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Two Storms Coming
Since the financial markets are almost shut today due to “Frankenstorm,” and will in fact close early today, I am writing this article early on the notion that (a) it will be difficult to write later and (b) there will be little additional news worth writing about.
Not much paradigm-changing economic data has come out recently. Thursday’s Durable Good numbers were approximately on-target (ex-transportation +2.0% versus +0.9% expected, but with a revision to August’s figures of -0.5%), as were Initial Claims (369k, right in the middle of the range) and Friday’s initial release of the Q3 GDP report (2.0% vs 1.8% expected, with Personal Consumption +2.0% vs +2.1% expected). Today’s Personal Consumption and Spending reports were as-expected, as were all of the price deflators. The Dallas Fed Manufacturing Report was a bit stronger-than-expected but is merely back in the middle of the 3-year range.
There is, though, some positive economic news although it will take some time to be realized in the official figures. Gasoline futures recently approached the lows for the year (although in the last few days the approach of Hurricane Sandy and the general tightness in the delivery markets has caused a not-negligible rally), and retail gasoline prices which were recently threatening $3.90 are back to $3.54 (I wait with bated breath to see whether the people who shriek about the inflationary impact of gasoline rising will shriek with joy now that it’s falling – this volatility, folks, is why the Fed focuses on core inflation…not because they don’t drive). This is an unmitigated positive, if a small one, for the economy. While gasoline prices are still a multiple of where they were at the 2008 lows, they are only 18% above where they were to end 2007 (see chart, source Bloomberg).
Set against that, however, is the unmitigated negative of the election and the fiscal cliff. A Wall Street Journal story from late last week identified something we have seen in our business and which has been reported anecdotally by a number of our contacts.
Here is why dozens of chief executives have inserted themselves into the debate over reducing the federal budget deficit: Some say uncertainty over the looming “fiscal cliff” of tax increases and spending cuts already is hurting their business. “It’s a pause button,” Robert Swanson, executive chairman of Linear Technology Corp., told investors Oct. 17, after the semiconductor maker reported a 3% drop in fiscal first-quarter profit. Chief Financial Officer Paul Coghlan said companies that use Linear’s chips are growing more cautious before the election and the Dec. 31 deadline.
It isn’t merely the fiscal cliff itself. I’ve heard from a number of potential clients (in the financial industry and elsewhere) that there is great uncertainty associated with the results of the election itself. While the ‘fiscal cliff,’ a collection of tax increases and spending cuts that automatically kick in at year-end if Congress and the President do not agree to an alternative budget, could cause great short-term damage to growth in 2013, business-owners also believe that for the first time in the last half-dozen or so elections the results of the Presidential contest will have a significant effect on the business climate going forward. From a taxation perspective, on the basis of the future of Obamacare, on the degree of regulatory intrusiveness, the candidates seem to differ much more significantly than were McCain v. Obama, Bush v. Kerry, Bush v. Gore, Clinton v. Dole, or Clinton v. GHW Bush. Arguably Dukakis vs. GHW Bush showed a meaningful difference, and certainly Reagan v. Mondale, but it has been a generation since the election was thought to matter very much to business. This year, it certainly does. A storm is coming on November 6th, but like Frankenstorm it will pass.
But that doesn’t mean the election frees the stock market. I believe that a Romney victory (which is the current odds-on bet since undecideds typically break heavily for the challenger and he already has a lead overall and is tied or ahead in every important battleground state) would send stocks lower, while an Obama victory would send them higher – in the short term. The reason I believe this is that I think investors will interpret a Romney victory as producing a greater chance of fiscal austerity (relatively, that is – we’re not getting any important austerity in this country for a while) and a greater chance of a less-accommodative Fed over the next couple of years especially when a President Romney would replace Bernanke (whose term is up in January 2014) with a hawkish Chairman. These things would be more likely to produce a deeper recession in 2013 than we are already likely to get under Obama.
However, let me be clear: I think the Romney policies are closer to the correct policies, and I am highly confident that the stock market in five years would be significantly higher under Romney’s stated policies than under Obama’s. But the stock market is full of short-term-focused investors these days, and the more immediate focus would be on the near-term implications of a change from a relatively profligate fiscal and monetary policy (that anaesthetizes near-term pain even as our limbs are sawed off) to one that aggressively moves to address the nation’s financial future sanely, at a somewhat higher short-term cost.
The data seems to support this. Below is a chart combining the Intrade market for the probability of President Obama’s re-election (in white) and the S&P 500 (Source: Bloomberg), showing that this phenomenon has existed for a while. There is some argument that the causality runs the other way – that a lower stock market indicates a slower economic outlook and therefore a lower likelihood of Obama’s re-election, and I agree there is some circularity there. But I suspect the current consensus view, that a Romney victory is a big win for “risk-on” assets, is wrong in the short-term.
Now, I should say that I think Intrade investors are far off on the actual probabilities, but the point is the direction of movement. Also note that because the Intrade market is a binary option that either ends up at 100 or 0, it will naturally gain volatility as the market gets closer to election day. A similar effect will happen in the equity market, but it will not of course be as pronounced. (See my note on the subject of option-like market behavior here.)
I expect to get some partisan vitriol on this article. Save it – the power is going to be out, and so your anger will go unrequited! (Do you think it was an accident that I wrote this article today?!) Good luck to all in the hurricane’s path. It’s going to be a bumpy ride.
Mounting Pressure
The most striking facet of today’s trading was that the stock market actually reacted to the Fed’s announcement, which was precisely as universally expected: no change in anything but the technical language about where the economy currently stands. It wasn’t a huge reaction, but the fact that the S&P actually dropped 5 points on the news is mind-boggling to me because it implies that some people were expecting big things out of the Fed today.
