Category: Inflation

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Weekly Top Themes from Bob Doll | Nuveen

  1. U.S. monetary policy should remain equity-market friendly. In her comments last week, Janet Yellen stated that the neutral rate for the fed funds rate is “currently quite low,” and rates would not have to rise much more to become neutral. In our view, a neutral fed funds rate is closer to 2% than the 3% currently implied by the fed funds futures market. If this is accurate, it would likely be good news for economic growth, corporate earnings and the stock market.
  2. Global monetary policy is starting to normalize, but still supports stocks. The Bank of China raised rates by 25 basis points last week and other central banks are becoming less dovish. We think this is good news since it reflects improving global economic growth, while overall policy remains easy. Central banks are still promoting liquidity, which should support equities and other risk assets.
  3. Inflation remains surprisingly low. Although economic growth is improving and the Fed is normalizing, inflation has not increased similarly. Inflation should eventually react to tightening labor markets, but the process is taking a long time.
  4. If the “Goldilocks” environment persists, we think equities can continue to make all-time highs. Low inflation, slow-but-positive economic growth, climbing earnings and a cautious Fed have contributed to record-high stock prices. We think these conditions should remain in place for at least the next 6 to 12 months.
  5. Active fund manager performance has improved. According to Merrill Lynch, 54% of active large cap U.S. equity managers outperformed their benchmarks for the first half of the year and more than half also outperformed for the last four months. This is the longest such streak since Merrill Lynch began tracking this data in 2009, and it marks the first time a majority of managers outperformed for the first half of a year.

Global monetary policy supportive of stocks, low inflation and slow-but-stable earnings growth. Nothing much wrong here. Inflation is the one to watch though. A surge in wage rates as the labor market tightens would tighten monetary policy, with a domino effect on earnings and stock performance.

Source: Weekly Investment Commentary from Bob Doll | Nuveen

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Australia faces headwinds

Australian wage rate growth, on the other hand, is declining. is in a worse position, with a dramatic fall in investment following the mining boom.

Australia: Wage Price Index

Source: RBA & ABS

As is inflation.

Australia: Inflation

Source: RBA & ABS

Growth in Household Disposable Income and Consumption.

Australia: Household Income and Consumption

Source: RBA & ABS

And Banks return on shareholders equity.

Australia: Banks Return on Equity

Source: RBA & APRA

But not Housing.

Australia: Banks Return on Equity

Source: RBA, ABS, APM, CoreLogic & Residex

At least not yet.

Falling house prices would complete the feedback loop, shrinking household incomes, consumption and banks ROE.

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US adds 222 thousand jobs

From the Wall Street Journal:

U.S. employers picked up their pace of hiring in June. Nonfarm payrolls rose by a seasonally adjusted 222,000 from the prior month, the Labor Department said. The unemployment rate ticked up to 4.4% from 4.3% the prior month as more people joined the workforce…..

Job Gains

Source: St Louis Fed & BLS

Forecast GDP for the current quarter — total payrolls * hours worked — is rising, showing an improving economy.

Real GDP Forecast

Source: St Louis Fed, BLS & BEA

Declining corporate profits as a percentage of net value added (RHS) is typical of mid-cycle growth, while employee compensation (% of net value added) is rising at a modest pace. Peaks in employee compensation are normally accompanied by troughs in corporate profits…..and followed by a recession.

US Corporate Profits and Employee Compensation as percentage of Value Added

Source: St Louis Fed & BEA

Average wage rate growth, both for production/non-supervisory and all employees, remains below 2.5% per year. Absence of wage rate pressure suggests that the Fed will be in no hurry to hike interest rates to curb inflationary pressure.

Hourly Wage Rate Growth

Source: St Louis Fed & BLS

Which should mean further growth ahead.

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Gold-Oil ratio warns of further easing

I don’t attach much significance to the Gold-Oil ratio on its own but it’s back in overbought territory, above 25.

Spot Gold/Light Crude

The chart below — plotting inflation-adjusted prices (over CPI) — far better depicts the relationship between gold and crude oil. Each major spike in crude prices over the last 50 years has been followed by a rising gold price.

Spot Gold/Brent Crude

Falling crude prices are likely to weaken demand for gold over the next few years, both through lower inflation and declining foreign reserves of major oil producing nations.

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Gold finds support at $1250

The Dollar Index continues to test support at 96.50. The primary trend is down and breach of support is likely, signaling a decline to test the 2016 low at 92/93.

Dollar Index

Spot Gold found support at $1250. A weaker Dollar and rising political uncertainty both favor an up-trend but rising interest rates are expected to weaken demand. Respect of support at $1250 would confirm the up-trend, while breach of $1200 would warn of another decline.

Spot Gold

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Australia: Warning signs of a contraction

Australia faces shrinking inflationary pressures.

Inflation

Wage growth is falling.

Wage Price Index

Credit growth is shrinking.

Inflation

Growth of currency in circulation is also slowing. The fall below 5% warns of a contraction.

