the current outperformance of equities over commodities could persist.
I would like to draw attention to the CRB spot raw as Martin Pring recently did in the May 2013 CMT Symposium. As Pring illustrates, the CRB Spot Raw Index is a useful gauge of inflation as it is almost entirely composed of industrial commodities that are free from the effects of both speculation and weather, with cotton being the only exception. Accordingly, it can be considered a more "pure" indicator of inflation.
While having experienced sharp moves in both directions, the long term trend is definitively still up and illustrative that the secular bull in commodities (and accordingly inflation) is still taking place.
On a shorter term there is cause for concern as price action appears to be at a critical juncture. Many will note the head and shoulders that appears to be developing, with price currently resting above the neckline. It is important to note that a head and shoulders is not completed until the neckline is breached, and the majority of head and shoulders tops never in fact are completed, instead the pattern turns into a continuation pattern. If and when the neckline is breached, the head and shoulders is a very reliable topping pattern and would be suggestive of much lower prices and accordingly a deflationary environment. Until such a time however, the current trend remains up, and inflation can be expected.
In the last 150 years the average secular bull in commodities has been 19 years while the average secular bear has been 21 years. So in terms of duration, it is reasonable to expect the current secular bull market in commodities to continue. The current is about 13 years old, and while it doesn't necessarily have to approach the average, it is more probable that it will.
Housing has also recovered from 2009 levels and once again home prices appear to be climbing. Like any of the other mentioned indicators, it could turn down, but for now the trend is up and accordingly inflationary.
CPI, PPI, & PCE
The Consumer Price Index has trended very distinctly "up", and while perhaps somewhat more bumpy over the last year, continues to make new highs. Again, this is inflationary.
The Producer Price Index, while flat over the last two years, is still quite clearly in a long term uptrend. While potentially indicative of a future change in trend, most chartists will view the recent consolidation simply as a continuation pattern within a longer term uptrend. A move above 210 would suggest an inflationary environment still in play, while a move below 200 would imply that deflationary forces have prevailed.
And finally the Fed's preferred measure, Personal Consumption Expenditures excluding Food and Energy, continues to increase.
Any of the above can change, but for now all are in long term uptrends and suggestive of an inflationary environment.
The below chart is slightly outdated (January 2013), however is still very relevant. Note that the first secular bear market in yields was 29 years, and the second was 21 years. The current secular bear is 32 two years which is quite "long in the tooth" as Martin Pring suggested. Time will tell whether the recent volatility in yields is indeed marking a bottom, but I think it is reasonable to expect higher yields. This again would be indicative more of an inflationary than deflationary environment (yields don't typically rise in a deflationary environment).
In the same conference that Pring advocated the case for inflation, Robert Pretcher - while advocating that deflation is to be expected - provided the below chart. The Kondratieff cycle has been quite precise particularly in indicating expected turning points in long term bond yields.
(click to enlarge)Source
Do higher yields lead to inflation? Probably not - most would argue it is the other way around. However the Fed has made it very clear that it is adamant in obtaining its inflation targets and is not timid in invoking monetary policy to achieve them. How exactly this may play out I do not know. But with a fed that is unwavering in achieving inflation targets and the first signs emerging of a top on bonds, it appears that both inflation and higher yields can be expected.
A look at the ratio of the CRB to the 30-year bond ties together the two assets classes in terms of inflation. When this ratio rises it indicates inflation is increasing and vice versa. The below chart illustrates this over the past two decades. The trend channels aren't perfect and are inherently subjective. However if one takes a close look, each downtrend (less inflation) is characterized by lowers highs and lower lows, while each uptrend (higher inflation) has higher highs and higher lows. Just recently this ratio made its first higher high and can be perceived as an indication of increasing inflation. At this point it is a very nominal new high, however every first new "higher high" or "lower low" has always marked a change in trend previously.
A look at a longer term chart of this relationship indicates that we have begun a short term uptrend within an even longer term uptrend and accordingly can expect higher prices.
QE, Money Printing, and Helicopter Ben
If one looks at the monetary base they will notice that the Fed has been inflating at a 33% annual rate over the past 5 years. There has been an incredible amount of money created, hence the assertion of "helicopter Ben" (and the analogy that Bernanke is dropping money from helicopters).
However the majority of that money has yet to hit the economy and is being held in excess banks reserves.
So rather than lending out all that money and stimulating the economy, banks are instead simply collecting interest on it. In part due to the fact that money is not being spent the velocity of money has continued to collapse, hence minimal inflation despite massive QE.
I am not an expert on the above, but does it not beg the question of what happens if and when banks begin lending the trillions of dollars they are sitting on? Are consumers not incentivized to borrow more now due to the expectation of rising rates? Up until this year rates have continued to decline and there has been no incentive to borrow; borrowing costs (rates) have decreased for over 30 years. For the first time in over three decades consumers actually have an incentive toavoid further delay in borrowing. And wouldn't banks begin to lend more as rates go up as well?