To be sure, the arrow of action on the Fed is clear and pointed to ever-increasing amounts of liquidity, but this wasn’t ever on the docket for today. However several Street economists have predicted, plausibly I think, that when Operation Twist expires in December (partly because the SOMA will run out of short-dated Treasuries to sell) the Fed might keep going with the buying leg of the Twist – effectively increasing the monthly outright purchases of paper to $85bln (including Treasuries) from $40bln (all mortgage paper) currently.
Operation Twist has been a useless operation from the standpoint of monetary policy – it has neither added nor subtracted liquidity from the system. It may have had some value from the standpoint of asset-market-maintenance policy, by removing duration from the market and forcing investors to accept more risk for the same amount of reward. So it may be the case that Twist had some effect, but mostly a bad effect since it certainly doesn’t seem from market pricing that investors have been timid about taking risk. And I suppose it ought also be observed that “asset-market-maintenance” isn’t part of the legislative mandate of the Federal Reserve. However, legislators can be generous when markets are being pumped up – it’s when the air goes out that they’re unhappy.
Weirdly, though, I would prefer Operation Twist, which has little impact, to what is likely to replace it (additional QE).
Policymakers globally are growing increasingly bold about quantitative easing. In Europe today, ECB President Draghi told German legislators that outright bond purchases by the ECB “will not lead to inflation. In our assessment, the greater risk to price stability is currently falling prices in some euro-area countries. In this sense, OMTs are not in contradiction to our mandate: in fact, they are essential for ensuring we can continue to achieve it.” (See also this story.)
Central bankers are getting bold, but I’m not sure I understand why. They clearly see the connection between QE and inflation – fending off deflation was the purpose of QE2 and Draghi is clearly indicating the same even though core inflation in the Eurozone has risen from 0.8% in 2010 to 1.5% now (see chart below, source Bloomberg). That’s not exactly flashing red signals on inflation, but it is utterly fantastic to suggest that it indicates deflation is a greater risk.
In the U.S., QE3 and the likely acceleration of QE3 later this year is happening in the context of year-on-year rises in median new home sales prices (released today) and existing home sales prices (released last week) of over 11%, as the chart below (Source: Bloomberg) shows. Note that the existing home sales data is much more dependable on a month-to-month basis, because the number of existing homes and existing home sales swamps the number of new homes sold, but both show the same, clear trend. Home prices are now rising nearly as fast, nationwide, as they did in the bubble years.
For the record, the all-time record one-year price rise in existing home sales was 17.4% in May, 1979. Of course, in May 1979 core inflation was rising at 9.4%. In fact, with the exception of the last phases of the bubble of the early ‘Aughts, existing home sales prices are rising at the fastest margin above core inflation ever, as the chart below shows (Source: Bloomberg; Enduring Investments calculations)
Policymakers, and investors, seem to be numb to the threat of additional QE for one of two reasons. Either it is because of the belief that prior QE did not cause inflation (incorrect, as illustrated above and by the statements of intentionality of the policymakers themselves) or because they’re buying the line that QE is only adding to “sterile” excess reserves.
I think that this is dangerously sanguine. In fact, although it is true that QE initially results in greater excess reserves only, and these have only slowly trickled into transactional money, I think there’s reason to believe that adding more QE may increase that pace of transmission. Picture a large cylindrical vat, open on top with a small valve at the bottom. The water in the vat represents excess reserves, and the water trickling out through the valve is transactional money.
Many things can affect the pace at which the vat water flows through the valve – lending opportunities tied to credit demand and credit quality, disincentives to lend such as Interest on Excess Reserves (IOER), and moral suasion in both directions. Crank IOER to 25%, and all of the water poured into the vat remain as sterile excess reserves and QE is just reliquifying the banking system. Put IOER at a 10% penalty rate, and all of the water going in the top will flow out of the bottom very quickly – and all of the other water that’s already in the vat, too.
But even if you don’t adjust the valve at all, the greater weight of water in the cylinder, as you keep adding more water, will increase the flow out of the valve. Adding more QE is akin, economically, to increasing the weight of water in the cylinder.
The parallel economic concept is that a greater of excess reserves increases the opportunity cost of reserves. The average return on assets for a bank gradually declines as more of these assets become excess reserves rather than required reserves against lent funds. Leverage also declines, with the result (as I have pointed out before) that return on equity suffers. The chart below (Source: Bloomberg) shows the return on equity for large banks (those with more than $10bln in assets). You can see that while bank earnings have recovered significantly from the nadir of the crisis, they also appear to have leveled off at around 8% compared to the 15% that was the consistent standard prior to 2007.
The lending officers in these banks, although they’re being told to increase the quality of their loans, are being told more and more to also increase the quantity of their loans. They cannot do both, but as the pressure of too many reserves on the balance sheet builds, the pressure to make more marginal loans increases as well. This is the part of the valve that the Fed cannot control, and where danger lies going forward. The multiplier may well respond, eventually, to the weight of the reserves themselves.
Conform Or Be Cast Out
I like unloved assets. I can be a patient investor when I find an asset or an asset class that is unloved, but not truly loathed. When an asset class is loathed, it can take an enormous amount of time to realize value from it although if one’s horizon is long enough and one’s patience deep enough, this is where the best risk-adjusted returns are hiding. But for most of us, finding unloved assets where value is realized over a handful of years is the best we can hope for.
