Tag: Inflation

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Can the Fed keep a lid on inflation?

Jeremy Siegel, Wharton finance professor, says the Fed has poured a tremendous amount of money into the economy in response to the pandemic, which will eventually cause higher inflation. David Rosenberg of Rosenberg Research argues that velocity of money is declining and the US economy has a large output gap so inflation is unlikely to materialize.

CNBC VideoClick to play

Both are right, just in different time frames.

Putting the cart before the horse

The velocity of money is simply the ratio of GDP to the money supply. Fluctuations in the velocity of money have more to do with fluctuations in GDP than in the money supply. If GDP recovers, so will the velocity of money. Equating velocity of money with inflation is putting the cart before the horse. Contractions in GDP coincide with low/negative inflation while rapid expansions in GDP are normally accompanied, after a lag, by rising inflation.

CPI & GDP

Money supply and interest rates

Inflation is likely to rise when consumption grows at a faster rate than output. Prices rise when supply is scarce — when we consume more than we produce. Interest rates play a key role in this.

Low interest rates mean cheap credit, making it easy for people to borrow and consume more than they earn. Low rates also boost the stock market, raising corporate earnings because of lower interest costs, but most importantly, raising earnings multiples as the cost of capital falls. Speculators also take advantage of low interest rates to leverage their investments, driving up prices.

S&P 500

In the housing market, prices rise as cheap mortgage finance attracts buyers, pushing up demand and facilitating greater leverage.

Housing: Building Starts & Permits

Wealth effect

Higher stock and house prices create a wealth effect. Consumers are more ready to borrow and spend when they feel wealthier.

High interest rates, on the other hand, have the exact opposite effect. Credit is expensive and consumption falls. Speculation fades as stock earnings multiples fall and housing buyers are scarce.

Money supply is only a factor in inflation to the extent that it affects interest rates. There is also a lag between lower interest rates and rising consumption. It takes time for consumers and investors to rebuild confidence after an economic contraction.

The role of the Fed

Fed Chairman, William McChesney Martin, described the role of the Federal Reserve as:

“…..to take away the punch bowl just as the party gets going.”

In other words, to raise interest rates just as the economic recovery starts to build up steam — to avoid a build up of inflationary pressures.

The Fed’s mandate is to maintain stable prices but there are times, like the present, when their hands are tied.

Federal government debt is currently above 120% of GDP.

Federal Debt/GDP

GDP is likely to rise as the economy recovers but so is federal debt as the government injects more stimulus and embarks on an infrastructure program to lift the economy.

With federal debt at record levels of GDP, raising interest rates could blow the federal deficit wide open as the cost of servicing Treasury debt threatens to overtake tax revenues.

Conclusion

Inflation is likely to remain low until GDP recovers. But the need to maintain low interest rates — to support Treasury markets and keep a lid on the federal deficit — will then hamper the Fed’s ability to contain a buildup of inflationary pressure.

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Jim Bianco forecasts higher inflation in 2021

Jim Bianco from Bianco Research:

“The problem the stock market has in 2021 is by most standard metrics (P/E, Market Cap/GDP, etc.) it’s overvalued. Now a lot of people expect it to stay that way for another year. If we don’t get inflation, that can actually happen and you could actually have the market stay at these elevated levels. But if you do get rising interest rates on inflation……that will frip earnings, make mortgage rates go up and lift interest rates. That has historically not been good for risk assets….”

The problem if we don’t get inflation will be far worse. MMT theorists will take this as validation and we are likely to see more calls for far higher stimulus checks. Why not $200,000 stimulus checks someone on Twitter asked. The bubble will keep expanding without any visible effect …..until it bursts.

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Stock prices: Jay Powell is talking through his hat

Daily COVID-19 cases in the US continue to climb, reaching 236,211 on Thursday 17th.

USA: COVID19 Daily Cases

Unemployment claims jumped by 1.6 million in the week ending November 28, exceeding more than 1 in 8 of the total workforce (Feb 2020).

DOL: Total Unemployment Claims, 28Nov2020

Initial claims under state programs climbed to 935,138 (unadjusted) by week ending December 12, compared to 718,522 for w/e November 28, while initial claims under pandemic assistance programs run by the federal government jumped to 455,037 compared to 288,234 for w/e November 28.

