The Inflation Trade Takes a Pause
One of the big market stories this year has been the rise in bond yields. This has led to modest losses for government bonds and is one of the reasons the equity market corrected in February. The bond narrative has gone something like this:
– Growth is going to boom because of the tax cuts…
– …which means faster inflation given that unemployment is down to 4%…
– …and bonds will be killed (and maybe stocks will be as well)
This has led to a huge increase in people shorting government bonds. The chart below shows that as of a week ago speculators had accumulated the largest short bond bet in history.
Data over the last couple weeks has called this trade into question, at least short-term.
First up is last Friday’s payrolls report. Job growth came in at a solid +313K, the fastest rate since July 2016. January was revised higher by 39K to 239K. But the number the market fixated on was the growth in average hourly earnings. These were up 2.6% year-on-year (see chart below) compared to expected growth of 2.8%. Not a huge difference, but enough to move the inflation hawks from high alert to waiting and watching.
This week’s core consumer price inflation report also soothed some fears. January’s number was hot, as you can see below and bond yields spiked higher on the news. February’s report was much tamer, up just 0.18% for the month. One data point doesn’t make a trend, but it is possible January’s number was an aberration.
It’s not just the inflation numbers that have moderated the inflation jitters for the time being. As it turns out, U.S. consumers were reluctant to open their wallets in February, with retail sales shrinking for a third consecutive month. We haven’t seen this for five-and-a-half years.
Specifically, retail sales shrank -0.3% in February after falling -0.1% in January and – 0.1% in December. Granted, consumer spending is still growing on a year-over-year basis, as you can see below, but the recent softness is surprising.
Fading Growth Expectations
This is translating into fading growth expectations. One widely followed measure is the Atlanta Fed’s estimate. Earlier in the quarter it was projecting 1st quarter growth of well over 4%. This is now down to 1.8%. Now this isn’t a bad number. But a lot of the economic boom talk that came about after the tax cuts seems to have faded.
Could We See Four This Year?
Why is this important? There are a couple reasons. First, bond yields have surged the last few months, and the softer data has pressed the pause button on the bond bear market. This isn’t such a bad thing. There are numerous studies that point out that it isn’t the absolute level of interest rates that causes problems for the stock market and the economy as much as the rate of change. As long as rates drift higher people can adjust. Short sharp shocks are when the problems develop.
Secondly, the softer data comes a week before the Fed meets. The outcome of their March 20-21st meeting will be closely watched this time around for a couple reasons:
– Some pundits have speculated the Fed might raise rates 0.50% instead of the widely expected 0.25%. The odds of this were never high (the Fed hates to surprise people), but the recent numbers make’s this idea a non-starter.
– Secondly, will the recent data mean anything about policy this year? We’d guess not. The Fed is probably on the fence regarding three or four rate hikes this year. I suspect nothing we have seen the last couple weeks would push them one way or the other. It is probably a coin flip between the two scenarios.
If you want a hawkish view Goldman sums it up nicely:
“Our own forecast remains that the Fed will hike four times each in 2018 and 2019, and we would not rule out a faster pace in 2019 or continued increases into 2020. One reason for our hawkish view is that we expect the Fed’s estimate of the longer-term neutral real rate, r*, to rise eventually from its current 0.75% level….to a level closer to the historical 2% average.”
This would be significant if true. It would mean the Fed would see the neutral rate at the 2% noted above plus an inflation premium (say another 2%). This would put the neutral Fed Funds rate at roughly 4% – something they’d probably want to achieve by 2019 or 2020.
So while inflation may not be taking off, the Fed is on the path towards tightening possibly four times this year regardless. If you were to add in another four hikes in 2019 the odds of a recession/bear market in 2019/2020 would rise materially.
Trade War – First Steel and Aluminum, Next Comes China
Of course there are a number of things that can throw the Fed off track. We won’t go down the list, but a trade war would almost certainly cause them to pause. As J.P. Morgan noted on Thursday:
“The Trump administration’s ‘America first’ rhetoric on trade policy is now becoming reality, as details of the trade tariffs on steel and aluminum imports were announced on March 8. This is the third and most significant round of trade sanctions, following the sanctions on lumber imposed in April 2017 and on solar panels and washing machine parts earlier this year. The recently signed broad-based tariffs on steel and aluminum imports go somewhat further than we expected, imposing a 25% tariff on imported steel and a 10% tariff on imported aluminum, and were authorized under the rarely-used Section 232 of the Trade Expansion Act of 1962, which gives the president the authority to impose protectionist measures if the Commerce Department finds a potential national security threat.”
