Stock, Bond Markets Too Sanguine About Inflation

The final week of the third quarter featured a continuation of the trends that have been in place since the Federal Reserve reversed its policy stance on August 17. Since that time, liquidity has been flowing to gold, crude oil, and commodities generally, as the U.S. dollar grinds to new record lows with each passing week and market participants have been quick to reinstate the "reflation" trade.

Within equity markets, the standout performer by a wide margin has been emerging markets (up 14% for the third quarter), which seem to offer the irresistible combination of rapid growth, commodity exposure, and currency diversification. With the MSCI Emerging Markets (E/M) Index now quite overbought on a technical basis, trading at a premium valuation to developed markets stocks, and having produced a stunning total return of close to 300% over the past five years, we would advise caution on new E/M purchases and would instead recommend that subscribers rebalance their E/M exposures.

In U.S. equity markets, leadership has been found in (1) commodity-based sectors (e.g. energy and materials); (2) sectors tied to capital spending and global growth (e.g. technology and industrials); and (3) the recession-resistant consumer staples sector, particularly companies with global franchises.

Third quarter trends were similarly persistent in the weakest assets, including (1) the U.S. dollar; (2) the financial sector; (3) real estate and home building; (4) the consumer discretionary sector; and (5) small-caps, which continue to suffer from relative over-valuation and reliance on U.S. rather than overseas economic growth.

Treasury bonds have been surprising resilient in the face of trends in other asset markets. The 10-year Treasury yield is actually slightly below its level of August 16, just prior to the reversal in Fed policy. Since that time, we have seen soaring gold, oil and agricultural commodity prices, a steadily weaker U.S. dollar, a strong recovery in the U.S. stock indices, and near parabolic rises in emerging markets stocks.

The only explanations we have for the ability of the bond market to hold up as well as it has over the past six weeks is (1) bond investors have sought refuge from riskier corporate and mortgage based in the perceived safety of Treasury instruments, and (2) the Treasury market is discounting a higher likelihood of a 2008 recession than the equity and commodities markets.

The message from the stock market seems to be that the housing recession and last summer’s inflection point in the credit cycle won’t derail the U.S. let alone the global economy, and that inflation pressures aren’t significant enough to alter the Fed’s now-friendly posture. The message from the bond market is that the economy will be weak into 2008 and such softness will alleviate current inflation pressures.

Our view is that both the stock and the bond markets are too sanguine and complacent about the inflation backdrop, and that inflation pressures will both constrain the ability of the Fed to act further and eventually lead to considerably higher longer-term Treasury yields, both of which will dampen the current enthusiasm for stocks, even if the economy escapes recession in 2008.

Given our continuing concerns about both the inflation and the growth backdrops, we are going to maintain for now our cautious stance towards the equity market. Even though the bulls appear to be back in control of the market, and the recent strength in equities and commodities belies the notion of an ’08 recession, we would rather err on the side of caution in what we think remains a high risk market environment owing to (1) the deflating housing bubble; (2) the paradigm shift in the credit markets and inflection point in the credit cycle; and (3) a persistent and largely under-recognized inflation problem.