One of the reasons is that asset managers (ahem) tend to be a very impatient lot, and most of their clients even more so. I heard it said once that “the patience of the client is three point zero zero years,” meaning that assets whose value may take more than three years to unlock are potential poison to the asset manager’s business. This is, therefore, where investors with longer time horizons, such as family offices, foundations, and pension funds, ought to focus. The problem is that most of these institutional investors lack the expertise to analyze deep-value propositions in all of the different possible fields, so they tend to rely on sell-side analysts and buy-side firms that clearly have a vested interest in persuading them that, say, farmland is still undervalued after years of being hot, or high-tech stocks are still worth buying back in 1999 because new metrics apply.
I am continually surprised in this context by how few people “get” something as simple as commodity indices. Perhaps it’s because most people think they understand the basic idea: a commodity is something that you can feel, like corn or cattle or copper. Seems simple enough, and since these assets have no cash flows associated with them, our discounted-cash-flow-trained brains tend to view them suspiciously. “If I can’t value tech stocks, because they don’t pay a dividend,” the thought seems to run, “then how can I value commodities? If I rely on another buyer coming along to purchase it from me, isn’t this the same as holding Pets.com and hoping another buyer comes along?” Deceptive similarities like this make investors treat commodities as much riskier than at root they are. The difference, of course, is that there may be value ascribed to Pets.com solely because someone else will pay for it, whereas the commodity item itself has value-in-use. That is, you can grind the corn into meal, you can slaughter the cow to make hamburgers, or you can draw the copper into industrial cabling. If you’re the last buyer of Pets.com, you may have nothing at all; but you will never be the last buyer of corn because there will always be Orville Redenbacher standing behind you.
Pets.com is much more like a dollar bill, when you think about it – it’s only worth something because someone else accepts it as being worth something. You can’t use it, per se, if you don’t like the price.
But commodities – and even worse, commodity futures – seem more ephemeral than stocks. You feel like you own something concrete when you own MF Global stock, or Lehman, or Enron, or General Motors… well, you get the point. What you own is a small part of a business that may or may not be there tomorrow, as the result of management decisions, government action, or a global financial crisis.
Now, all of this doesn’t mean that commodities are automatically undervalued. Some commodities are actually well-liked, such as gold. You either have to look at an independent measure, such as the ones we have developed that relate commodities to currency in circulation, or compare returns to some other asset class that we think we understand better.
And it is here that it becomes really obvious that commodities are really disliked. As of today, the S&P in real terms is just about exactly where it was at the end of the month Bear Stearns collapsed. Yet the DJ-UBS commodity index is still down 34% in real terms. (See chart, source Bloomberg, with 3/31/2008=100).
Equity bulls will tell you this is because stocks got cheap in 2009, and earnings rebounded with the economy. But these same people will tell you that commodities are languishing because of the risk of weak global growth. And commodities, too, were beaten up in 2009 (in fact, the DJ-UBS fell further than stocks). Where is their bounce?
The chart below shows a slightly longer time-frame, dating from roughly the lows of the post-equity-bubble bear market. You can see in this picture that these two markets move together much better, especially in the days since early 2009. The brief (oil induced) commodity bubble shows up in early 2008, but then the current period can only be called a negative commodity bubble (or, perhaps, the beginning of an equity bubble).
So I like commodities, and I like people telling me why they’re dead money. Those people are wrong, or they’re too impatient and that’s the same as wrong. By our measures, commodity indices are between 15% and 25% cheap to fair value while stocks are somewhat rich.
Mostly Molehills
I suppose it is more interesting to have a whole plateful of interesting news and data to look at than to be fixated on one thing (say, Europe), but it does make it much harder to figure out what things the markets will take seriously. Note that this is distinct from the things that the markets should take seriously. For example, Initial Claims launched higher today, to 388k, the highest level since June. This was clearly a correction from the incredible drop last week, which was the result of an error. In the mountain-to-molehill continuum, this definitely falls on the “molehill side,” as did the drop last week, but S&Ps rose 8 points on the release last week (which was obviously flawed) and dropped a mere 2.5 today on the reversal. Maybe that should tell us something about sentiment, but as investors we really ought to be ignoring both of them and focusing on the fact that the true run rate of ‘Claims seems to be pretty stable at around 365k-375k, and hasn’t improved measurably since January. To be sure, that doesn’t mean it isn’t about to improve. In 2011, Claims were basically stable around 420k until October, and then improved into the end of the year to about the current level (see Chart, source Bloomberg).
We also shouldn’t worry too much about Vikram Pandit, the ousted CEO of Citigroup. It makes good voyeuristic television to wonder about why Mr. Pandit was dismissed and to go back and forth about his reputation, but it doesn’t mean anything for most of us. It probably doesn’t even mean very much for Citi. The 1980s-90s global giant überbank model is dying, as I first predicted back in 2008 it would. It’s a very simple analysis: lower turnover, smaller margins, and less leverage means lower return on equity. It does so by definition, since these are the three components of the DuPont model. And, since at least 2008, the trends were really obvious: regulators are demanding less leverage, and have decimated off-balance-sheet leverage so that the effect is larger than it seems; turnover was almost surely going to ebb because banks were weaker and customers more cautious; and margins were going to be depressed by the evisceration of truly structured business and movements of most products to exchanges. To be fair, we didn’t know Dodd-Frank was going to enshrine these trends in legislation, but it was obvious where they had to go. So big banks will rally, big banks will sell off, but the fundamental pressures on the business means that banks will need to shrink and specialize to survive. So Mr. Pandit? He could no more have saved Citi in its current form than he could have turned back the tides, and neither will the next CEO.