Further escalation of both daily COVID-19 cases and unemployment claims is likely before vaccine distribution achieves a wide enough reach to make a difference. A major obstacle will be public reluctance to get the vaccine shot:

As states frantically prepare to begin months of vaccinations that could end the pandemic, a new poll finds only about half of Americans are ready to roll up their sleeves when their turn comes.

The survey from The Associated Press-NORC Center for Public Affairs Research shows about a quarter of U.S. adults aren’t sure if they want to get vaccinated against the coronavirus. Roughly another quarter say they won’t. (Associated Press, December 10, 2020)

Federal assistance

Further federal assistance may soften the impact of rising unemployment on the economy but Senate leaders are yet to conclude a deal. Both sides claim to want a deal but it seems unlikely that agreement will be reached before the Georgia run-off elections on January 5th. If the Democrats win both seats, and a Senate majority, they will not need to compromise. Unfortunately, large numbers of the least fortunate will suffer before then. Real leadership from the White House, needed to break the logjam, is sadly absent.

Jay Powell and stock prices

Jay Powell says he is relaxed about stock prices:

Stocks at record highs and bond yields not far from their historic lows are telling two different stories, but Federal Reserve Chairman Jerome Powell said he isn’t worried about the disparity.

In fact, the central bank chief said during a news conference Wednesday, the low rates are helping justify an equity surge that has gone on largely unabated since the March pandemic crisis lows.

“The broad financial stability picture is kind of mixed I would say,” Powell said in response to a CNBC question at the post-meeting media Q&A. “Asset prices are a little high in that metric in my view, but overall you have a mixed picture. You don’t have a lot of red flags on that.” (CNBC, December 16, 2020)

There is just one problem: bond yields are distorted by the Fed and do not reflect market forces.

S&P 500 PEmax

If we take the S&P 500 Price-Earnings ratio based on the highest trailing earnings (PEmax), this eliminates distortions from sharp falls in earnings during a recession. The current multiple of 26.69 is the second highest peak in the past 120 years, exceeded only by the Dotcom bubble. By comparison, peaks for the 1929 stock market crash (Black Friday) and 1987 (Black Monday) both had earnings multiples below 20.

S&P 500 PE of Maximum Trailing Earnings (PEmax)

Payback model

If we use our payback model, we arrive at a fair value estimate of 2169.50 for the S&P 500 based on:

  • projected earnings for the next four quarters as provided by S&P;
  • a long-term growth rate of 5%, equal to nominal GDP growth in recent years; and
  • a payback period of 12 years, normally used for the most stable companies (with a strong defensive market position).

The LT growth rate required to match the current index value (3709.41) is 14.0%. The only time such a growth rate was achieved, post WWII, is in the 1980s, when inflation was spiraling out of control.

Nominal GDP & Inflation (CPI)

Conclusion

Stock prices are in a bubble of epic proportions. Risk is elevated and we are likely to witness a major collapse in prices in 2021 unless inflation spikes upwards as in the 1970s to early 1980s.

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Rate cuts and buybacks – the emperor’s new clothes

The interest rate outlook is softening, with Fed chairman Jerome Powell hinting at rate cuts in his Wednesday testimony to Congress:

“Our baseline outlook is for economic growth to remain solid, labor markets to remain strong and inflation to move back over time.”
but…. “Uncertainties about the outlook have increased in recent months. In particular, economic momentum appears to have slowed in some major foreign economies and that weakness could affect the US economy.”

Stephen Bartholomeusz at The Sydney Morning Herald comments:

“Perhaps the most disturbing aspect of the Fed shifting into an easing cycle before there is strong evidence to warrant it, is economies already stuck in high debt and low growth environments will be forced even deeper into the kind of policies that in Japan have produced more than 30 years of economic winter with no apparent escape route.”

If the Fed moves too early they could further damage global growth, with long-term consequences for US stocks. But markets are salivating at the anticipated sugar hit from lower rates. Stocks surged in response to Powell’s speech, with the S&P 500 breaking resistance at 3000. A rising Trend Index indicates buying pressure.

