Inflation, Growth And The Stock Market

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Includes: SPY, TLT
by: Kevin Flynn, CFA

Summary

The constant presence of geo-political worries.

The recently revived inflation worry.

Neither are likely to derail the stock market.

The stock market may be overvalued, but the current batch of scares may only end up adding fuel to its rise.

There are always things to worry about in this world, from the Cuban Missile Crisis to the Tet Offensive to the fall of Saigon to well, you get my point. Some of the darker chances do indeed come to pass; thankfully most don't. That's by no means a vote for ignoring danger when it comes to your investments, you shouldn't. But for the stock market, most political dangers come and go quickly insofar as the worry level and its effect on prices. The Ukraine, Syria, Egypt - but also the Iraq wars, the Vietnam war, the Six Days War. Once the denizens of lower Wall Street determine that the danger does not extend to the trading floor itself, there is a tendency to return to the more pressing business of following the prevailing trend.

There is reason to be concerned about the fallout in the Middle East, but now that the story is no longer new, the stock market is more likely to take its cue from oil prices than headlines about violence. If oil keeps rising, it will mean trouble for stocks, but don't expect the market to throw in the towel right away. It didn't in 2008.

Another worry is inflation, for which there may or may not be reason. I don't think the outcome is preordained yet, but whatever it will be, the market isn't going to give in right away, despite the recent hue and cry from the inflationistas. Fellow SA writer The Inflation Trader already beat me to the punch by citing the latest missive from Grant Williams, but I too would point out a good read in which the latter paints his usual dire case for a bad ending to the monetary policies of the Federal Reserve and its fellow central banks around the world. Grant always puts up a lot of intriguing data and charts, though one ought to keep in mind that as a gold and precious metals man, every day that the peasants haven't started to put up guillotines in the town square and invited the local dignitaries is apt to come as something of a surprise to him.

Grant is one of many convinced that the monetary final days are upon us. The Inflation Trader characterized the outburst that accompanied the latest CPI data (a sudden jump to over 2% year-on-year inflation for the first time in years) as largely due to pundits going on record just in case things do go badly, but my own sense is that there are plenty of investment managers worried out there besides the hard-money set that practically yearns to see the demons of runaway inflation punish the wicked central bankers.

I'm not ready to give in on inflation either. For one, here is a monthly chart of year-on-year PCE (the preferred Fed indicator) inflation rates. One can see why the Fed might not be ready to go to code blue quite yet, as there have been three cycles since 2010 that have seen the rate go approach the 2% level and beyond before subsiding again.

Click to enlarge

I realize that not all are happy with PCE as an inflation indicator. The Williams piece also includes a revealing chart from David Stockman showing how many staples - oil, gasoline, eggs, natural gas and the like - have experienced price increases that are many multiples of the changes in both the PCE index and the CPI. However, most of the increases reflect the rise in the price of oil since that time - agriculture is highly dependent on petroleum-derived products. It's an increase that would not have happened without the surge in Chinese demand, one that took 16 years to double from 1980 and only 8 to double from 2000, with most of the increase in global oil demand over the last decade coming from that country. Whether oil had been priced in dollars or euros, I believe it would be more expensive today.

The recent increases in energy and food prices are more supply-related: fears over disruption in the Middle East for the former, and some lousy weather-affected production (including the California drought) for the latter. Otherwise, the velocity of money remains at historically low levels that are very much like those of the Great Depression. There are still differing schools of thought in economics about the "real" mechanics of the Depression - a period that gave rise to the coining of the term, "liquidity trap" - but it's worth noting that the velocity of money didn't really start to increase until the U.S. re-industrialized itself by way of World War II.

The Great Recession was not as severe as the Great Depression, but we don't know how long the Depression's economic damage might have continued to linger without the war. I suspect that given Ben Bernanke's study of the period and the influence of not only his work, but of those who trained him and studied alongside, that current Federal Reserve thinking, notably including that of Chair Janet Yellen, reflects an at least provisional belief (or hope) that velocity is unlikely to get any traction without a significant increase in output - or a far more significant increase in the money supply. That view is consistent with the Fed's actions in recent years, from the quantitative easing programs, to the taper (let's not try to find out how much more money we can print) to its implicit belief that it can moderate its balance sheet in tempo with a recovering economy.

Only the economy refuses to break out, as shown by the latest GDP data, the latest Fed forecasts, and the last four years. Clearly the first quarter was hit by weather and inventory correction at the same time, but the inventory aspect has been periodic, occurring every four or five quarters. I don't know about you, but I've really begun to weary of the way each expansion in the inventory cycle is treated as the beginning of "escape velocity" and each subsequent de-stocking is treated as some sort of freak one-off. The annualized rate of growth in business cap-ex spending, as measured by the durable goods category "new orders for non-defense capital goods excluding aircraft," is 2.2 % over the last two years and has been steadily easing since it peaked in February 2012.

Beguiled by rising prices, the stock market generally likes to believe that Miss "Goldilocks" - who says that either the economy grows faster and the increase in earnings propels stocks prices higher, or the economy doesn't and central banks will continue to ease (and backstop equities) - will somehow live forever. She never has and never will. On the other hand, Fed Governor James Bullard's remarks about rate increases this morning that rattled equity cages are simply a way of inuring the market to the reality that the Fed needs to get away from ZIRP. The bank wants the asset markets to be well prepared, and as the above history about political conflicts suggest, so long as adversity doesn't progressively and quickly worsen, stocks will progressively and quickly learn to ignore it.

Don't expect that the first rate increase will lead to a sudden collapse in equity prices. If history is any guide, a well-prepared stock market will rally on the grounds that the increase wasn't larger. The outcome that the Fed may be concerned about is the very realistic possibility that neither hyper-inflation nor deflation obtain in the near future, but an end to the expansion leg of the business cycle. The stock market's obsession with job numbers tends to promote the notion that growing employment inevitably leads to accelerating growth, it's not the case: Employment peaks after the business cycle is over and goes on contracting well after expansion has restarted. What the jobs numbers really tell you is that the deceleration phase might not have started yet.

If the business cycle should start to end next year or the year after - they don't last forever, not even in China - then the Fed will need to be in another place besides ZIRP and forward guidance. Having short-term rates at the historically very low level of 1% (the rate Greenspan was criticized for in the first part of the decade as being too low and giving rise to another asset inflation bubble) shouldn't be a drag on the economy, so long as we don't jump there in one or two moves that destabilize financial markets.

I would suggest the following conclusions: one, that without further supply shocks, inflation will not get traction in the current business cycle. This is in large part due to two, general inflation will continue to be constrained by diminished purchasing power, low real wage growth, and moderate economic growth overall. While we will surely see some better quarters for growth rates than the last one, including its cyclical opposite, the economy is unlikely to move from five years of low growth to five years of higher growth without interruption or significant change in the current economic structure.

Three, until the next credit contraction comes to pass, asset inflation will continue in select areas, including high-end real estate, collectibles, fine art, and equities. Though the recent low in stock market volatility will not last, one should expect a transition period of occasional outbursts rather than a sudden discontinuity (though geo-politics can change this).

Finally, the real threat for the end of the current cycle resides not so much in interest rates rising to still-low levels, but that asset inflation continues to widen the divergence between select price levels, particularly equities, and the general price level dictated by the real economy. Should the business cycle reach a natural end at a time when asset prices - encouraged by the usual failures of global worries to morph into global disasters - have climbed back to historically maximal deviations from the mean, their return to the mean (and typically beyond) is far more likely to cause the credit system disaster that the stock market and central banks fear, than would a modest increase in the level of real rates.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.