The formal establishment of the ESM, with a tiny sliver (~$32bln) of leverage-able capital, could potentially mean more, but only if it’s used intelligently. On past history, that seems unlikely, but in any event until it is used it doesn’t mean anything. I guess it means more than the two items above.
What about the rotten mid-day earnings from Google (horrendous) and Microsoft after the bell (awful)? Now, when the analysts tell us not to worry because something isn’t very meaningful, that’s when I start wondering about how important it is. I should say I couldn’t care less about either of these companies. I still can’t figure out how Google makes $36.5 billion (in 2011) from search. Who actually clicks on those ads? I once used a Google placement to try and sell my book. I generated millions of impressions, a couple hundred clicks, and sold one book. The campaign cost me $200. It was mainly an education expense because I was curious how it worked. It doesn’t. Oh, I’m sure you can sell some product through cute banner ads, but it’s only attractive if it’s dirt cheap. And if it’s dirt cheap, how do you sell $36.5bln of it? Even more, how do you keep growing that chunk, when it is getting harder and harder to keep attention on any given website or search engine? As I said, I don’t understand Google’s business and I don’t much care about the results. I understand Microsoft’s business a bit better, since it’s essentially a slow-growing industrial concern now that churns out a set of products (buggy software) that dominate their niches. But it still doesn’t matter to me, because I don’t own MSFT (or GOOG or C, for that matter), and likely never will.
But does it matter to the market? It’s only Microsoft and Google, right? Sure, and it was only Stonewall Jackson who got killed at the Battle of Chancellorsville. It matters when the generals fall, especially late in the year. I’m not saying it means that stocks are going straight down, but it is not a good thing, and it may matter.
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The 30y TIPS auction today doesn’t matter to most observers, but it matters to me. The auction was good, better than was widely feared. After all, the last few TIPS auctions have looked very weak, and this was $7bln of a 30-year accreting issue. It’s a lot of duration (roughly the equivalent of $19bln 10-year TIPS), but the market needs duration in inflation-linked product. Last year, the Fed took out of the TIPS market as much as the Treasury was increasing issuance in that sector, which is one of the reasons that TIPS yields are as low as they are. There is a shortage of inflation-linked paper (and a great opportunity to issue, incidentally, although corporate issuers in the U.S. are always remarkably reticent to issue real bonds for some reason), and especially at the long end of the curve where inflation matters more than at the 5-year point. Not every TIPS bond auction has gone well, or will go well, but it doesn’t surprise me much when they do.
A Summary Of My Post-CPI Tweets
This is a summary of my Post-CPI tweets today. You can follow me @inflation_guy.
- Core CPI +0.146%, just barely missing the soft +0.2% people were looking for. But y/y still rose to 2.0%.
- that dip in core is over – next several months have easy year-ago comps.
- Services inflation +0.3%, as is Housing. It’s only core commodities that’s a drag now (+0.0% after -0.1% last month).
- Rents (both primary and OER) rose +0.2% and the y/y rise matches core inflation at 2.1%. The inflation-sapping bust is over.
- unrounded y/y core CPI: 1.988%.
- Y/Y core services inflation is 2.5%. Y/Y core goods is +0.7%. It was services that dragged core down in 2009-10. That’s over. [Note: see Chart, source BLS, below]
- accelerating subgroups: Housing, Apparel, Transport, Recreation (66.2%). Decelerating: Food&Bev, Other (20.2%). Med Care & Educ/Comm unch.
- Both primary rents (+2.7% y/y) and OER (+2.1% y/y) are accelerating – by which I mean they are inflating at a faster y/y pace.
- Median CPI from the Cleveland Fed was +0.2%, and the y/y rate steady at 2.3%. The recent disinflation is an illusion.
The first supplementary chart is for core goods and core services. The sum of these two (weighted, of course) is core CPI. As you can see, it was the decline in the core services component (notably housing) that drove the decline in core CPI in the late ‘Aughts; the overall core number was temporarily kept afloat by the rise in core goods, but the crisis caused that to collapse as well.
Over the last couple of years, core services have returned to 2.5%, and core inflation is only as low as 2% now because core goods prices have begun to decline again. However, taking a broader view, it appears to me that the disinflation in goods from the early 90s to the early 00s is over and that goods prices are gradually taking a higher track. I’ve written previously about the possibility that the “globalization dividend” in terms of disinflationary pressures has shown some signs of ebbing. Obviously, should core goods inflation return to the levels it achieved a year ago (2.2% in November and December), overall core inflation would be comfortably above 2% even if core services inflation did not continue to accelerate.
In a non-CPI related note, New York Fed President Bill Dudley said today that the Fed won’t be “hasty” to pull back easy money: “If we were to see some good news on growth I would not expect us to respond in a hasty manner.” This confirms what we already knew – the Fed is willing to risk letting the inflation genie out of the bottle. Now, faster growth is not actually causal of inflation, as I frequently point out, so not responding to growth is ironically the right strategy, but it’s important to consider the reasons he gives for this policy. He is not saying that the Fed will not respond to growth because growth is not something they can affect; what he’s actually saying is that (since the Fed believes they can affect growth meaningfully) there is a very high hurdle to tightening even if prices accelerate somewhat further as long as growth remains slow.
