October 9, 2020
By Steve Blumenthal

“I find it funny that people who didn’t think there was any inflation
in the pipeline are now talking about stagflation. This is
nothing like the 1970’s, which was a pretty dismal period, and not just
because of polyester and disco.”

– Barry Ritholtz (Co-founder, Chairman, and CIO of Ritholtz Wealth Management) in
“Watch inflation now!” by Chris Isidore, CNN Money

A few weeks ago, I wrote about inflation. Right now, the central banks around the world are battling deflation. In the end, there will be inflation. But when is when?

This past week, I listened to an excellent research call in which David Rosenberg squared off with his good friend A. Gary Shilling. My good friend Wade Barnett from JPMorgan served as host, and shared the recording with me. Both Gary and David concluded: deflation now, inflation later (actually “stagflation,” which is rising price inflation with very little economic growth). When it came to timing, though, they differ. Rosie sees inflation becoming a problem within two years. Gary thinks it will take a bit longer.

Shilling is famous for one of the greatest calls of all time. In 1998, he wrote a book titled, Deflation: Why It’s Coming, Whether It’s Good or Bad, and How It Will Affect Your Investments, Business, and Personal Affairs. In 2012, he doubled down, publishing The Age of Deleveraging, Updated Edition: Investment Strategies for a Decade of Slow Growth and Deflation. (As a quick aside, you can subscribe to Gary’s research letter here. Rosie has an excellent service too, and you can sign up for a free trial here. I follow Gary and subscribe to Rosenberg Research. Please know I don’t get paid to promote either—I’m just a big fan.)

When is when? Nobody knows for sure. But the answer will show up in price behavior. One of my favorite indicators is the Ned Davis Research Inflation Timing Model. Most economists track the annual rate of change of the Consumer Price Index (CPI), and many individual incomes depend on it. Social Security and Medicare benefits are linked to changes in inflation over time. Those adjustments are based on changes in the CPI. The August 2020 year-over-year number is 1.3%. I favor the NDR inflation model because it consists of 22 individual indicators that measure the rates of change of various commodity prices, the CPI, producer prices, and industrial production.

Each week in Trade Signals, I simply note whether inflationary pressures are low, moderate, or high. The current reading is low, and it is the output of the NDR model. You can follow along each week (follow the link to Trade Signals in every On My Radar post, or just bookmark the Trade Signals page). Here’s an excerpt from Wednesday’s post (note the red arrow):

As you’ll see in the next chart, the model has signaled “Low Inflationary Pressures” for several years. From an investor perspective, low inflation is generally associated with declining interest rates, which is good for bond investments (when interest rates decline, long-duration maturity bond prices go up). Declining bond yields are good for stock investors.

Focus in on the data box in the lower section of the following chart. NDR scores the 22 individual indicators as follows: each indicator gets a +1, 0, or -1 score. If price rises above a certain threshold, a +1 score is given, if it declines below a certain threshold, a -1 score is given. Add up each of the 22 subcomponent scores and today the reading is -8.

The DJIA has performed best, gaining 12.99% per year, when inflationary pressures were low. That is where we are today. When the collective score was above 10.5, the DJIA performed worst, declining an annualized -5.03%.

Performance is best when inflationary pressures are low and worst when inflationary pressures are high. For a combined 77.37% of the time since 1962, markets were in a healthy inflationary regime. Let’s keep watch for a move above the upper dotted line (above a score of 10.5).

How does this relate to investing?

Inflation affects the performance of various industry groups and sectors. Sectors such as precious metals, industrial materials, and energy tend to perform well when inflationary pressures are high. Sectors such as utilities, financial, and long-term bonds tend to do well when inflationary pressures are low. Overall, stocks tend to perform especially well when inflationary pressures are low. Having a process to monitor inflation is important because, I believe, one must change investment focus in inflationary regimes.

