Is It Time to Worry About Inflation?

Overnight futures declined sharply on the evening of January 7^th, as news of the Iran missile strike became public. Market participants (like us) were watching closely, monitoring events and planning trades. As often happens, it was best not to trade the overnight market. By morning there was word that no lives were lost and damages minimal. If you look only at the trading in market hours you would not know that anything happened. This is why I sometimes use the futures chart.

The market gained 0.9% for the week. The trading range was 2.1%, not including the decline in the futures on Tuesday night. You can monitor volatility, implied volatility, and historical comparisons in my weekly Indicator Snapshot in the Quant Corner below.

Noteworthy

How the STEM Crisis is Threatening the Future of Work
is a provocative analysis from The Visual Capitalist. Check out their post for a giant chart laying out the entire argument. Here is one piece. [Jeff – I’m not sure I agree with the policy prescription, and I’m very interested in comments.]

The News

Each week I break down events into good and bad. For our purposes, “good” has two components. The news must be market friendly and better than expectations. I avoid using my personal preferences in evaluating news – and you should, too!

New Deal Democrat’s high frequency indicators are an important part of our regular research. This report is fact-based. NDD is consistent with the package of indicators. Each has a source and often an accompanying chart. Here is the update of money supply, a subject of plenty of recent uninformed commentary.

NDD summarizes that the results remain positive in both the long- and concurrent-time frames, and the short-term forecast remains neutral. NDD continues to emphasize the split in producer and consumer indicators, something he is watching closely.

The Good

• ISM services MarketWatch Brian Wesbury
  

  At the end of the day, the service sector report from the ISM should be given more weight than the manufacturing report when it comes to the outlook on the broader economy, but the media loves negative news and these data simply don’t support their dour outlook. Fear sells, even when the fear isn’t justified.

• ADP private employment for December showed a gain of 202K, soundly beating expectations of 155K and last month’s 124K (upwardly revised from 67K).
  
• Initial jobless claims edged lower, to 214K. This beat expectations of 225K and last week’s 223K. The four-week moving average also moved lower. This is a widely-followed smoothing technique, but can react strangely when a very good or very bad week drops out of the average.
  

The Bad

• Factory orders for November declined .7%. This was actually better than expectations of a 0.8% decline, but I cannot score it as “good” when October’s result was a gain of only 0.2%, downwardly revised from 0.3%.
• The unemployment report
  • The slowing rate of growth is concerning to some. James Picerno describes the “nine-year low” as a gradual but persistent slowing.
  • Growth remains well above the levels required to maintain the record low unemployment. In a CNBC interview, Jan Hatzius mentions the weak points, but sees a strong labor market. He cites other wage indicators that are stronger. He explains the likely Fed reaction, comments on the change in the trade deal (a subtraction of negative growth), and comments on the reduction in manufacturing jobs. 2018 saw the tax cut and no trade war. 2019 showed a much greater trade effect. This interview covers several important and sophisticated points.
• Rail traffic continues its deceleration. (Steven Hansen, GEI).

The Ugly

The Ukranian passenger plane crash, now known to have been the result of an Iranian missile attack. The Iranians blamed human error when air defense personnel had only ten seconds to identify the incoming flight, which they thought was a cruise missile. It was a time of increased US military flights around the Iranian borders, combined with the fear of escalation. Iran placed part of the blame on “US adventurism.” [CNN]

This is exactly the kind of mistake I have been fearing. When tensions escalate and military action is employed, trigger fingers get itchy.

The Week Ahead

We would all like to know the direction of the market in advance. Good luck with that! Second best is planning what to look for and how to react.

The Calendar

The economic calendar is a big one, featuring inflation and housing data. Retail sales is also important. The NFIB small business optimism has gained interest among those focused on business investment. Fed devotees will do a deep reading of the Beige Book. Michigan sentiment gives a clue about consumers. I am not very interested in the regional Fed surveys, but some data mavens follow them closely. There is something for everyone!

And perhaps of greatest significance, we get the start of earnings season. Brian Gilmartin has a preview.

Briefing.com has a good U.S. economic calendar for the week. Here are the main U.S. releases.

Next Week’s Theme

The market got a taste of the possible consequences from increased Middle East conflict. Much of the punditry was left amazed that the impact was not greater. Their business is discussing what to worry about, so they are wondering why their daily reports are not having a greater effect.

My biggest worry is hardly mentioned – at least outside of the doomster network. For years I have said that inflation news was not relevant but would be someday. I have also cheered for modest inflation levels while others sought an increase to the Fed target of 2%.

With this week’s PPI and CPI reports (and I don’t expect anything unusual) we have an occasion to think about what we should be watching. We should be wondering:

Is it time to worry about inflation?

