Much has been made recently of the disinflationary trends globally together with the apparent end of the commodities super cycle which is now evident in global price indices. Please note we are using the term "disinflation" (a decrease in the rate of inflation) which should not be confused with "deflation". Now, this has been reasonably well noted by market participants, but TMM thinks that the effects are not yet well explored. Specifically, TMM thinks the decline in inflation volatility has subtle but strongly positive effects on financial asset prices and a negative effect on commodities. To that end, history may serve as a guide. The last time the US went through a period of stable inflation, whereby both headline and core (i.e. headline ex energy & food) inflation were closely coupled, was in the 1990’s:
TMM recognizes that given the backdrop today, the 90’s may seem quite different. But it’s worth noting that for this exercise, we are not comparing absolute levels. Instead, we are concerned with relative changes. In other words we are more concerned with the direction rather than the size of the move.
The Effect on Bonds is a bit tricky to measure, since Fed policy is such a big driver. But in this respect, we can use the yield curve as a very rough proxy for the yield premium on long term treasuries. And the story there seems to be one of a declining yield premium. From 1995 to 1999, the 5s30s yield curve actually flattened, even though the Fed cut rates by over 100bps. It’s quite possible that the improving budget deficit at the time may have had an effect , but the budget deficit is also improving now. All in all, this makes sense – with decreasing inflation volatility, (and by extension central bank activity) investors are likely to demand a lower premium for long dated bonds.
The Effect on Stocks is also quite positive, as they are also a long dated financial instruments. With declining inflation volatility, nominal earnings volatility can also be expected to decline, which should reduce the risk premium. There is an old 20-CPI estimate for the S&P PE ratio which has had some reasonable success over the long run. This is now suggesting that PE should be in the very high teens:
The disinflation impact on gold, however, appears to be quite bearish. The chart below shows gold in white, Fed Funds rate in Orange, CPI in Yellow, and the price of WTI crude oil in purple. Note that from the mid 90’s, the price of gold fell ~60%, even though during this period the Fed cut rates, we got a series of systemic events (LTCM, Asia crisis) AND oil prices rose. Again, the improving federal budget deficit may have also contributed back then – but that is also happening now.
In addition, there are some unique instances that are worth mentioning. Obviously disinflation gives DM central banks more room to pursue QE. But ironically, the disinflationary impact probably also makes QE less effective at generating inflation. Case in point: Headline Inflation in Japan has averaged 40bps above core inflation over the past decade. This suggests that once the inflationary impacts of the weak Yen runs its course, it will be even harder for the BoJ to achieve its 2% inflation target. The small caveat here is that the Nipponese CPI basket can actually be changed or rebased to give the appearance of higher inflation, at least temporarily. TMM expects such a change within 2 years and remember the basket being manipulated in 2006 to, believe it or not, print inflation lower (smoke and mirrors and government payments).
For Europe, current austerity targets look even more difficult to achieve, given that EMU inflation has averaged 56bps over core inflation the past decade:
So where does this leave us? Last to the party with yet another reason as to why equities will keep on going to the moon and gold through the floor? We would actually like to think we were one of the first to arrive at this current party but popped out at the end of January to get some cigarettes only to find that everyone is high by the time we return. But this is a longer term trend and as we are calling for the party to go on into the night we might as well wade in.
But how? We actually think that the chances of a melt up are still pretty high. Some of us were there in 1997-2000 and can smell exhuberance and fear. That darkest of fears, the one of missing a profit. As we have said many a time, it ain't over til 25yr olds are driving around in 3 series BMWs bragging about their portfolios. We are adding to low delta SPX calls. Gold? Well we are already short and happy to ride that into a golden sunset.
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