Manufacturing And Inflation Get A Lift

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Both inflation and real growth are getting a modest lift these days. Recent economic data continue to support the notion that economic activity has firmed a bit in the second half of the year, after being weak in the first half. The improvement is modest, but nevertheless encouraging, especially since there are signs that overseas activity is picking up as well. The market is also pricing in a modest pickup in inflation, with expectations now centering around 2% over the next 5 and 10 years.

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As the chart above suggests, he November ISM manufacturing report is consistent with an economy that is growing at a modest 2-3% pace.

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It's encouraging that eurozone manufacturing surveys point to some improvement in the second half there as well.

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Industrial metals prices have surged almost 45% year-to-date and that is very impressive. Some of the upward impetus could be speculative in nature, a bet that a Trump administration will ramp up infrastructure spending in a big way. The hoopla surrounding the ARRA infrastructure spending bonanza was way overblown, but this time could be different. Instead of relying on local governments to identify "shovel-ready" projects, Trump may instead rely more on tax incentives and private sector funding, and that could mean an infrastructure push that could be more efficient and more productive. Caterpillar's (NYSE:CAT) stock, up 60% since January, is sending the same message. However, I note that prices have been increasing all year, well in advance of any expectation that Trump might win.

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This year has seen a remarkable divergence between the value of the dollar and industrial commodity prices. They normally move inversely (e.g., a stronger dollar coinciding with weaker commodity prices), but this year both the dollar and commodity prices have moved up (resulting in the divergence shown in the chart above). When prices move inversely it is a sign that the change in commodity prices has a monetary component (e.g., tight money is pushing the dollar up and deflating commodity prices). Now that they are moving together it could be that the rise in commodity prices is mostly being driven by improving economic fundamentals both here and abroad: prices are rising because demand is outstripping supply. The dollar has its own reasons for rising: the Fed is clearly in a mood to raise rates, while most other central banks are still on the sidelines. More recently, the dollar has gotten a boost from speculation that a Trump administration will be more growth-friendly.

Traditionally, a stronger dollar has spelled bad news for emerging market economies. That's because a stronger dollar has usually coincided with weaker commodity prices, and commodities are very important to emerging market economies. But this time emerging market economies have been taking a beating of late, even though commodity prices have been rising. Perhaps there is too much pessimism? Might it be the case that a stronger dollar and an improving U.S. economy and rising commodities will act like a rising tide that lifts all economies, particular those in the Western hemisphere?

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The yen has fallen almost 13% against the dollar in just the past 3 months and Japanese stocks have reversed to the upside. The strong inverse correlation between the value of the yen and the stock market is still in place. It's unusual for a weaker currency to be good for a country's stocks, but the case of Japan looks different from that of most countries. A weaker yen may be a sign that deflationary pressures - which have weighed heavily and uniquely on Japan's economy for many years - are being replaced by some much-needed reflation.

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The U.S. stock market has outperformed the eurozone stock market for many years now and nothing seems to have changed of late. The outlook for the U.S. economy is still brighter than it is for the eurozone economy.

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Inflation expectations, as derived from the prices of TIPS and Treasuries, have moved meaningfully higher in the past three months. The chart above shows how this has played out with 5-yr TIPS and 5-yr Treasuries. Nominal yields have risen much more than real yields, with the breakeven spread (equivalent to the expected average annual rise in the CPI over the next 5 years) rising from a low of 1.3% in early August to now 1.9%. 10-yr inflation expectations are now 2.0%. At the very least, this means that deflation worries are a thing of the past.

Caution: if this process continues (i.e., if inflation expectations continue to rise), it will mean that the Fed is falling behind the inflation curve and will therefore need to speed up its normalization of short-term interest rates. As I've warned for years, the Fed's biggest nightmare is the return of confidence, and confidence is definitely picking up these days. With rising confidence and less risk aversion, the pubic's demand for all the money that has been created in the past 8 years will begin to decline, unless the Fed takes offsetting measures to boost money demand by raising short-term interest rates.

UPDATE: As seen in the chart below, the Chemical Activity Barometer is still rising impressively, up 4% in the year ending November. Such a move has tended to foreshadow a pickup in industrial production, which has been flat for quite awhile.

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