Background

Inflation is important for several reasons.

• It is a foundation for Fed policy. Price stability is one half of the dual mandate.
• Failure to act soon enough to deal with incipient inflation is the most frequent cause of recessions.
• Inflation begets higher inflation expectations which beget lower market multiples.

There is a sharp contrast between the Fed’s analysis of inflation and that of the trading community. The wedge is further driven by constant commentary from the “reliably bearish” list on my Twitter feed. Last week there was a good illustration. One week ago Ben Bernanke, former Fed Chair, Former Chair of the Princeton Economics Department, and currently a Distinguished Fellow in Economic Studies at Brookings Institution delivered the 2020 American Economic Association Presidential Address. He takes on the question of very low interest rates and the challenges of 21^st century monetary policy. Briefly put, he finds that the modern tools of central bankers are generally effective until nominal interest rates are lower than 2%. He highlights the need for cooperative fiscal policy. He gives a nod to the “victory over inflation under Fed chairs Volcker and Greenspan” and how this has created a new perspective:

In a world in which low nominal neutral rates threaten the capacity of central banks to respond to recessions, too-low inflation can be dangerous. Consistent with their declared “symmetric” inflation targets, the Federal Reserve and other central banks should defend against inflation that is too low as least as vigorously as they resist inflation that is too high.

The Twitter response to this was “Hasn’t he learned anything yet?” This take, supported by some bloggers and a staff member who had a cup of coffee at the Fed, apparently resonated with many of their followers. It is difficult to compare ideas when some are just seeking confirmation and page views.

By coincidence at the very time of Bernanke’s speech my former colleague Marty Finkler was circulating some of his thoughts on the role of central bankers. His final version, What Should Central Banks Do? Central Bankers Volcker, Mishkin, Rajan, and King Provide Excellent Guidance
explores the changing goals confronting central bankers. Not incidentally he describes the need for clarity from legislative bodies. He concludes as follows:

In my view, if monetary policy is left to politicians who are elected on a relatively short term basis, countries face incentives to manipulate monetary policy to serve short term ends. Such incentives are strengthened by recognition that the lag between monetary policy and output is much shorter than that between monetary policy and both inflation and financial fragility. We need the Paul Volckers of the world to sustain long term economic viability by targeting both price and financial stability. I, for one, recognize his contribution to economic vibrancy in the United States and mourn his passing.

With a knowledge of the differing perspectives and what is at stake, I will examine some specific points.

Goals

Since 1977 the Fed has had a dual mandate from Congress, to “promote effectively the goals of maximum employment, stable prices, and moderate long term interest rates.” (Richmond Fed). Public resources, some cited in the article, illustrate the policy in action. These include transcripts of FOMC meetings.

The popular take is quite different. The Fed is held accountable for providing income to savers. It is charged with creating asset bubbles and resulting market crashes. In current days there is a sense that the Fed will not allow market prices to decline below a certain level (referred to as the Fed “put”),

Inflation Target and Measurement

The Fed has announced a symmetric target of a 2% annual increase in the core PCE. They use the PCE because it emphasizes factors that have more economic relevance than the CPI. They use the core rate since it clarifies the underlying trends by removing two volatile elements.

The popular view is that of the many inflation measures, none of them is accurate. Individual experience always differs from the aggregate, so it is easy to find a large price increase to use as a criticism. And why 2%? Why not zero? [This criticism frequently comes from the same sources who are worried about a low return to savers!] At the extreme, some sources claim that inflation has exceeded 10% for many years.

What counts in the measurement

The Fed relies on government data concerning actual spending by consumers. There are many variants, but all include a collection of goods and services.

The alternative view is that asset prices should be part of the indicator. If stocks and commodity prices rise, this should be measured. Furthermore, it should be part of the Fed mandate to stabilize these prices, regardless of the economic consequences.

My Take

What I have been calling the “popular” or alternative view is readily accepted by most people. Inflation is a challenging topic. Some who have spent careers analyzing it have tried to improve the measurement. The average person gives it a moment’s thought. It is easy to play upon feelings like this. You can ask, “Why exclude food and energy? Don’t you have to eat and drive your car?”

One of my specialties is identifying concepts that present an “easy” viewpoint versus one that is more challenging. It is one of the best opportunities for investors to profit. It is like sitting at a poker table with a group of fish.