So in what I think is the most likely case, continued slow growth with rising inflation, the Fed wouldn’t likely start to tighten the screws until core inflation was near 3% (and more importantly, until the economists who are modeling inflation as a function of growth decide they’re wrong, and stop forecasting a decline from whatever level we are at today). Since there is a significant delay of at least 6 months from Fed action to any effect on prices, this means that core inflation could easily get comfortably above 3% before any Fed action took effect – and, with the amount of money they’d need to withdraw, and the likelihood that they would start timidly, I have no idea how long it would take for them to stop an inflationary process which, at that point, would have considerable momentum.
So, in summary, this will not be the last uptick we see in core inflation.
The Good News On Inflation Seems Likely to End
In case you haven’t yet heard, congratulations are due to the EU – the recipient of this year’s Nobel Peace Prize. Hey, don’t laugh; they need the money. And don’t click over to the news, where you may find pictures of riots in various places as the peace and prosperity (which, as we now know, was purchased on credit that can never be repaid) is taken away. That’s an inconvenient truth…which, ironically, won the price in 2007. I think I see a pattern.
Back in the real world, American-style capitalism (such as it is) showed some temporary vigor today with Retail Sales announced stronger than expected (+1.1% ex-autos, with a +0.2% revision, versus +0.7% expected). That’s not a huge beat, but the three-month change of 3.04% is the highest rate since late 2005. To be fair, some of that is a payback from a weak Q2, and the year-on-year number is still well below the pace of 2011 and parts of 2010. Optimists, however, will see a glimmer of hope in this number, even if kick-starting the economy through the channel of retail sales isn’t exactly the “high-quality” growth we would like to see.
Speaking of high-quality growth, the bad news today was that the Empire Manufacturing figure was weaker-than-expected, bouncing only feebly from last month’s figure (which was itself the weakest since early 2009).
The equity market responded to the data (or, more likely, to the notion that last week’s mild selloff makes stocks “cheap”) with a healthy +0.8% rally albeit on weak volume. Commodities were smashed for the second day in a row, somewhat inexplicably since the dollar didn’t strengthen and there wasn’t a lot of economic news out today.
Indeed, Monday was pre-climactic, as Mondays often are but this week in particular. For tomorrow is the monthly CPI report.
Last month, recall, core inflation printed +0.052%, a very weak surprise that pulled the year-on-year figure to 1.9%. It was especially surprising since Housing, the heaviest-weighted index, accelerated. The number was dragged down by Apparel, and the quirky drags from August did not all get reversed.
The consensus Street estimate for September CPI is +0.5% headline, +0.2% core. The consensus for the year/year changes is +1.9% for the headline, and an uptick to +2.0%.
An uptick on core is all but assured, because last September’s change in core was only +0.08%. The year-on-year number will print +2.0% if the month-on-month change is only +0.11% tomorrow. In fact, if the monthly figure for core is +0.21% (the monthly changes for March through June of this year averaged +0.22%), year-on-year core inflation will spring all the way back up to +2.1%. That would, incidentally, really help the Treasury sell the $7bln in 30-year TIPS they have to sell this week.
There is some reason to expect these upticks. As I’ve mentioned, the weak inflation data from a year ago is one reason, but even the nature of the last few months’ changes suggest that we are not likely to be in the midst of a broad slowdown in inflation. Median inflation is as high above core inflation as it has been for several years. Housing appears to be accelerating, not decelerating. And, needless to say, global central banks continue to ease aggressively. M2 has begun to re-accelerate and is back to +7% y/y (+8.2% annualized over the last 13 weeks, which is the highest rate since January).
If core comes in weak again tomorrow, it will create a difficult analytical dilemma. A string of unusually weak numbers at the same point of the year in consecutive years could point to faulty seasonal adjustment. Since other economic data have been having difficulty with seasonal adjustment, we would have to consider that possibility. But the more likely interpretation would be that something about the underlying dynamic of inflation has changed, and price increases are decelerating again. I don’t think this is going to happen, but if it does I will have to address that possibility.
‘Scary’ Analysis
On Wednesday, I was trapped listening to CNBC because I was at one of our major consulting clients’ offices and it was on. I was struck by, and thought I would share, their insightful advice about what to do if the market has a ‘scary October.’ Their advice, phrased a number of different ways at a number of different times during the day, was to “average in,” and “take the opportunity to buy low.” So: respond to weakness in stocks by buying.
It would reasonable to consider whether that is solid advice – after all, it is much better to buy lower prices and multiples than higher prices and multiples – except for the fact that it’s the same advice they give when the market is rallying: buy. In fact, if one were to buy every time CNBC said to buy, and sell every time CNBC said to sell, over the last 15 years, I am pretty sure you’d be about 2500% long.
In this case, I don’t fault the advice itself, just the track record of the advisor. If the market actually declines an appreciable amount (2.5% off the highs does not, I think, qualify), then it makes sense to buy. Stocks are, after all, real assets. They don’t tend to perform well in inflationary periods, because of the initial shift in valuation multiples as inflation moves from low and stable to higher levels, but once valuations have adjusted, they do just fine. So far, valuations have not in fact adjusted, and remain high; so also do gross margins and corporate earnings as a percentage of GDP (which is currently near the highest levels of the last 60 years). I would buy equities after a ‘scary October,’ but not unless it’s a lot scarier than it is right now.
Stocks are doing poorly despite the suddenly whiz-bang employment picture. Today’s 339,000 print on Initial Unemployment Claims (versus a consensus of 370k) was the best since January 2008 (see chart, source Bloomberg).