Again, I am not proficient in this particular area and I am only speculating. QE has been around for a few years now and the majority of money continues to sit in banks. But for the first time rates appear to be reversing and I think this could be indicative of a sign of change.
What outcomes would challenge the inflation prediction?
While I believe there is a clear case for the expectation of inflation over deflation, I also think we are at a critical point and that deflation, while avoided thus far, is still possible. Developments that I believe would be indicative of a deflationary environment are as follows:
- Gold, Silver, and/or Copper fail to hold recent lows and continue lower
- The Head and Shoulders top confirms in the CRB spot raw
- CPI, PPI, and/or PCE revert back towards or below zero
- Bond yields fail to break out of their downtrend
- The velocity of money fails to bottom and turn, and banks simply continue sitting on hoards of cash
- The $USD continues to regain strength and appreciates. While there have been times that both the $USD and commodities have appreciated together, there remains a very strong long term inverse correlation.
The moderate and stable inflation that has been achieved in the last few years has played a key part in boosting equities: periods of low inflation (rather than deflation or hyperinflation) are historically quite strong for stocks. However if the Fed begins to actually achieve its inflation target, or even overshoots, things could change quickly
In the typical intermarket cycle bonds peak, followed by stocks and finally commodities. I think this is very much in line with the current environment. Bonds appear to have put in a top and prices have begun to rollover. Price action in equities remain strong despite seasonal, presidential, and secular cycles that are all bearish. The process of topping takes time however, and one can only define a top after the fact. I think given the state of bonds and commodities, and an expectation for higher inflation, it is reasonable to suggest that equities are topping or approaching a top.
Typically longer term secular cycles are characterized either by hard (commodities) or soft (paper, ie. stocks and bonds) assets appreciating, but not both. Since 2000 commodities have been in a secular bull market while stocks have been in a secular bear. I am of the opinion that these secular trends, while potentially mature, are not complete.
I believe an outcome similar to that of the 70's is possible. In the charts below one can note that both real and nominal stock market returns were negative throughout the 70s.
Unadjusted S&P 500 (SPY) returns 1958-1983
Particularly when inflation shot up (as measured by CPI) real returns plummeted. While the actual levels of inflation were quite a bit higher in the 70's, it was the unexpected rate of increases that caused damage to equities.
S&P 500 / CPI 1958-1983 (S&P 500 adjusted for inflation): S&P/CPI blue, CPI red
I am not suggesting that equities will necessarily follow the above script - we are still far from achieving any significant inflation and there are many other variables at play. But the above example does illustrate what happens when inflation turns up. Given the current secular bull market in commodities, secular bear in stocks, and potential top in bonds, I think this is a probable outcome.
There are also other consequences of higher rates on equities aside from inflation.
- If rates increase, bonds prices decrease, and investors suffer losses. Consequently equities may need to be sold to rebalance the average stock-bond portfolio.
- Many valuation methods incorporate a discount rate (the ten year yield being most common) when determining intrinsic value. An increase in the discount rate to just 3% from 1.5% can significantly decrease the intrinsic value of a stock as determined by many financial models.
I don't know the magnitude of effect the above two would have, but they certainly are not bullish for equities. One can make the case that people will move money from bonds to equities which may in fact support equities. While that may occur with some investors, the classic stock-bond allocation is well ingrained in most retail and institutional investors and I don't see many deviating from that.
In terms of investment implications I believe commodities will be the best investments. If however recent lows in precious metals are taken out, the head in shoulders in the CRB raw is triggered, or other signs of deflation emerge I will have much less conviction in this outlook. On a risk to reward basis, most of these "stops" are not far off, so one need not incur significant losses to be proven wrong in taking such a position.
On a risk to reward basis I think the contrary is the case with equities. Any sign of unexpected inflation and equities could come under significant pressure. Many will argue that equities are not expensive, but when compared to valuations in past secular bears, they indeed are quite high. Past secular bear markets have concluded with P/Es below 10, quite a bit lower than current levels (see P/E levels on bottom of chart below).
Historically secular bear markets in equities are also longer in duration than the current.
It is not my intention to suggest that there is no more upside in equities. Price action has been unequivocally strong and many have been early (as I have) in shorting the market. The current environment of low or disinflation can be supportive of equities. But while there may be more upside potential, I think the downside is much larger, particularly if inflation increases. Personally I am conflicted by strong price action but weak underlying fundamentals.
For those maintaining a long equity exposure I think those sectors that would benefit from inflation; energy and basic materials for example, may outperform while interest rate sensitive sectors such as utilities will underperform.
Mr. Bernanke and the Fed have been resolute in avoiding the deflation that took place throughout the 1930's, and have thus far been successful. In attempting to reach their inflation mandate is it not possible that they will in fact overshoot it? My guess is that this scenario is more likely than most expect and accordingly commodities will outperform both stocks and bonds.