CPI rises but US stocks rally

June consumer price index (CPI) jumped to 2.8% but forward estimates of inflation, represented by the 5-Year breakeven rate (5-year Treasury yield minus TIPS) remain subdued at 2.06%.

CPI and 5-Year Breakeven

Core CPI (excluding food and energy) is at 2.2% while average hourly earnings (total private: production and non-supervisory employees) annual growth, representing underlying inflationary pressure, is higher at 2.7%.

Core CPI and Average Hourly Earnings: Production and Nonsupervisory

Credit and broad money supply (MZM plus time deposits) growth remain steady, tracking nominal GDP growth at around 5.0%. A spike in credit growth often precedes a similar spike in broad money supply by several quarters.

Credit and Broad Money Supply Growth

And a surge in broad money supply growth, ahead of nominal GDP, flagged rising inflationary pressures ahead of the last two recessions, prompting the Fed to step on the brakes.

Nominal GDP and Broad Money Supply Growth

Overall, the inflation outlook appears subdued, with little urgency to hike interest rates at present.

The market is also getting more comfortable with the idea of trade tariffs. The S&P 500 is testing resistance at 2800. Breakout is likely and would suggest a primary advance to 3000.

S&P 500

The Nasdaq 100 followed through above 7300, confirming the primary advance, with a target of 7700.

Nasdaq 100

This is the final stage of a bull market but there is no sign of it ending. I am wary of the impact of a trade war on individual stocks and have reduced exposure to multinationals that make a sizable percentage of their sales in China.

Financial markets are supposed to swing like a pendulum: They may fluctuate wildly in response to exogenous shocks, but eventually they are supposed to come to rest at an equilibrium point…. Instead, as I told Congress, financial markets behaved more like a wrecking ball, swinging from country to country and knocking over the weaker ones. It is difficult to escape the conclusion that the international financial system itself constituted the main ingredient in the meltdown process.

~ George Soros on the 1997 Asian Financial Crisis and the need for greater regulation of global financial markets

Outlook for 2018

At this time of year we are usually inundated with projections for the year ahead, from predictions of imminent collapse to expectations of a record year.

We live in a world of uncertainty, where both extremes are possible, but neither is likely.

We are clearly in stage 3 (the final stage) of a bull market. Risk premiums are close to record lows. The yield spread between lowest investment-grade (Baa) bonds and equivalent risk-free Treasuries has crossed to below 2.0 percent, levels last seen prior to the 2008 global financial crisis. The VIX is also close to its record low, suggesting high levels of investor confidence.

Corporate Bond Spreads and VIX

Money supply continues to grow at close to 5.0 percent, reflecting an accommodative stance from the Fed. MZM, or Zero Maturity Money, is basically M1 plus travelers checks and money market funds.

Zero-Maturity Money

Inflationary forces remain subdued, with average hourly wage rates growing at below 2.5 percent per year. A rise above 3.0 percent, which would pressure the Fed to adopt a more restrictive monetary policy, does not appear imminent.

Average Hourly Wage Rates

Tax relief and higher commodity prices are likely to exert upward pressure on inflation in the year ahead. But the Fed’s stated intention of shrinking its balance sheet, with a reduction of $100 billion in the first 12 months, is likely to have an opposite, contractionary effect.

The Leading Index from the Philadelphia Fed gave a bit of a scare, dipping below 1.0 percent towards the end of last year. But data has since been revised and the index now reflects a far healthier outlook.

Philadelphia Fed Leading Index

A flattening yield curve has also been mooted as a potential threat, with a negative yield curve preceding every recession over the last 50 years.

Yield Differential 10-Year compared to 2-Year and 3-Month Treasuries

A yield differential, between 10-year and either 2-year or 3-month Treasuries, below zero would warn of a recession. When long-term yields fall below short-term yields financial markets stop working efficiently and bank lending tends to contract. Banks, who generally borrow at short-term rates and lend at long-term rates, find their margins are squeezed and become strongly risk-averse. Contracting lending slows the economy and normally leads to recession.

But we are some way from there. If we take the last cycle as an example, the yield curve started flattening in 2005 (when yield differentials fell below 1 percent) but a recession only occurred in 2008. The market could continue to thrive for several years before the impact of a negative yield curve is felt. To exit now would seem premature.