Now, unfortunately, this number can’t be taken at face value. Unlike with the Employment report, all that you need to massage a weekly Claims number is for the government workers in a state to work a bit slower processing unemployment claims that week. As it happened, the BLS noted in the report that one state was responsible for most of the drop, which is not what you’d expect to see if the ranks of the jobless were suddenly thinning due to economic growth. It looks like one state (the BLS won’t say which one, but it must have been a big one; I’m guessing California, where some gas stations were closed last week and gasoline prices shot to near $6/gallon in some places, but I am not sure why the BLS wouldn’t tell which state since they typically do).
But, again, I must admonish readers to remember that the reported numbers are not as important as whatever is actually happening in the economy. If the numbers are not a good reflection of that, the man on the street will know it. They certainly know it in this case.
Now, there is certainly a possibility that employment has suddenly accelerated. But I don’t consider that a very likely possibility, since employment (as we are incessantly reminded near turns in the economy) tends to lag the business cycle rather than lead it. We haven’t seen a sudden surge in Durable Goods or purchasing managers’ reports, and seasonally-adjusted gasoline demand is the lowest it has been since 2008 (see the busy chart below, source Bloomberg, that plots the DOE Motor Gasoline Implied Demand by calendar date for the last five years. The white line represents 2012).
Total trucking miles are also at the lowest level, not the highest, since 2009 (see chart, source ATA and Bloomberg).
And, in case that’s partly a response to high gasoline prices, here are US Freight Carloads from the Association of American Railroads (with the 52-week moving average, in red. Source: AAR and Bloomberg).
That, and not the weekly Claims numbers, are what Americans feel. While consumer confidence may improve simply if things don’t get worse, that’s not the same as the way confidence will improve if ever activity – not just stock prices – starts to actually improve.
Europe continues to be the biggest threat to the global growth dynamic, but last night’s S&P downgrade of Spain two notches (from BBB+ to BBB-) was ignored by the market. Spanish yields actually declined. This is the way it should be, because we all know ratings are fairly useless generally but especially for sovereigns. As I have written previously, the only circumstance in which sovereign ratings make any sense is in fact in countries like Spain that may be unable to pay their debt because they cannot print their own currency. In any country that can print, it is impossible for there to be a forced bankruptcy; ergo, the rating of such sovereigns (such as the US) must be trying to measure not the ability to pay (which is absolute) but the willingness to pay rather than to default – even if to do so requires inflating, that isn’t a default. But if ratings have to measure willingness, they’re completely messed up. We have no way to evaluate willingness to pay. All of which is a long-winded way of saying that ratings only matter these days I think because of the risk of ratings triggers, such as when investors can only hold ‘investment grade’ paper and so need to sell bonds if they’re downgraded below that level. And I suspect this isn’t a big problem with Spain, as most conscious investors probably concluded months ago that this is not an ‘investment grade’ credit.
The election and earnings season remain the foci for the month of October. (And inflation traders also look forward to the 30-year TIPS auction, next week, which has started to put mild downward pressure on BEI already). There are plenty of other global issues still in play, but I’d expect stocks to continue to drift lower under the growing pressure of end-of-year selling to lock in lower tax rates, a weak earnings season, and increasing signs that the global slowdown is real. Will it get ‘scary’? I doubt it will get scary enough to buy.
Shifting Regimes And Those at Risk of Toppling
Equities weakened today, while commodities strengthened (and especially energy commodities). Although it is only one day’s trading, this messes around a little bit with the popular themes at the moment regarding why stocks are so high despite widespread expectations for a lackluster Q3 earnings season.
One theme has it that the stock market is doing well because the economy had been looking pretty good, especially with Friday’s positive (although not terrific) Employment Report, even if Q3 turns out to be disappointing. After all, stocks are supposed to discount the future, not the past, right? In line with that theme, today’s pullback might represent a weakening of sentiment about global growth. The IMF revised downward its forecast for global growth to 3.3% this year (and advanced economies only 1.3%). However, if that’s the reason then surely commodities ought to have suffered as well, especially gasoline. On the contrary, gasoline rose 2.6%, with November RBOB coming within $0.60 of a contract high set in March.
Another theme is that quantitative easing has been levitating stocks, despite weak fundamentals. But that doesn’t hold water either, since quantitative easing ought to be pushing commodities higher at least as much as it is pushing equities (which, after all, tend to trade with weak multiples in high-inflation regimes). The chart below (source: Bloomberg) shows the last year’s trading in the S&P, gold, and the DJ-UBS generally, normalized to October 10th = 100. While all three of these markets have rallied since the first implementation of the “soft” Evans rule back in June, stocks have clearly outpaced the markets that traditionally respond best to monetary largesse. So stocks are not likely up here because of QE, although that excuse probably helped over the last month.
It could, of course, be an equity-specific reason…like high valuations and probably unsustainable gross margins…but that doesn’t play well in Peoria so even though it is the simplest answer, it probably isn’t one the majority of analysts will put forth. It would be bad for business!
More subtle is the possibility that the inflation regime is moving from one that is accommodative to equity valuations (low, stable inflation) to one that is less accommodative. A ‘regime shift’ in inflation expectations is consistent with the way that inflation markets are trading – although breakeven inflation weakened very slightly today, 10-year BEI have rallied back to near all-time highs after the set back in the second half of September. It isn’t that the regime shift has happened today, and I’m not claiming that, but that it may be in the process of happening as the stock market is looking and acting toppy while inflation markets are showing some vibrancy.
It is hard to say why regime shifts happen, and the econometrics doesn’t tell you why – it just gives you ways to measure it and model it after the fact. It may be something incalculably complex, or something as easy as a news story that causes investors to reassess the context of the risks they are taking. A story, for example, about the rapidly rising prices in Iran and the collapsing rial.
