E-piphany

December Retail Sales were weak, and that may be significant since December is an important month for said sales. However, November’s sales were revised up by a similar amount, which blunts the message somewhat. That is still a worse outcome than if it had happened in the opposite direction (November down, December up), but the volatility of the series being what it is I wouldn’t want to put a bunch of money on that significance.

Neither, it seemed, did people in the market. Stocks continued their new-year climb, albeit gently, and bonds rose a little as well. Treasuries did very well today, given the amount of supply that has recently come to market, but I suspect yields will be higher at month-end.

Except…that in saying such things I might be falling victim to the same complacency that is afflicting everyone else. Let us say that I suspect yields will be higher in the absence of something bad happening. But that makes the investment decision difficult, because a good probability of somewhat higher yields is countered by a low probability of significantly lower yields. With implied volatilities this low, it suggests to me that playing a further selloff with options (given the skew, probably selling bonds and buying protection with calls rather than buying puts themselves) may be the right play. I not in a position to invest this way, but I think that’s what I would do.

I was cautioned about complacency via a trading desk note from a sell-side bond shop (Deutsche), who reminded us that among the things to worry about we can include the following:

• China is taking steps to slow its economy.
• The European PIIGS are getting uglier and uglier.
• There are a number of US states facing a severe fiscal crisis, probably leading to more furloughs, job losses, and higher taxes.

I would say that of these three, #1 and #3 are pretty important medium-term concerns, which I wouldn’t necessarily expect to be incorporated into asset prices until one day when they abruptly are, while #2 contains the possibility of a shorter-term calamity. It is a good reminder that we continue to live in a dangerous world, and markets are not presently pricing in that danger. After all, the VIX is at 2.5-year lows, while prime jumbo mortgages are sporting record high delinquency rates. Which reminds me: to those three things above, we should add an old favorite, the continuing mortgage crisis – delinquencies and foreclosures haven’t stopped rising, yet!

One fear that is not likely to be realized, in the near term anyway, is the fear about how the extraordinary actions of global monetary authorities will be translated into inflation. There are lags involved, and at this point the lags are pointing downward. Tomorrow, the BLS releases the CPI, with the consensus estimate being for an 0.1% month-on-month rise in core inflation (1.8% year-on-year).

The dynamics of the number have been described in this space previously. Most of the index, ex-housing, is rising while the Shelter component continues to languish due to the declining cost of a substitute (owning, rather than renting, a home). But Shelter is more than a third of the core index, and is the dominant effect here.

I think the consensus estimates may be too high at a meager +0.1%. Last month, the year-on-year figure was unchanged at +1.7%; but the Median CPI produced by the Cleveland Fed fell to 1.3% from 1.5%. Some people consider the Median CPI to be a superior measure, since it isn’t influenced as much by outlier points as an average is; personally, this happens to interest me since the models I follow regularly are suggesting that Core CPI ought to be declining on a month-on-month basis rather than rising 0.1% as the consensus expects. Lags are coalescing into near-term downward pressure: last month, my preferred model said 1.7% year-on-year; this month and for the next 4 months it is forecasting +1.5%. If that is realized this month, it would say a -0.2% month-on-month print for Core CPI, rather than +0.1% as the consensus estimates, is to be expected. I think we’ll be more like 0.0% or -0.1%: missing by 0.3% from the consensus would be a huge miss and I think TIPS, which have been pricing increasingly high inflation expectations recently, would get slaughtered.

Now, the models I follow don’t strip out Shelter, and so the lags they are expecting are largely expressed in the weak Shelter subcomponent of CPI. But I will note that the “16% trimmed mean” CPI from the Cleveland Fed actually rose last month to 1.3% from 1.2%. This is consistent with what I am seeing in the dynamics of CPI: Shelter is weak, but lots of other components are starting to look perky.

By the way, headline inflation is expected +0.2%, but I barely look at that. It’s important for the valuation of TIPS, but policymakers will look at Core or one of the other 56 flavors of inflation.

Although they will barely register for me, there is a lot of other data due on Friday. The Empire Manufacturing Index is expected to come in at +12.00 from +2.55. I am skeptical, given the other weak prints recently. Industrial Production/Capacity Utilization (Consensus: +0.6%/71.8%) I actually think could surprise on the high side given the recent cold snap since utility output will have been higher than normal. University of Michigan Sentiment for December is expected to rise to 74.0 from 72.5.

If you look at the consensus guess on all of these numbers, you definitely can perceive the complacency among economists. They think the economy is springing back in typical post-recession fashion. I don’t, and until economists start ratcheting back their forecasts I think there’s more risk of the data missing on the low side.

At some point – and history tells us that it is very difficult to identify that point – investors will abruptly realize that the script they have been reading from, which calls for a strong recovery to follow a deep recession (enter strong recovery, stage right), isn’t working out and they will need to look for a different script. Unfortunately, all alternative scripts imply a lower rate of growth and higher risk (aka discount factors) to be applied to asset flows, and therefore a lower price for equity. If this adjustment happens gradually, we may have a gentle retracement and retrenchment of recent stock market gains. If it happens abruptly, we could have a sharp break in prices.

I don’t have any idea which outcome is more likely, but I am on guard. It is harder to be mugged when you’re looking for it.

The market is closed on Monday for Martin Luther King, Jr. Day. I will probably publish something over the weekend following up on the CPI print, but no promises.