Currency in Circulation: Growth

One piece of good news is that Chinese monetary policy seems to be easing. After a sharp contraction of M1 money stock growth in January, February shows a partial recovery. Collapse of the Chinese property bubble may be deferred a while longer.

China M1 Money Stock

Which is good news for iron ore exporters. At least in the short-term.

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Inflation surges

Inflation is rising, with CPI climbing steeply above the Fed’s 2% target. But core CPI excluding energy and food remains stable.

Consumer Price Index

Job gains were the lowest since May 2016.

Job Gains

But the unemployment rate fell to a low 4.5%.

Unemployment

Hourly wage rate growth has eased below 2.5%, suggesting that underlying inflationary pressures are contained.

Average Hourly Earnings Growth

The Fed is unlikely to accelerate its normalization of interest rates unless we see a surge in core inflation and/or hourly earnings growth.

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Jobs, Inflation & the Fed | ECRI

From Lakshman Achuthan at ECRI:

Headline jobs growth came in well below expectations, and weather played some part in suppressing job growth, both in construction and retail.

But the jobless rate dropped to 4.5%, its lowest reading since 2007, so the Fed’s “full-employment” mandate has been met.

Their other mandate is on inflation, and over the past year I’ve discussed our U.S. Future Inflation Gauge, which anticipated the inflation cycle upturn shown by the chart. Today the forward looking USFIG remains near an 8¾ -year high.

The chart shows the year-over-year PCE inflation rising sharply to a 5-year high, and breaching the Fed’s 2% inflation target which is defined by this inflation measure.

For those who might think this is just about oil prices, please note that core PCE inflation, ex-food and energy, has also been rising, and now above 1¾%, the highest reading in over 2½ years.

This is what a cyclical upswing in inflation looks like.

Moreover, the U.S. economy has a good tailwind from rising global growth.

All of this helps explain why the Fed is finally able to implement a full-fledged rate hike cycle.

Source: Jobs, Inflation & the Fed | News | News and Events | ECRI

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Robert Shiller: Is he right that stocks are overpriced?

I frequently come across stocks such as Netflix [NFLX], trading on a forward PE of 137 (Morningstar), or even Coca Cola [KO] and Procter & Gamble [PG] that leave me muttering about unrealistic valuations.

Nobel laureate Robert Shiller this week commented that he was no longer buying stocks as he believed they were overvalued. His justification is the CAPE index which compares current stock prices to the 10-year average of inflation-adjusted earnings.

Shiller CAPE Index

The index is below its Dotcom high but is approaching the same level that it peaked at in 1929. Is the CAPE index flawed or does this portend disaster?

Bear in mind that Shiller is not selling all his existing stocks — he has merely stopped buying — and is the first to point out that the CAPE index is a poor tool for timing market tops and bottoms.

Before we make any rash decisions let us compare Shiller’s index to a few other handy measures of market valuation.

Warren Buffett’s favorite

Warren Buffett’s favorite measure of market value is to compare total stock market capitalization to GDP. The higher the ratio, the more the stock market is overvalued.

US Market Cap to GDP

This looks even worse than the CAPE index, with market cap to GDP well above its 2007 high and well on its way to Dotcom levels.

Adapting the ratio to include offshore earnings of multinational companies makes very little difference to the results. Here I compare market cap to GNP as well as GDP. GNP, or gross national product, includes offshore earnings of domestioc companies rather than just domestic earnings as with GDP. The end result is much the same.

US Market Cap to GNP

Market Cap to Corporate Profits

When we compare market capitalization to current profits after tax, however, valuations are still high but nowhere near the irrational exuberance of the Dotcom era.

US Market Cap to Profits after Tax

The current peak resembles earlier peaks in the 1980s and 1960s.

What this tells us is that corporate profits are rising faster than GDP. And that a 10-year average may be a poor reflection of future sustainable earnings.

Sustainable Earnings

Are current earnings sustainable? There is no clear answer to this. But there are some key criteria if earnings are to remain at current levels of GDP.

First, wage rate growth remains low. The graph below illustrates how profits fall when employee compensation rises (per unit of value added).

Wage Rates

Second, that interest rates stay low. The Fed is doing its best to normalize interest rates but monetary tightening would spoil the party. That is, deliberate tightening by the Fed to subdue rising inflationary pressures.

A third element is corporate taxes but there seems little risk of rising taxes in the current climate.

The key variable for both #1 and #2 is wage rates. At present these are subdued, so no cause for alarm.

Wage Rates

….yet.

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Australia’s economic growth is slowing.

Employment and Participation rates are falling.

Australia Employment & Participation Rates

Wage rate growth is slowing.

Australia Wage Rates

Slowing wage rate growth and inflation confirm that the economy is faltering.

Australia Underlying Inflation

The RBA, with one eye on the housing bubble, has indicated its reluctance to cut rates further. Increased infrastructure spending by Federal and State governments seems the only viable alternative.

With the motor industry winding down and apartment construction headed for a cliff, this is becoming increasingly urgent.

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