S&P 500

The argument for higher stock prices is that lower interest rates may stave off a recession. The chart below shows how recessions (gray bars) are normally preceded by rising interest rates (green) followed by sharp cuts when employment growth (blue) starts to fall.

Fed Funds Rate & Payroll Growth

Rate cuts themselves are not a recession warning, unless accompanied by declining employment growth. Otherwise, as in 1998 when there was minimal impact on employment, the economy may recover. Falling employment growth is, I believe, the most reliable recession warning. So far, the decline in growth has been modest but should be monitored closely.

Falling employment is why recessions tend to lag an inverted yield curve (negative 10-year minus 3-month Treasury yield spread) by up to 18 months. The negative yield curve is a reliable warning of recessions only because it reflects the Fed response to rising inflation and then falling employment.

Yield Spread

Valuations

A forward Price-Earnings ratio of 19.08 at the end of June 2019 warned that stocks are highly priced relative to forecast earnings. The forward PE  jumped to 19.55 by Friday — an even stronger warning.

S&P 500 Forward Price-Earnings Ratio

June 2019 trailing Price-Earnings ratio at 21.52 warned that stock prices are dangerously high when compared to the 1929 and 1987 peaks preceding major crashes. That has now jumped to 22.04.

S&P 500 Price-Earnings (based on highest trailing earnings)

The only factor that could support such a high earnings multiple is unusually strong earnings growth.

But real corporate earnings are declining. Corporate profits, before tax and adjusted for inflation, are below 2006 levels and falling. There are still exceptional stocks that show real growth but they are counter-balanced by negative real growth in other stocks.

Corporate Profits before tax adjusted for Inflation

Impossible, you may argue, given rising earnings for the S&P 500.

S&P 500 Earnings

There are three key differences that contribute to earnings per share growth for the S&P 500:

  1. Inflation;
  2. Taxes; and
  3. Stock Buybacks.

Inflation is fairly steady at 2.0%.

GDP Implicit Price Deflator & Core CPI

Quarterly tax rates declined from 25% in Q3 2017 to 13.22% in Q4 2018 (source: S&P Dow Jones Indices).

S&P 500 Quarterly Tax Rates

Stock buybacks are climbing. The buyback yield for the S&P 500 rose to 3.83% in Q4 2018 (source: S&P Dow Jones Indices).

S&P 500 Buyback Yield

The 2017 Tax Cuts and Jobs Act caused a surge in repatriation of offshore cash holdings — estimated at almost $3 trillion — by multinationals. And a corresponding increase in stock buybacks.

S&P 500 Buybacks, Dividends & Earnings

In summary, the 2018 surge in S&P 500 earnings is largely attributable to tax cuts and Q1 2019 is boosted by a surge in stock buybacks in the preceding quarter.

Buybacks plus dividends exceed current earnings and are unsustainable in the long run. When the buyback rate falls, and without further tax cuts, earnings growth is going to be hard to find. Like the emperor’s new clothes.

It’s a good time to be cautious.

“Only when the tide goes out do you discover who’s been swimming naked”.

~ Warren Buffett

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“Stocks rebound but sentiment soft”

From Bob Doll at Nuveen Investments. His weekly top themes:

1. We think the odds of a U.S. recession are low, but we also believe growth will remain soft for a couple of quarters. U.S. growth may bottom in the first half of 2019 following a relatively disappointing fourth quarter and the recent government shutdown. We expect growth will improve in the second half of the year.

Agreed, though growth is likely to remain soft for an extended period. The Philadelphia Fed Leading Index is easing but remains healthy at above 1.0% (December 2018).

Leading Index

2. Inflation remains low, but upward pressure is mounting. With unemployment under 4% and average hourly earnings rising to an annual 3.6% level, we may start to see prices rise. So far, better productivity growth has kept the lid on prices, but this trend bears watching.

Agreed. Average hourly earnings are rising and inflation may follow.

Hourly Earnings Growth

3. Trade issues remain a wildcard. The U.S./China trade dispute appears to be making progress, but the timeline is slipping and significant disagreement remains over tariff levels and intellectual property protections.

