- Reflation has been the goal of central banks since the 2008 financial crisis.
- Prior to recent weeks, there were strong indications that we were moving toward this period of reflation.
- If this is only a scare and equity markets return to normalcy, reflation may resume.
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We need the Fed to come out and say, basically, 'Guys, we got your back.' Gene Goldman, Cetera Financial Group
For some time, I have argued that the US will soon be entering a period of reflation. Prior to the events of recent weeks, there had been several indications that this reflationary period had already begun.
Reflation is marked by a steepening yield curve, rising inflation, and a weakening dollar. This has been the objective of the Fed and other central banks since the Financial Crises. I spoke about this with Jake Merl of Real Vision Finance a little over two months ago. At that time, I told him I expected the Fed to sit back and do nothing and allow for a weakening dollar to create inflation without having to enact further monetary policies or cutting interest rates. Given the nearly $250 trillion in global debt, with the US accounting for roughly 60% of that debt, I argued that the Fed would adopt the traditional strategy inflating the US out of its debt.
Obviously, two months ago, I did not have knowledge of the novel coronavirus, and the long-term effect that it may, or may not have on US monetary and fiscal policy, and the world economy as a whole. Despite these concerns, the Fed decided earlier this month to keep interest rates between 1.50% and 1.75%. Fed Officials remarked that, while the Fed was closely monitoring the situation in China, the US economy is strong, and the current rates are appropriate to sustain US economic expansion, maximum employment, and stable prices. On February 29th, following the worst week since the Financial Crisis, Federal Reserve Chairman Jerome Powell reasserted that the US economy remained strong, but that the Fed was willing to "act as appropriate to support the economy."
Many are predicting the Fed to have 3 or more rate cuts by the end of this year. President Trump has continuously called on the Fed to lower the interest rate. If the Fed chooses to cut the interest rate, the resulting money flooding into the economy will increase the rate of inflation and may bring about the Fed's desired reflation. What we do not know is whether the recent dip in the US economy is simply the result of short-term worry over the coronavirus or the beginning of an economic crash.
I cannot answer this question. However, prior to last week, there were some signs which indicate that the level of inflation may currently be understated or prone to rising in the near future. I have written about the ability of the price of lumber to forecast future economic conditions. When prices of commodities rise, it can lead to cost-push inflation, as the cost of the commodities flow from the producers to the consumers. Given the inability to significantly increase the supply of lumber given environmental regulations, the price of lumber is closely tied to the current and anticipated construction activity. The price of lumber reacts efficiently to anticipated construction activity and can be an important indicator of cyclical growth and rising inflation expectations. Prior to last week, in the last 6 months, the price of lumber has increased approximately 28%, including 12% in the past 3 months. Much of this growth was erased last week, and the price of lumber fell about 14% to approximately $400.
Commodities Futures Price Quotes for Lumber: Source - Nasdaq
Gold had also been bullish, rising to a price of $1,642.85 per ounce. This was a 12.5% rise in the last six months and the highest price since 2013. While gold is more of a risk hedge and not always a clear indicator of inflation, its increase may be an indicator of concern over a future reflationary landscape and a trend toward transitioning away from large-cap equities. However, like with lumber, a significant percentage of the recent gains was wiped out in the last week. The price of silver had also begun to show signs of modest growth until it plummeted last week.
The dollar has not yet decreased in value. This is, again, possibly due to concerns over the coronavirus. In fact, it has raised slightly, which does not bode well for increased inflation. It remains to be seen whether the traditionally positive indicators - such as rising consumer confidence, elevated wages, higher retail earnings, and an upwards trend in the CPI - will continue during this period of downturn, and whether they will impact the dollar's value.
In truth, the economic downturn of the last week was predictable. The growth of the S&P 500 has been due to the meteoric growth of a very small number of large companies, many of whom are thoroughly interwoven with China and the Chinese supply chain. Had it not been the coronavirus, the next event to throw off the regular course of business in China was going to lead to a panic in the US.
What remains to be seen is how deep this damage will run and how quickly the rest of the world will be able to right the ship. One needs only to look at the widely circulated NASA Chinese pollution maps to see just how great the disruption is right now in China. On Twitter, I recently posed the question of whether we are in a full crash. The diversity of answers I received reflects the wide uncertainty in the investment community. I maintain that, prior to last week, there were several strong indicators that the reflation period was imminent. Now, it remains to be seen what will happen, and whether this is recession, depression, or merely a scare.
With these considerations, my opinion continues to be to diversify your portfolio to include exposure to markets other than the S&P 500. The growth generated in the S&P 500 continues to be from a small number of large-cap stocks, which are particularly susceptible to disruptions in China. The S&P's meteoric growth cannot continue forever and a certain percentage of those gains will be redistributed to areas such as a small-cap stocks, commodities, and emerging markets. These sectors will not underperform the S&P forever, and the time to buy is when they are still subdued.
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