Thursday, February 26, 2015

TIPS say the deflation "threat" has passed

According to the pricing of TIPS and Treasuries, the bond market has decided that the negative inflation shock of falling oil prices has run its course. In fact, inflation expectations have been rising since year end: the bond market now sees inflation (of the CPI variety) averaging 1.7% over the next five years, and 2.0% from years 5 through 10. With the labor market having improved in recent months and long-term inflation expectations now back to levels that the Fed deems appropriate, it's only a matter of time before the Fed begins to raise short-term rates. This long-awaited "normalization" of rates should come as no surprise and should not in any way threaten the health of the economy or financial markets.


The chart above shows the nominal yield on 5-yr Treasuries, the real yield on 5-yr TIPS, and the difference between the two, which is the market's expected average annual inflation rate over the next five years. Inflation expectations began to fall last summer, about the same time the oil prices began to decline. They reached a low of 1.2% late last year, and closed today at 1.7%.


The chart above shows the price of crude oil futures; note that prices have stopped declining and have been relatively stable since early January. Investors have been speculating that the bounce in prices marked the end of oil's decline, and the bond market action is confirming this.


The price of wholesale gasoline futures (see chart above) has actually been rising in the past month: in fact, prices today are up 35% from their mid-January low.


Gasoline prices at the pump have also been rising, as the chart above shows.


The rise in oil and gasoline prices could prove to be the proverbial "dead cat bounce," but the significant decline in active oil drilling rigs (chart above) confirms what the market is saying about oil prices having hit bottom. Lower prices are having the predictable effect of shutting down exploration efforts, which, in turn, will lead to reduced oil production in the near future. Supply and demand are likely to come back into balance somewhere around the current level of prices.


As the above chart shows, inflation ex-energy has been running right around 2% a year for the past 12 years. The market is saying we're likely to see more of the same in the years ahead. The result of falling oil prices is thus likely to be stronger growth rather than lower inflation. The Fed is correct in ignoring the recent decline in inflation.


The chart above looks at inflation expectations over the next 10 years, which are now around 1.8%.


Even though inflation expectations are back to "normal," the real yields on TIPS are very low (see chart above). The market is not afraid of inflation being any different than it has been in the past (~2%), but the very low level of real yields (and the correspondingly very high level of TIPS prices) suggests that the bond market holds out very little hope for any meaningful pickup in the outlook for real economic growth. TIPS are very expensive at these levels. Investors are willing to accept an almost insignificant real yield in exchange for protection against uncertainty. Rather than cheering cheaper energy, the market continues to worry about the lack of growth and opportunity, and is willing to pay up for safety.


This same preference for safety is seen in the chart above, which compares the price of gold with the price of 5-yr TIPS (using the inverse of their real yield as a proxy for their price). Both assets are still trading at fairly high levels from an historical perspective. This suggests that the market is still dominated by pessimism, not optimism. In a very optimistic market environment, the price of gold would be an order of magnitude lower, and the real yield on TIPS would be north of 3%. We are many years away from either.

The market may be right in its belief that inflation will remain in a 1.5-2% range and economic growth will remain sub-par. But if the market is wrong, I'm willing to bet that both growth and inflation will prove higher than expected in the years to come. I'm optimistic if only because the market seems to be still so pessimistic.

UPDATE: As of 8:00 am PST 2/27, markets have continued further in the direction of higher inflation expectations: the expected inflation rate for the next five years has increased to 1.8%. The real yield on 5-yr TIPS has fallen to -0.3%, which points to an even more cautious market.

Monday, February 23, 2015

Good news overseas

The outlook for Europe has improved significantly in the past month or so, a fact that still seems to be flying under the mainstream media's radar. On balance, the outlook for the global economy continues to improve. Very good news.