This is the dominant issue facing global markets. Call me skeptical but I don’t see a happy resolution. There is too much at stake for both parties. Expect a drawn out conflict over the next two decades.

4. We do not expect Brexit to cause widespread market issues. We think the risk of a hard Brexit is low, since no one wants to see that outcome. Some sort of soft separation or even a Brexit vote redo appears more likely.

Agreed. Hard Brexit is unlikely. Soft separation is likely, while no Brexit is most unlikely.

5. The health care sector may remain under pressure due to political rhetoric. Health care stocks in general, and managed care companies in particular, have struggled in light of talk about ending private health care coverage. We think Congress lacks the votes to enact such legislation. But this issue, as well as drug pricing policies, are likely to remain at the center of the political dialogue through the 2020 elections.

Health care is a political football and may take longer to resolve than the trade war with China.

6. Downward earnings revisions may present the largest risk for stocks. As recently as September 30, expectations for first quarter earnings growth were +7%. That slipped to +4% by January 1 and has since fallen to -3%.

A sharp fall in earnings would most likely spring from a steep rise in interest rates if the Fed had to combat rising inflation. That doesn’t seem imminent despite rising average hourly earnings. The Fed is maintaining money supply growth at close to 5.0%, around the same level as nominal GDP, keeping a lid on inflationary pressures.

Money Supply & Nominal GDP growth

7. Equity returns may be modest over the next decade compared to the last. Since the bull market began 10 years ago, U.S. stocks have appreciated over 400%. It’s nearly impossible to imagine that pace will be met again, but we feel confident that stocks will outperform Treasuries and cash over the next 10 years.

Expect modest returns on stocks, low interest rates, and low returns on bonds and cash.

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President Trump should look in the mirror

President Trump has repeatedly attacked the Fed and his recent appointee Jerome Powell for raising interest rates. In an interview with the Wall Street Journal, the President made clear his displeasure, stating that he sees the FOMC as the biggest risk to the US economy “because I think interest rates are being raised too quickly”.

What the President fails to grasp is that his actions, increasing the budget deficit when the economy is thriving, are the real threat. Alan Kohler recently displayed a chart that sums up the Fed’s predicament.

Unemployment and the Budget Deficit

The budget deficit is normally raised when unemployment is high (the scale of the deficit  is inverted on the above chart to make it easier to compare) in order to stimulate the economy. When unemployment falls then the deficit is lowered to prevent the economy from over-heating and to curb inflation.

At present unemployment is at record lows but Trump’s tax cuts have increased the deficit. The Fed is left with no choice but to steadily increase interest rates in order to prevent inflation from getting out of hand.

Real GDP growth came in at a robust 3.0% for the third quarter, while weekly hours worked are rising.

Real GDP and estimated Weekly Hours Worked

It’s the Fed’s job to remove the punch-bowl before the party gets out of hand.

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How will a bond bear market affect stocks?

10-Year Treasury yields broke out of their triangular consolidation at 3.00%, while the Trend Index recovered above zero signaling a fresh advance.

10-year Treasury Yield

Importance of resistance at 3.00% is best illustrated on a long-term monthly chart. Yields declined for more than three decades (since 1981) in a bond bull market but the rise above 3.00% completes a double-bottom reversal, warning of rising yields and a bond bear market. Target for the advance is 4.50%.

10-year Treasury Yield

The yield differential between 10-year and 3-month Treasuries has declined since 2010, prompting discussion as to whether a flat yield curve will cause a recession.  Interesting that the yield differential recovered almost 20 basis points in September, with long-term yields rising faster than short-term. Penetration of the descending trendline would suggest that an imminent negative yield curve is unlikely.

10-year Treasury Yield

How would a bond bear market affect stocks?

Capital losses from rising yields on long-maturity bonds would increase demand for shorter maturities, driving down short-term yields and causing a steeper yield curve. A bullish sign for stocks.

Inflation is low and the rise in long-term yields is likely to be gradual. Another bullish sign.

