Low Inflation Rate May Go Even Lower

   Today the BLS released CPI data showing the core rate was 2.1% year over year and 1.6% for the quarter. If one accepts my theory that Owner’s Equivalent rent needs to adjust the CPI downward by 0.25% (or even more), then the 90 day core CPI would be 1.35%. With oil in the mid-50’s, its dramatic drop will surely put more downward pressure of CPI in the future. I remember when oil went up above $40 in 2004 and it seemed like a big deal, a high price at the time. Adjusting for inflation, a $40 price 14 years ago is like $53 this week (it’s now $56 for WTI oil) so we are almost equivalent now to the $40 price of 2004.
Today Germany and Japan each had negative GDP of 0.2% or 0.3%. The SP was down 0.7%. Many equities are down 10% for the year. Since some stock investors may have had a slightly worse than average experience then these investors could get discouraged and withdraw from stocks, creating an imbalance of sellers over buyers. During a bubble top phase the stock market’s breadth narrows so that the index is kept up solely by a tiny number of prestige FANGS type companies. If an investor instead owned underperforming companies like supposedly safe GE or PCG (PG&E) only to see big losses then that investor may decide to retreat from stocks. It is amazing that GE (recently a Dow Jones  Industrial Average 30 member), at $8.32 a share, is equivalent to about its 1990 price of $5, adjusted for inflation, or if ignoring inflation, it is at its 1993 price.
The investment themes of investing in commodities, oil, EM markets, and stocks have all been badly hurt this past October. The problem with that is that during a bubble top the reason stocks go up is not because of fundamentals, but because of “momentum” which is a crowd psychology phenomenon. Once momentum is broken by its price breaking through a line on a chart like a 200 day average or a 50 day average then the belief in a stock’s momentum is lost and the crowd wakes up from its hypnotic trance and realizes that, based on fundamentals, that stocks are too high and will go down. The people scramble to get out and prices go down.
A crashing stock market will help the Fed to slow down or stop its rate increases. When stocks crash that creates a reverse wealth effect where people feel poorer and cut back on their planned purchases, thus creating a possible dip in GDP growth. This trips up issuers of junk bonds who desperately need outsized growth to be able to pay their debts. Upon their default the marketplace will become alarmed and tighten the issuance of credit thus triggering recession.
These disinflationary news items imply that bond investing is a reasonable hiding place to get away from a crashing stock market. The old paradigm that real yields for the 10 year Treasury should be 2% (it is now 1%) should be tempered by QE by about 0.5%, assuming the QT withdrawal program is soon abandoned by the Fed and the Fed never sells off their QE purchases. That means real yields only need to rise by 0.5% to reach equilibrium. However, if inflation instead of being about 2.5% is suddenly verified to be a whole 1% lower, at 1.5%, then that means nominal rates need a 0.5% cut to be in equilibrium.
Just try living in Switzerland or Japan and putting all your money into the local bank and getting a negative yield, then compare that to the yields available in the US where the 2 year Treasury yields 2.87% (3.15% adjusted for state-tax taxable equivalent if you live in CA, NY, etc., since they are free of state tax). So the yield difference between negative 0.3% in Japan, versus in CA positive 3.15% is 3.45%, which is a gigantic spread. Assuming the Fed tightens an extra 0.75% then the spread will be 4.2%, truly unbelievable! Remember the US, Canada are the only developed countries with their own oil and very cheap fracked oil at that. Oil prices are an important component of inflation.
I just don’t see where inflation can come from if workers have had the best jobs shipped offshore and the recent 2018 hires were mostly credit- rating-challenged minimum wage type of workers who can’t qualify to go to a bank and get a loan and create some inflation.
I’m open to the idea that the government could make the Fed monetize the deficit and cause inflation after the next recession but that’s 3 years from now for a new reflation then time lagged inflation cycle. For now it’s time to go into a classic disinflationary recession cycle, thus expect crashing asset prices (except for mid-term investment grade bonds).
Investors need independent financial advice about the risks of stocks crashing.

2018-11-14T17:32:05+00:00November 14th, 2018|mayflowercapital blog|Comments Off on Low Inflation Rate May Go Even Lower

About the Author:

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Donald Martin has a B.A. in Accounting and M.B.A. Finance, and has passed the rigorous CFP® exam and met the experience requirements needed to become a CERTIFIED FINANCIAL PLANNER™ professional. He has been employed in the financial services industries for 30 years and has been investing for his own account for 38 years. Donald Martin’s 19 year career in lending prepared him for fixed income analysis, Securities analysis, and macro-economic analysis used for investing. Donald Martin founded Mayflower Capital in 1993 to provide independent financial advice and implementation of advice about loans. In 2005 Donald Martin changed the company’s mission to providing independent financial advice about investments and financial planning and stopped providing loan services. Donald Martin has a B.A. in Accounting and M.B.A. Finance, and has passed the rigorous CFP® exam and met the experience requirements needed to become a CERTIFIED FINANCIAL PLANNER™ professional. He has been employed in the financial services industries for 30 years and has been investing for his own account for 38 years.