The impact of the new tariffs should be modest. After all, the new measures target imports accounting for less than 1% of U.S. GDP and 2% of global trade. Canada, the largest supplier of steel and aluminum, and Mexico, the fourth-largest supplier of steel, along with Australia, are exempt from the latest order.
The worry is that this move is but another step in a series of such moves. And there is something to this idea. As The Economist notes, there is more to come:
“Mr Trump has asked China to slash its $375bn bilateral trade surplus by as much as $100bn, a nigh-impossible task. And an investigation into China’s intellectual-property practices is almost over. Mr Trump wants to punish China for the alleged theft of American corporate secrets. Reportedly he will seek to place tariffs on up to $60bn of Chinese imports, focused on technology and telecommunications.”
What specifically might the administration use against China?
1) Tariffs. These are easy and would probably be applied to sectors such as telecom, computers, and other electronic equipment.
2) Inbound investment restrictions. In light of the Trump Administration’s focus on “reciprocity” in trade relationships, it is quite possible the White House announces restrictions on investment by Chinese firms–and potentially individuals–in US companies or assets.
3) Outbound limitations regarding intellectual property. A third potential action, though less likely than tariffs or investment restrictions, would be to limit the ability of US companies to provide Chinese companies with intellectual property.
Most observers we follow think we see something here in the next couple weeks. Again, the economic impact should be modest, but fear about reprisals will persist. If there is a bright spot for equity investors it is that the President appears to use the stock market as his approval guide. Policy is likely to be dictated by how they think the markets will react. And any major stock selloff will probably lead to a modified policy.
Something Uplifting on a Rainy Day
A recent survey asked the following question:
“All things considered, do you think the world is getting better or worse, or neither getting better nor worse?”
The results were surprising. In Sweden, 10% of the respondents thought things are getting better, in the US the figure was only 6%, and in Germany only 4%. Very few people think the world is getting better.
Well, I’m not a stranger to a bit of pessimism, but this seem seems a bit extreme, even to me!! So, while we channel Steven Pinker, here is a quick snapshot of how the world might actually be getting better, despite what we see on cable news.
Have a good weekend.
Published by Gemmer Asset Management LLC The material presented (including all charts, graphs and statistics) is based on current public information that we consider reliable, but we do not represent it is accurate or complete, and it should not be relied on as such. The material is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be illegal. It does not constitute a personal recommendation or take into account the particular investment objective, financial situations, or needs of individual clients. Clients should consider whether any advice or recommendation in this material is suitable for their particular circumstances and, if appropriate, see professional advice, including tax advice. The price and value of investments referred to in this material and the income from them may fluctuate. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Fluctuations in exchange rates could have adverse effects on the value or prices of, or income derive from, certain investments. No part of this material may be (i) copied, photocopied or duplicated in any form by any means or (ii) redistributed without the prior written consent of Gemmer Asset Management LLC (GAM). Any mutual fund performance presented in this material are used to illustrate opportunities within a diversified portfolio and do not represent the only mutual funds used in actual client portfolios. Any allocation models or statistics in this material are subject to change. GAM may change the funds utilized and/or the percentage weightings due to various circumstances. Please contact GAM, your advisor or financial representative for current inflation on allocation, account minimums and fees. Any major market indexes that are presented are unmanaged indexes or index-based mutual funds commonly used to measure the performance of the US and global stock/bond markets. These indexes have not necessarily been selected to represent an appropriate benchmark for the investment or model portfolio performance, but rather is disclosed to allow for comparison to that of well known, widely recognized indexes. The volatility of all indexes may be materially different from that of client portfolios. This material is presented for informational purposes. We maintain a list of all recommendations made in our allocation models for at least the previous 12 months. If you would like a complete listing of previous and current recommendations, please contact our office.