At this juncture, it is hard to miss the signs of incipient global reflation which could take place over the course of the year, and perhaps even beyond. The key to understanding how this reflation process will evolve lies in the ability to put disparate but relevant elements together, and tuning out those that do not matter in building the montage. The IFO global economic survey sets the foundation of the analysis:
Note 1: Better global, and China, growth prospects ahead
2015 looks entirely different from the previous 4 years. Global growth is finally showing robust, initial signs of recovery. This may have to do with what we expect from overlapping growth among many major economies during the rest of the year. For the first time since 2010, the global economy may undergo synchronized expansion as Europe, Japan and some large emerging countries may see a return to economic growth. US growth meanwhile is going over some rough patches (and indeed Q2 2015 looks like a disappointment again) but we have higher hopes for the rest of the year.
Furthermore, a re-acceleration of Chinese growth has also become more likely as the central government commits itself to stimulating the economy with various measures such as the recent reduction in benchmark rates -- the third cut in six months.
The Chinese central bank also cut benchmark interest rates for deposit and lending of 0.25%. This may be followed by further interest rates cuts, reductions of the reserve requirement ratio for the banks and injections of liquidity by the PBoC -- in fact, rumors of a possible Chinese QE have emerged.
These policy moves, and prospects of further easing of financial conditions, have ignited the Chinese stock markets. The recent large gains in the Chinese equity markets have not translated into visible recovery in domestic growth -- something that has puzzled a lot of investors. But the answer is quite simple -- the transmission mechanism, which generally runs through changes in the level of the domestic currency, is not very efficient. The impact of Chinese equity gains therefore shows only after 3 to 4 quarters. However, the inflection point is upon us, and so positive fallout from the torrid rise in Chinese equity markets will start contributing to the economy by late Q2 this year. The run of benefits may extend all the way to H2 2016 (see chart above), on the equity gains that have been seen so far.
A recovery in global growth (see chart below), and a Chinese economic healing, is naturally a very positive environment for cyclical and hard assets, and growth-sensitive commodities such as energy and base metals. This double-barreled growth blast, ex-US, will also severely weaken the US Dollar, which feeds back into further hard asset gains, if it happens as we believe it will.
The IMF reaffirmed in its latest report that Asian economies will lead global growth this year, expanding by 5.6% as recoveries in India and Japan are expected to offset a slower growth in China, relative to recent data. There are growth indications now which support the IMF forecast (see chart above).
Exports from developing Asian countries are likely to recover as they benefit from a weaker exchange rate. Lower fuel prices -- oil prices fell by a larger amount than local exchange rates -- should also act as economic stimuli for large oil importing countries. India, Indonesia, Malaysia and China are likely to benefit from the decline in oil prices. India is likely to be one of the fastest growing major economies in the world this year, expanding by 7.5% due to the combination of lower oil prices and recent policy reforms.
Note 2: Inflation is poised to return, as inflation expectations rise sharply
- The chart below shows the 10-year breakevens for three countries. The US breakeven is depicted by the dark blue line. The 5yr breakeven found a trough in January near 1.53%. By mid-March it was near 1.64%; it is now near 1.95%.
- Germany's breakeven is represented by the yellow line. In early January, the German 10-year breakeven fell below 0.60%. But by mid-March, it had doubled to 1.22%. It is now near 1.35%.
- The UK's 10-year breakeven is depicted by the gray line. It has risen from about 2.26% in mid-January. It moved to 2.6% in March and is now trying to push through 2.8%.
The message from the rise in breakevens: inflation expectations are rising -- bond inflation expectation premia will therefore rise, so bond yields will also rise -- perhaps sharply since inflation expectation is the largest component of bond yields in recent years (see chart below). Since the short-end is anchored close to zero, and with economic growth far from satisfactory (hence requiring only minimal adjustment to the short-term rate), the rise in the 10s and 30s will essentially exaggerate the steepening of the yield curve.
The synchronized uplift in sovereign yields also sends the unmistakable note that global growth is starting to recover (see chart below). Therefore it makes sense that higher sovereign yields should be seen in the near term at least (although we are making the case that US long-term rates may climb during the entire year).
Other data that point to rising inflationary pressures:
- The WTI light crude oil June futures contract appreciated by 16% in April alone. On a broader basis, Diapason's commodity index DCI®TRUS has appreciated by 9.5% during the same period. Headline CPI will likely follow upwards in due course, usually after 30-45 days. As we have been saying since early January, the Core CPI could rise for the whole of 2015 due to the impact of higher employment cost in the past 4 quarters (see chart below).