The last bond bear market lasted from the early 1950s to a peak in September 1981. Higher interest rates were driven by rising inflation ( indicated below by percentage change in the GDP implicit price deflator). The 1975 spike in inflation was caused by the OPEC oil embargo in retaliation for US support of Israel during the 1973 Yom Kippur war.

1950 to 1981: 10-Year Treasury Yields and GDP Implicit Price Deflator

Stock prices continued to climb during the bond bear market, apart from a 1973 – 1974 setback, but the Price-Earnings ratio fell sharply in ’73-’74 and only recovered 10 years later, in the mid-1980s.

1950 to 1981: S&P 500 and PE Ratio

Alarmists may jump to the conclusion that a bond bear market would lead to a similar massive fall in earnings multiples but there were other factors in play in 1975 to 1985.

First, crude prices spiked after the OPEC oil embargo and only retreated in the mid-1980s.

1960 to 1985: West Texas Intermediate Crude prices

The rise of Japan also threatened US dominance in global markets.

1960 to 1985: Nikkei 225 Index

We should rather examine the period prior to 1973 as indicative of a typical bond bear market. The S&P 500 Price-Earnings ratio was largely unaffected by rising yields. Real interest rates actually decreased during the period, with the gap between 10-year yields and the inflation rate only widening near the 1981 peak.

At present, real interest rates are near record lows.

1981 to 2018: 10-Year Treasury Yields and GDP Implicit Price Deflator

We can expect real interest rates to rise over time but that is unlikely to have a significant impact on earnings multiples — unless there is a strong surge in long-term yields ahead of inflation.

 

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Capital spending on the rise

Just released July 2018 manufacturers’ new orders for capital goods, excluding defense and aircraft, show that the recovery is gathering speed.

Manufacturers New Orders: Capital Goods excluding Defense & Aircraft

Any fears that easy money has undermined capital budgeting restraints — and that the economy is entering the final heady stages of a boom before the bust — can be dispelled by adjusting the above graph for inflation.

Manufacturers New Orders: Capital Goods excluding Defense & Aircraft adjusted for Inflation

Adjusting manufacturers orders by the GDP implicit price deflator shows that the recovery in capital spending has barely started and is a long way from the excesses preceding the Dotcom crash and the GFC.

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Australia: Good news and bad news

First, the good news from the RBA chart pack.

Exports continue to climb, especially in the Resources sector. Manufacturing is the only flat spot.

Australia: Exports

Business investment remains weak and is likely to impact on long-term growth in both profits and wages.

Australia: Business Investment

The decline is particularly steep in the Manufacturing sector and not just in Mining.

Australia: Business Investment by Sector

But government investment in infrastructure has cushioned the blow.

Australia: Public Sector Investment

Profits in the non-financial sector remain low, apart from mining which has benefited from strong export demand.

Australia: Non-Financial Sector Profits

Job vacancies are rising which should be good news for wage rates. But this also means higher inflation and, down the line, higher interest rates.

Australia: Job Vacancies

The housing and financial sector is our Achilles heel, with household debt climbing a wall of worry.

Australia: Housing Prices and Household Debt

House prices are shrinking despite record low interest rates.

Australia: Housing Prices

Broad money and credit growth are slowing, warning of a contraction.

Australia: Broad Money and Credit Growth

Bank profits remain strong.

Australia: Bank Profits

But capital ratios are low, with the bulk of profits distributed to shareholders as dividends. The ratios below are calculated on risk-weighted assets. Raw leverage ratios are a lot weaker.

Australia: Bank Capital Ratios

One of the primary accelerants of the housing bubble and household debt has been $900 billion of offshore borrowings by domestic banks. The chickens are coming home to roost, with bank funding costs rising as the Fed hikes interest rates. In the last four months the 90-day bank bill swap rate (BBSW) jumped 34.5 basis points.

The banks face a tough choice: pass on higher interest rates to mortgage borrowers or accept narrower margins and a profit squeeze. With an estimated 30 percent of households already suffering from mortgage stress, any interest rate hikes will impact on both housing prices and delinquency rates.

I continue to avoid exposure to banks, particularly hybrids where many investors do not understand the risks.

I also remain cautious on mining because of a potential slow-down in China, with declining growth in investment and in retail sales.

China: Activity

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