• First, which approach does not work? The Fed bashing is concentrated among those who are attempting to explain failed theories or bad predictions. Some have so much credibility invested in the subject that they can’t change. And many do not need to be right. They just need readers! And what would have happened if the Fed had responded to the bogus 2011 signal on asset prices?
• Second, why not think like an FOMC member? You cannot change policy, even if you think it is wrong.
• Third, the best way to get the public view of inflation is the market-based spread between TIPS and Treasuries. I publish this each week. Next best is looking at the Michigan Sentiment survey expectations, which usually run slightly higher than market prices.
• Finally, you can profit from understanding the Fed perspective and what is likely to happen next. You want to understand policy changes and adjust your portfolio.

These are the elements of “Don’t Fight the Fed” with just a little added explanation.

I’ll have some additional observations in today’s Final Thought.

Quant Corner and Risk Analysis

I have a rule for my investment clients. Think first about your risk. Only then should you consider possible rewards. I monitor many quantitative reports and highlight the best methods in this weekly update, featuring the Indicator Snapshot.

Both long-term and short-term technical indicators remain neutral, but are now deteriorating.

The C-score has moved slightly lower implying greater odds of a recession within the next nine months. Since May we have been watching for confirming data. Like others, we don’t see much of that. Most sources have lowered recession odds, so why has the C-Score fallen? The potential for inflation. So far, so good on that front, but it is important to keep the Fed out of play while we start to enjoy reduced trade war effects.

The Featured Sources:

Bob Dieli: Business cycle analysis via the “C Score”.

Georg Vrba: Business cycle indicator and market timing tools. The most recent update of Georg’s business cycle index does not signal recession nor does his unemployment rate method.

Brian Gilmartin: All things earnings, for the overall market as well as many individual companies.

Doug Short and Jill Mislinski: Regular updating of an array of indicators. Great charts and analysis. With the release of the employment data, it is time for an update of the excellent “Big Four” presentation.

Guest Sources

Here is an interesting approach to the analysis of GDP. Goldman Sachs looks at what level of GDP growth is implied by a long list of individual indicators – in the absence of any other information.

Paul Schatz discusses the “early January indicator.” (That always seems to get a big play when there is a weak start to the year). He does some testing. Yes the market usually moves higher – 78% of the time. It also moves higher 74% of the time for any random year since 1990.

“Davidson” (via Todd Sullivan) has a good take on the challenges of quantification when evaluating unusual events. He considers the effects of the reduction in regulation, some accomplished and more to come.

Take a look at the list of policy changes he cites. Here is just one example:

Deregulation remains in early stages. Dodd-Frank legislation has virtually stalled single-family mortgage lending at less than half what the MCAI(Mortgage Credit Availability Index) suggests should be normal during economic recovery. This has left single-family starts stalled equal to the lowest levels experienced in housing recessions since 1959. The roll-back of Dodd-Frank rules treating community banks, the source of most mtg lending, with the same set of regulations as the Money Center banks has only just begun. Should this prove successful, upwards of $600Bill annually of new mortgage lending could enter new single-family building to offset the severe housing shortage we currently have in single-family homes. More Quid Pro Quo. It will take several years to satisfy single-family housing demand and this is one reason to expect 3yrs-5yrs of additional economic expansion this cycle. But, there is more policy to this story.

Insight for Investors

Investors should understand and embrace volatility. They should join my delight in a well-documented list of worries. As the worries are addressed or even resolved, the investor who looks beyond the obvious can collect handsomely

Best of the Week

If I had to recommend a single, must-read article for this week, it would be Chuck Carnevale’s This Is How You Can Beat The Market Without Fail. As usual, this is worth a careful read backed up by viewing the video. First, how to measure performance.

Moreover, this speaks to one of my biggest pet peeves as a financial professional, which is listening to the common refrain that most active managers can’t beat the market (S&P 500). The reason this aggravates me so much is that I have never found it practical or useful as a professional manager to even try to “beat the market.” Investors are unique, and as such, possess investment objectives that are also unique to their own goals, objectives and risk tolerances.

He supports this idea with a great example.

…[I]nvestors might be better served to build a portfolio of individual stocks that meets their specific goals, objectives and risk tolerances. A good example could be a portfolio of blue-chip dividend aristocrats with a long history of increasing their dividend every year. In contrast, the S&P 500 would also include stocks that don’t even pay a dividend.

Next, fitting the investment to real needs – frequently dependable income no matter the environment.

And what about counting realized versus unrealized gains and losses? He looks back to the 1998 – 2000 era where the “false profits” disappeared in short order.

The lesson of the story is that unrealized gains can quickly turn into losses, while unrealized losses can quickly turn into gains. Stock prices are temporary in nature, but fundamentals are more enduring. Once again, it’s a fact that the market does not always correctly price stocks. This is precisely why I am on record many times of stating that measuring performance without simultaneously measuring valuation is a job half done. But more to the point, when I measure stock performance, I consider whether I am measuring an undervalued opportunity or an overvalued risky investment.