- Labor costs are indeed rising in the US, as well as in Japan and in Germany. In the US, the Employment Cost Index has been rising sharply since early Q1 2015 and has gone above the median inflation measure of the Cleveland Fed (see chart above and below). Although this has only modest significance to the overall determination of inflation pressure, it does add to the litany of factors which argue for higher CPI inflation down the road.
Nonetheless, we feel that the labor cost push alone is likely insufficient to trigger a Fed rate hike. But additional inflation push from elsewhere (e.g., housing owner's equivalent rent and CPI shelter elements -- see chart below) and impact from the recent uptick in gasoline prices may combine with labor cost-push to provide a cover for a Fed Reserve rate hike in June or September. This of course assumes that growth in the US will go back on track during H2 2015, as we expect.
Hard assets (Gold? Silver?) should outperform in a reflation
The potential combination of strong wage growth/employment costs, house and shelter elements, and sharply higher commodity prices plus rising inflation expectations, will be a potentially explosive mix in the near-term, at least for central banks which are still fixated on disinflation/deflation issues.
If we add the likelihood of sharp rise in global growth to the brew, a possibility also suggested by Bloomberg's World GDP forecast survey (see chart below), the biggest casualty could be bonds as interest rates rise and the yield curve steepens. Equities may also be vulnerable in many aspects, although this is a straight-line projection of the stock market's current behavior of displaying weakness whenever there is a significant rise in bond yields. That behavior may or may not persist. Nonetheless, rising yields and rising inflation on a global basis may indeed force a rethink over the relative valuation of paper assets.
On the other hand, hard assets including commodities (Gold? Silver?), could be potential outperformers as a logical extension of asset rotation concept if the two primary asset classes do spiral into a funk mode. If this is the case, Silver itself, or Silver over Gold, could be an optimal bet on a global cyclical reflation event which could take place over the course of the year, and perhaps even beyond.
Silver is not a trivial choice - the Silver over Gold ratio has been a leading proxy for the US dollar and the inverse of Money Demand (the short yield curve, 1Y/3Y) since the advent of the Great Financial Recession, see chart below. The ratio also tracks global growth with a high degree of fidelity. If there is indeed a global reflation this year, demand for money should wane, and the US dollar should also decline in a big way (as we expect). That environment provides hard assets further wherewithal to outperform -- precious metals being primary beneficiaries of a risk-on phase in this type of circumstance -- and the Silver over Gold ratio could soar.
Conclusion: The threat of deflation has ebbed and inflation expectations are rising quickly. Actual CPI inflation is not far behind. The largesse coming from the global central banks' GFC QE stimuli is perhaps starting to be leveraged into having actual impact on the real economy. Banks could not use or borrow directly against those bank reserves, but those reserves allow the banks to "borrow" against their other assets, if they wish to. Those "borrowed" funds can be loaned out. Slim net margins at this juncture may be encouraging banks to expand their loan portfolios in search of spread income. This route may indeed provide a conduit for bank excess reserves parked at the Fed to transit from the Monetary Base into the real economy, via credit creation, and eventually into the money supply.
Money Supply measures are starting to rise everywhere (see chart above), and these could be a manifestation of the bank reserves' transition process that we are suggesting above. Credit creation eventually morphs into money supply after a lag (see chart below), and the pick up in these money measures is maybe a record of the recent upsurge in global credit levels, the most notable of which has been seen in the eurozone. This may explain the torrid rise of M2 in the area in recent months (see chart above). The implications of rising money supply may also add problems to monetarist central banks (e.g., Germany's Bundesbank) at least on conceptual and intellectual basis. But if you agree with monetary economics that a surfeit of money supply beyond the needs of an economy has some part in pushing inflation higher, then the money supply deserves a close watch from here onwards.
The primary consideration in all these is to be cognizant of the lag between changes in inflation expectations and the rise in actual CPI. It could be as long as 2 Quarters, as it has been in the past. But since breakevens have been rising since January, the take-off in CPI will potentially accelerate by end of Q2 2015. The recent rise in Employment Cost Index and owner's equivalent rents (OER) could also play a large part in pushing inflation higher as discussed earlier.
The key thing to watch is how global growth expectations will continue to pan out over the next months. Also watch the US M2 Money Supply which we believe will soon resume its uptrend, if its historical relationship with credit creation holds true. The simple model which we use in this regard is the lead that bank credit creation has on M2 money supply -- changes in loans and leases lead M2 money supply changes by 5 quarters (see chart above). If an M2 upwards trend starts soon, and more so if it coincides with a rise in Core CPI as we suggested earlier, then the combination will reinforce an incipient market conviction that inflation is again ready to march higher, worldwide.
Disclosure: The author has no positions in any stocks mentioned, but may initiate a long position in SLW over the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The company which the author represents may be invested in the commodities discussed in this report.