It is hard to measure just exactly what inflation is in Iran. The latest figures from the central bank are from April, and show that inflation in the first four months of the year was running at a 44% annualized rate. But from all accounts, this has accelerated recently, and the behavior of consumers in the article linked to above smacks not of 3% monthly inflation, but of a much higher rate.
The reason that some people are calling this ‘hyperinflation’ is because the black market exchange rate for Iranian rials has apparently collapsed (I personally am not in touch with the black market so I have to take that on faith). The official rate, shocker of shockers, hasn’t changed much; since February you’ve been able to get about 12,350 rials for the dollar (see chart, source Bloomberg).
Now, whether or not the exchange rate is 12,000 IRR/$ or 40,000 IRR/$ isn’t as important to the average Iranian as the exchange rate of IRR for stuff – that is, the price level. This fact has led to some analysts making the rather wacky claim that inflation isn’t really that bad since the exchange rate doesn’t really matter to most Iranians. According to the story linked to here,
The politically-important lower-classes…are shielded from devaluation of the dollar because their day to day lives don’t even involve dollars. Salehi-Isfahani told Business Insider, “The Iranian currency is very worthwhile for poor people. They go to work, they get their daily wage, they go buy their chicken and bread, and they get the same that they got the day before.”
That’s crazy. If prices are changing for the upper class, I can’t think of how the lower class could possibly be insulated from those price changes. Economies just don’t work that way. If there is one exchange rate for one set of goods and another exchange rate for a different set of goods, it implies a changing exchange rate between those goods, unless there is to be arbitrage. So, to make up an example: perhaps the price of an egg is table in rials, except that a few months ago it was enough to buy bus fare and now you can trade it for a car, because both can be exchanged for enough rials to equal $1. See anything absurd about that? The relative prices matter, and you can’t stop barter, and therefore you can’t have different exchange rates in different parts of the economy without completely screwing up the economic system – probably worse than if you just let the inflation do its thing, which would at least not destroy the relative prices of goods to each other.
Moreover, the anecdotal stories don’t point to a low level of inflation, whether it’s called “hyperinflation” or not. Any way you slice it, when inflation is 40%+ whatever wealth you have saved up for a rainy day is vanishing quickly, and in Iran this is undermining an already unpopular regime (although probably not quickly enough for Israel!).
The simple realization is: when inflation starts getting out of control (and wonder of wonders, M1 money supply in Iran has risen at roughly a 34% per annum pace since 2007), all your stored-up wealth had better be in real things, or you won’t have any stored-up wealth. This is more true at 60% inflation than at 6% inflation, but even 6% inflation will halve the real value of your wealth in less than a decade. In that context, in context of the mere risk of such an outcome, I’ve wondered for a long time why more investors don’t look to protect a bigger portion of their portfolios with inflation-linked solutions. Maybe that regime is finally shifting (the inflation expectations regime, that is, not the Iranian regime) as we have an example that we can see today, rather than harkening back to the 1970s.
Incidentally, if you’re thinking about inflation investing, you may be interested in the following item. In the August “Beyond the Numbers,” a publication put out by the Bureau of Labor Statistics, there was an article entitled “Consumer Price Index data quality: how accurate is the U.S. CPI?” If you know any of those people who grouse and grumble about hedonic adjustment (the net effect is almost zero) and about the substitution of chicken for steak (the BLS makes no such adjustment, which is an ‘upper level’ substitution; the BLS only suggests that if the price of Purdue chicken goes up you might buy a different brand of chicken), then suggest this piece to them. It describes and addresses some of the biases in the CPI and how the BLS deals with them. Those that take the time to read this (relatively brief) piece will understand a lot more about how the number is actually computed, as opposed to how some hacks claim it is computed, and hopefully such an understanding will open up a wider universe of potential investments in the ‘inflation control’ toolbox.
A Summary of My Post-Employment Tweets
Here is a summary of my post-Employment tweets (@inflation_guy on Twitter):
- Before any comments about unemployment, a note: it isn’t the NUMBERS that affect the political race, it’s the reality of unemployment.
- Unemployment rate 7.796% from 8.111% and vs expectations of 8.2%. 114k new jobs, tho weak in private payrolls, +86k net revisions though.
- According to household survey, 873k more people are employed this month. Uh huh. can you say ‘seasonal adjustment problem?’
- I doubt there is manipulation in these numbers, but they’re the kind of numbers that make people suspect manipulation.
- avg hourly earnings and avg weekly hours both a tick higher than expected.
- In sum, this isn’t a robust report by any stretch (114k new jobs), but it’s better than expected. I expect the unemp drop will retrace.
- Series I like, “Not in Labor Force, Want a Job Now,” fell to 6.727mm people: still 2nd highest since series started in 1994.
- As a reminder: people don’t vote the numbers they see on TV. They vote the numbers they see and feel.
The Employment report was good, but not terrific. Any way you slice it, 114k new jobs isn’t going to get anyone dancing in the streets, even with revisions. A quick word to the conspiracy theorists out there: if I was going to manipulate this number, I would do a better job. By monkeying with seasonal adjustments and secondary assumptions, you could produce a much better “new jobs” number. It would require a whole lot of people to be “in on it,” so you might as well get some value out of it, if you’re that kind of sleazebag. So I don’t think there’s any manipulation here, just bad seasonal adjustment.