This is all great advice. “Beating the market” involves meeting needs in differing ways and time frames.

Stock Ideas

Artificial Intelligence was the dominant theme at CES2020, writes Kirk Spano. He writes about what he learned, including analyzing several specific stock ideas. I especially liked this quotation from a CES panelist: “The jobs of tomorrow aren’t invented yet.”

Want some energy exposure without the typical volatility? Ray Merola discusses Royal Dutch Shell plc (RDS.A) as a good candidate for those seeking diversification and good yield.

Barron’s suggests Bet on the Big Banks — and Bank of America.

Do you think it is too late to buy Apple? (AAPL) Brian Gilmartin channels his inner Peter Lynch to show the potential in new markets.

Eddy Elfenbein provides some color on the annual changes in his buy list.

Is the recent decline in Shake Shack (SHAK) a good entry point? (Stone Fox Capital).

Defense stocks on the rise? Michael A. Gayed evaluates the prospects for United Technologies Corporation (UTX) after the merger with Raytheon (RTN). After examining financials, the defense business, technical analysis, and UTX’s record of integrating acquisitions, he concludes, “All in all, The United Technologies stock is likely poised to post strong gains in the upcoming year and decade.”

Or how about Northrop Grumman (NOC)? (24/7 Wall St.)

The Great Rotation

One element of the Great Rotation is the rising importance of emerging markets. KraneShares provides expert analysis in this sector, especially concerning China. 2020: The Year of The China / EM Comeback
provides solid information about events from last year and an interesting prognosis for the year ahead. Their take is that many of the 2019 catalysts will continue. Here is a key quotation:

Another major highlight from 2019 was the announcement on December 13th that China and the US reached a “phase one” trade deal. China has promised to make purchases of no less than $200 billion of US goods over the next two years, including $40 billion in agricultural goods, and lower tariffs on key products including frozen pork and pharmaceuticals. In exchange, the US will lower tariffs from 15% to 7.5% on $110 billion worth of Chinese exports, while additional duties may remain.⁵ The storm is not over yet, but we can make out clear skies ahead. This year we believe the US-China relationship may stabilize as President Donald Trump focuses on the election and Chinese President Xi Jinping focuses on sustaining growth. We believe neither would like to see tensions rise and trade impeded further.

And later, this great observation:

Morgan Stanley research predicts a recovery in global GDP growth from 2.9% in the fourth quarter of 2019 to 3.4% in the fourth quarter of 2020, suggesting an average growth rate of 3.2% for 2020.⁹ This pickup may be largely fueled by Emerging Market economies, while Developed Market economies may continue to slow.

The near decade-long S&P rally may be jeopardized in 2020 given the market volatility implied by impeachment, the US election, and the likelihood of no new fed rate cuts in 2020. As such, investors may pivot to Emerging Markets in search of growth. In their 2020 outlook, JP Morgan advised investors to look for dividend, i.e. value, stocks, rather than growth stocks in Developed Markets, and reserve growth strategies for Emerging Markets.¹³

But you still need to know what stocks to buy.

Keeping in mind what is at stake.

Watch out for

GrubHub Inc. (GRUB). Stone Fox Capital provides a nice analysis of the food delivery business. The growth of competition has hurt GRUB’s profits and market share. See also Taylor Dart’s similar conclusions.

Schlumberger: Eye On North America And Cost Control
from D.M. Martins Research concludes that SLB is still not cheap, despite the impact of recent higher oil prices.

Final Thought

Understanding the Fed perspective is a great place to start, but we can do even better. Why am I getting worried about inflation? And when might the Fed join in?

1. The Fed typically is too slow. Yes, they know that lags in their policies are long and variable. They try to ignore political pressures. Despite that, the history is that they need actual inflation to support action.
2. The labor market is tightening. The worry should not be slowing growth, but rather finding skilled workers. This creates upward pressure on wages. That is good for workers and maybe for society, but not for investors. This is why the JOLTS report is important. And also the slack in labor force participation. So far, we have been able to draw workers from the sidelines and the gig economy.
3. Market multiples. I am untroubled by a forward multiple of 18.5. This is what I view as the base case in a low interest rate environment. It can move higher as long as the ten-year note is below 4%, so there is plenty of room. The multiple reflects investor confidence in future earnings and inflation expectations. These are both elements of my weekly update. A good earnings season would help along with the low inflation expectations.

Great Rotation Hint of the Week

Some other items on my radar

The need for more workers, including those with particular skills. (Yahoo Finance).

Another Iranian incident.

© NewArc Investments, Inc.

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