Weak earnings, low oil prices, unexpected currency trends, unicorn valuations, a Brexit…2016 has provided plenty of subjects for Wall Street to ponder on.
Is inflation, however, getting the attention it deserves?
This is purely a thought, but one that could be worth contemplating. Essentially, we may be coming to a binary juncture in the markets, in which inflation could catapult to becoming the defining factor for 2016’s returns. The outline is as follows: the inflationary trend defines US monetary policy, which, in turn, dictates capital flows – which influence asset prices in the short run. In other words, macro moves take precedence over company fundamentals, and short-term outcomes would be binary – with asset classes moving in tandem – all based on inflation data. Ok, that’s quite long-winded. Let’s lay this out:
The Context: The Federal Reserve’s mandate involves maximizing employment and promoting price stability…aka inflation, with a stated 2% goal. By several measures, including March’s U3 5.0% unemployment rate, recent weekly jobless claims, and an upturn in labor participation, one could argue that the first objective has essentially been achieved. The focus, then, should turn to inflation for defining the next hike – especially so, given it has significantly underwhelmed during this expansion; headline CPI was still at 1.0%, and core PCE, while trending up, was still at 1.7% as of February (BLS data). Alongside, we can assume that inflation is not skyrocketing anytime soon, given commodity prices are still under pressure, emerging markets’ import demands remain lackluster, China’s debt concerns linger and a generally deflationary global environment persists. Meanwhile, the ECB and the BOJ are continuing to ease with full steam through negative interest rates, wholesale bond buying, and potentially even expanding to ETFs and other assets. In other words, without inflation reaching or passing 2%, if the Fed were to tighten rapidly, it would essentially be the only large central bank doing so – a massive international divergence which could cause all sorts of confusing results in the markets and economy.
Under these conditions, the Fed has refrained from hiking again after December. I remain of the opinion that this action (or lack of it) has been the key factor for explaining almost all major asset class returns YTD. After December’s hike, interest rate expectations were massively diminished by January’s volatility; since then, emerging market equities (via EEM) have returned over 7%; the euro and yen have strengthened by over 4% and 7% respectively, and the dollar has weakened against all major currencies except the peso, pound, hryvnia and the ruble – notable exceptions for country-specific reasons. Alongside, local emerging market debt has been by far the best fixed-income performer, returning 9.1% (JPM Data) YTD; high yielding debt, despite February’s plunge, was up 3.4% as of April 1st, and since mid-February, US equities have delivered well over 10% in returns as well. So, we’ve seen a very obvious move toward risk(ier) assets given diminished US rate hike expectations – all in sync with the dollar’s weakening. Dividend-paying stocks further attest to this – the utilities and telecom sectors are up over 10% YTD. It’s not like electricity and water consumption just decided to zoom higher; in fact, earnings growth overall remains quite weak, if not negative, in most sectors. As a result, one can surmise that investors are just looking for an income stream of dividends when there’s virtually none in fixed income; the 10-year Treasury’s 1.7% yield is way below the S&P 500’s 2.3% dividend yield.
Now, amid the recent diminishing returns and potential limits (as could be argued with NIRP’s effects on the yen) of central bank actions, credibility remains of paramount importance – and currently, the BOJ’s policies are under the microscope. The US Fed is still far from being questioned, but it’s unlikely Janet Yellen would risk any such damage – especially after the reception of September’s minutes, where the emphasis on global conditions caused all sorts of reactions on Wall Street. My point? If employment remains solid (which it should), and regardless of global conditions (which are unlikely to change over a few weeks), if inflation picks up, the Fed would have a very strong case to raise rates.
Presenting Inflation: Now, assume inflation picks up. Rates rise. Should one expect a reversal of much of the behavior above? In my opinion, yes. Here’s what one could expect:
As rate hike expectations increased in 2015, the dollar strengthened; post December, it weakened. If inflation picks up and the next rate hike appears on the horizon, the dollar could repeat this trend; the yen and euro would correspondingly weaken, aiding European and Japanese equities. US multinationals would, then, turn downwards – the DJIA would likely underperform domestic firms – reversing Q1’s trend while the dollar weakened. Banks would be the outlier, likely gaining due to the relaxation on their net interest margins. Small caps in the US would do better citing domestic strength – again, a reversal from their underperformance YTD. TIPs would extend gains, and emerging markets would sell off – beginning with oil-exporting ones, as commodities, mostly priced in dollars, would also come under pressure. This would again hurt high yielding debt – over 25% of which is in the energy space, per JPM. Essentially, we may converge back to January’s behavior – indiscriminate sell-offs across classes regardless of the quality of individual assets. The domino effect could spiral into emerging market currencies – enter China – would the pressure on the yuan lead China’s PBOC to sell foreign reserves? As of February, the stash was approximately $3.2 trillion (JPM data); the IMF has stated $2.8 trillion to be the critical safety limit. What if it gets breached? Could the stronger dollar trigger a yuan depreciation? Similar situations were making headlines in January – right after December’s rate hike. And we know what happened in the five weeks after. All in all, we could see some pretty serious moves repeating themselves if the Fed raises rates upon inflation picking up.
And then, the reverse. If inflation does not pick up, the Fed would stay put, and the current trend of investors seeking yield wherever possible would continue. This could occur if the US economy were to slow down – say – if oil collapses again, banks suffer more than expected, capex spending never picks up, and wage growth stalls. However, this would just mean kicking the can down the road…someday, you’d think rates would have to rise given another need to deleverage, diminishing policy impact, and perhaps even new political leadership.
That’s why I think we may have a binary outcome in the short term – all based on inflation. Now, a quick thought on that. Amid the hype around high yields and equities, note that TIPS have returned 4.5% YTD – the 2nd best fixed income class. Gold is up 16% as well – strangely contrary to all the other risky-asset strength. Both are solid inflation hedges. Other data points resonate as well – core CPI was up a solid 2.2% in March; alongside, existing home sales were up 5.1%, with the median price up 5.7% YoY. While average hourly earnings grew 2.3% YoY in March, per the Atlanta Fed, the three-month moving average of median wage growth was up 3.2% – looking at historical data, that’s nearly equal to December 2003’s 3.3% value. Yesterday’s unemployment claims were at their lowest level in 42 years, per the WSJ, and oil seems to be holding steady, despite Doha’s lack of outcome. So, there is a fair case to assume inflation will pick up, and the Fed, as a result, will hike in the coming months.
What it means for you: Of course, this is all just a scenario. But it does beg the question of whether company-specific trades aimed at short-term gains within 2016 are possible, given the throwing-the-baby-out-with-the-bathwater mayhem is quite likely if monetary policy holds sway – as it seems to have had in the recent past. For long-term investors, of course, such times provide phenomenal bargains on amazing companies – and frankly, this just is how markets function. Investors shouldn’t complain – we’ve had significantly above-average annual returns in equities during this expansion compared to long-run averages, that too, amid lackluster global growth. The bottomline? Wall Street should keep in mind that while certain asset classes will continue to make waves in 2016, the reason for many of the individual moves may not be due to stellar cash flows or sparkling management…it might just be inflation.