But more importantly, it isn’t the number that affects the election. People think that because the unemployment rate and the re-election success of the incumbent are related, the former causes the latter. It’s not so. It’s that both are related to a third factor, the actual condition of the labor market. Remember that these are experiments, imperfect estimates of real world conditions. As it turns out, individuals are really good at assessing the state of the job market without any help from the statisticians – they just look at how many of their pals are out of work. So even if this was a completely made up number (or, more likely, just a fortuitous wiggle in the Obama direction), it wouldn’t affect the polls. Thought experiment: if the BLS today had reported 4% unemployment, what would the effect on the election be? The correct answer is zero, because everyone would know that’s not the real unemployment rate.
It’s the same thing here. If the unemployment rate really dropped 0.3% in one month, then it will affect the polls. If it didn’t, it won’t.
Judging from the total of the various employment and activity series we have, I think we have an economy that is still growing slowly, but decelerating and risking a relapse into recession. But we’re not there yet.
Option-Like Payoffs
It seems we have a lot of option-like payoffs looming in the next few months.
By that I mean that we have a number of events that are likely to result in either-or (binary) outcomes. Think of them as options that are going to either finish in the money or out of the money. For example, either President Obama will win re-election, or he won’t. Either the Bush tax rates will be extended, or they won’t.
Those two are truly option-like, in that they also have a fixed maturity. We will know in 33 days who the President for the next four years will be. While the Bush tax rates could always be extended retroactively to cover 2013 even if it takes until February to hammer out an agreement so that can happen, the deadline to make transactions that put income or capital gains into 2012 rather than 2013 is December 31st.
Now, what we know about options is that as you get closer to expiry and are “near the money,” your gamma increases. Gamma is a measure of how quickly the option’s delta changes – how quickly you go from feeling like a likely winner to a sure loser. An example will help. If you own $660 call options on AAPL (closing price today $666.80), and they expire in a year, then it’s probably roughly a coin flip whether those calls will end up in the money or not.[1] We would say the delta is about 0.5. If AAPL sells off to $650, then looking one year out it’s still probably pretty close to a coin flip – obviously slightly less likely, but not a bunch. Maybe 0.49 is your delta, meaning that you have something like a 1% worse chance of ending up in-the-money.
But if, on the other hand, the options are expiring at 4pm today, then your $660 call is looking pretty good when the stock is trading at $666.80 at 2pm. Your delta might be 0.95. But when, by 3pm, the stock drops to $650, your chances of winning have declined dramatically. Your delta is perhaps 0.02. Because these odds move much more dramatically, we say this option has more gamma. This is a function of both the time to maturity and the nearness of the strike to the current price.
Option traders, who try to manage their risk by delta-hedging an option, like gamma a lot if they’re long options, and dislike it immensely if they’re short options.[2] That’s because if they’re short, the hedge involves them buying into strength (aka “buy high”) and selling into weakness (aka “sell low”), and often leads to frenetic trading and on occasion, serious moves on expiry day.
Where am I going with this? An observation: as we get closer to these “option events,” if they are still not resolved one way or the other the markets will likely grow more volatile. Consider what happens to an equity investor thinking about the ‘fiscal cliff’ as year-end approaches and no deal has been struck on taxes. The investor is going to be increasingly concerned about selling stocks in which he has gains, to book those gains in 2012 in case the tax rates go up a lot. If it appears that Congress is starting to resolve some issues, then this selling pressure may relent and the markets rebound. This could go back and forth as often as the headlines change, and I will tell you that those headlines will get more frequent as the deadline draws nearer. This implies to me that market volatility will probably increase as we get closer to the election, and as we move into year-end, because of these option-like events.
There are other option-like events, although less certain in timing (Israel attacks Iran, or not. Spain asks for aid and gets it, or not. Greece defaults, or not). These will have less obvious “gamma effects,” although as long as in each case they have at least two plausible outcomes that could well happen, it will tend to contribute to volatility.
In other words, with the VIX is near the lows for the year options seem inexpensive to me.
I’m having these thoughts today because I’m watching the wild gyrations in gasoline, which was -12 cents at Wednesday’s lows (finishing -7 cents) and +14 cents today. November gas covered nearly the entire 2-month range in 2 days’ trading. More near to my heart, inflation breakevens have spiked for the last few days (+8bps today) after spending half of September retracing from a spike to touch all-time wides (see chart, source Bloomberg).
Note that this is the ten year breakeven, so it isn’t reacting here just to gasoline. And I am not aware that the outlook for growth has changed dramatically this week, nor any major money metric. What is going on? My only guess at the moment is: gamma. Small things, like a win for the Republican challenger in last night’s debate, can cause big changes in expectations, and this will become even more true as long as the race stays tight.
If we look at just that market, we could also mull the technical issues. A market that spikes to all-time highs is one thing. A market that spikes, retraces, and then rallies back to a new high would be quite another thing altogether, and might signal a new range for inflation expectations is being formed. And oh, my, would that be significant?
The equity market remains elevated, and rising inflation expectations will eventually take a toll on multiples. It always does. I don’t want to bet against equities while inflation is currently low and the Fed is trying to push the market higher, but I believe we have some volatility ahead. With implied volatilities so low on options right now, it may be worth buying puts.
[1] I am ignoring the important nuance that in this case, the forward price will be different than the spot price – it’s not important for my illustration, but you really want to compare the strike price to the forward price of AAPL, not the spot price. I make this footnote just so that readers familiar with option theory won’t think I don’t know what I’m talking about.
[2] Again, this isn’t quite true. An option trader knows that an option with a lot of gamma also has a lot of time decay, and vice versa. As a former options trader, I can tell you there is no more helpless feeling than being long gamma on expiration day and watching the market sit in a 2-tick range, knowing you’re going to lose all your time value with no delta-hedging gains, and nothing you can do about it.