Released last Friday, the Markit Eurozone Composite Purchasing Managers' Index jumped to 53.5, as shown in the chart above. This means the outlook for the Eurozone economy has brightened considerably of late, no doubt due in part to a relaxation of Russia/Ukraine tensions and the likelihood of an acceptable solution to the Greek debt crisis. Even if Greece were to exit the Eurozone, its economy is so small that it wouldn't make much difference. The important issue here is to preserve the integrity of the Euro, a goal which appears to be widely shared among ECU members; if Greece exits, it will pay a price (i.e., the higher inflation that would follow a devaluation of its currency) that will deter others from doing the same. The experience of Argentina tells us that a big currency devaluation only provides a temporary boost to growth—as some of the capital that fled in anticipation of the devaluation returns—but in the end, the inflation that accompanies big devaluations is destructive, especially for the lower and middle classes.

Meanwhile, we recently learned that the German economy expanded at a 2.8% annualized rate in the fourth quarter of last year, up from zero in the second quarter. This is quite encouraging. After a pause in the second half of last year, the Eurozone economy appears to have re-synchronized with the U.S. economy, as both continue to grow. That is an important and positive change on the margin.



As the first of the two charts above shows, since the end of last year Eurozone equities have outperformed U.S. equities by an impressive 10%, after lagging miserably for the preceding five years. But don't get too excited, because in dollar terms, Eurozone equities are still down almost 8% from last summer's post-recession high. The recent relative outperformance of Eurozone equities is overshadowed by a much weaker Euro from a U.S. investor's perspective. Nevertheless, that doesn't negate the fact that Eurozone investors do see an improved economic outlook.



Japanese equities are now at a new 15-year high. The recent improvement in the equity market closely tracks the weakening of the yen, as seen in the first of the two charts above. But unlike the situation in the Eurozone, Japanese equities are up 30% in dollar terms in the past two years (i.e., equity market gains have been much larger than the weakening of the yen). On balance, the market is telling us that things have really improved in Japan in recent years.

As the second of the two charts above shows, the yen is for the first time in 30 years approximately equal to its Purchasing Power Parity value vis a vis the dollar—according to my calculations. It's not that the BoJ has severely depressed or devalued the yen, it's that the yen is now more "normally" valued. The BoJ appears to have successfully switched from a deflationary monetary policy to a neutral monetary policy, and that, in turn, has been a positive for the economy.

Even China is doing better these days: the Shanghai Composite index is up over 60% since last summer, even though growth in the Chinese economy has "slowed" to 7% a year. If only we could all grow 7% a year....


Positive developments overseas add up to a new all-time high for the value of global equities, as shown in the chart above. In the past six years, the market cap of global equities (in dollar terms) has increased more than 160%, rising from its March 2009 low of $25.5 trillion to over $67.3 trillion today. That's a gain of almost $42 trillion! Excluding the $16.8 trillion increase in U.S. equity valuations over this same period, the value of stock markets overseas has increased by $25 trillion. We are talking real, serious money, and a genuine recovery. That's not to say things couldn't or shouldn't be a whole lot better, but the improvement is impressive nonetheless.


Not everyone is doing so well, unfortunately. The Brazilian economy stands out in this regard, with its stock market having lost about 60% of its value in dollar terms in the past four years. Many emerging market economies (e.g., Argentina, Brazil, Venezuela) are burdened by weak commodity prices, poorly-designed fiscal and monetary policies, and endemic corruption.

Friday, February 20, 2015

The 65-year trends in equity prices

It's taken almost 15 years, but the S&P 500 has finally exceeded its August 2000 high in inflation-adjusted terms (though just barely). Here's how I see the long term trends for this index, in nominal and real terms:


The nominal index is now 37% above its 2000 high, and over the past 65 years it has risen at an annualized rate of about 7.7% per year. The trend lines I've drawn represent annualized growth of just over 6%.


In inflation-adjusted terms, over the past 65 years the S&P 500 has risen at an annualized rate of about 3.9%. The trend lines represent 3% annualized growth. The CPI has risen at an annualized rate of 3.6% over the past 65 years. 

Technicians can argue all day about what this means. In my view, I don't see anything unusual going on. Stocks can be very volatile over shorter time horizons, but over time they do pretty well.