“But hang on one minute, Steve,” you say, “I’m seeing inflation.” Me too. I just renewed my firm’s medical insurance plan. It’s up more than 15% from a year ago. And that’s on top of similar increases the last few years. That really hurts. All businesses—large and small—are affected by changes like these. That and continued economic pressures will likely keep salaries from rising. Not a bullish endorsement for the economy. Stagflation indeed.

If you buy things today, and you do, you are seeing prices rise. Especially on the stuff we need like food and healthcare. Could this be the beginning of the shift to outright inflation in a few years? Maybe. I’m a weight-of-evidence guy, so I’m sticking to the model.

I found the following twitter post from @JesseFelder this week interesting. That gap between the government-reported CPI and the prices on stuff we are actually buying vs. the stuff we aren’t buying is getting bigger.

“On stuff we want” year-over-year price inflation looks like this:

Maybe you’ll pass on a new bicycle, but insurance, food, and rent?

“Stuff we don’t want is cheaper.” The year-over-year rate is down.

Notably missing is energy and gasoline prices. They most certainly get factored into CPI and are tracked in the NDR inflation model. Energy prices there are mostly lower, and I’m not going to touch the prices of shoes, suits, and dresses. Some may argue they fit in the “want” category, others in the “need” category. But those musts—food, healthcare, and rent—are just that: needs for everyone, and that 5%-plus rise in prices year-over-year far exceeds the 1.3% CPI that incomes more closely follow. Less income growth plus higher expenses equals upset humans.

I write a little bit more today on deflation, as I do think that’s what grips us currently. In the deflation vs. inflation argument, no one I know has been more right over the last thirty years than Dr. Lacy Hunt. The mutual fund he manages along with his partner Van Hoisington invests in U.S. Treasury bonds. They have maintained a near 30-year maturity duration since the 1980’s. It’s paid off handsomely for their investors. In his Q2 quarter-end post, Lacy argues, “Four economic considerations suggest that years will pass before the economy returns to its prior cyclical 2019 peak performance. These four influences on future economic growth will mean that an extended period of low inflation or deflation will be concurrent with high unemployment rates and sub-par economic performance.”

In Lacy’s view, more deflation remains ahead, and he continues to believe the long-term Treasury bond yield is heading lower. I share my summary notes with you when you click through below (and provide a link to Lacy and his partner’s Q2 Hoisington letter.

In chair with coffee in hand? Let’s go. Read on and have a great week!

If a friend forwarded this email to you and you’d like to be on the weekly list, you can sign up to receive my free On My Radar letter here.

Included in this week’s On My Radar:

• Deflation – Dr. Lacy Hunt and Van Hoisington
• Trade Signals – Don’t Fight the Tape or the Fed Moves Back to -1
• Personal Note – Let’s Dance!

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Deflation – Dr. Lacy Hunt and Van Hoisington

I’m going to share a few of the charts and noted commentary (my bullet-point format) from Hunt and Hoisington’s research piece, and then jump to their conclusion. You can access the full piece here.

Four economic considerations suggest that years will pass before the economy returns to its prior cyclical 2019 peak performance. These four influences on future economic growth will mean that an extended period of low inflation or deflation will be concurrent with high unemployment rates and sub-par economic performance.

• First, with over 90% of the world’s economies contracting, the present global recession has no precedent in terms of synchronization. Therefore, no region or country is available to support or offset contracting economies, nor lead a powerful sustained expansion.
• Second, a major slump in world trade volume is taking place. This means that one of the historical contributions to advancing global economic performance will be in the highly atypical position of detracting from economic advance as continued disagreements arise over trade barriers and competitive advantages.
• Third, additional debt incurred by all countries, and many private entities, to mitigate the worst consequences of the pandemic, while humane, politically popular and in many cases essential, has moved debt-to-GDP ratios to uncharted territory. This ensures that a persistent misallocation of resources will be reinforced, constraining growth as productive resources needed for sustained growth will be unavailable.
• Fourth, 2020 global per capita GDP is in the process of registering one of the largest yearly declines in the last century and a half and the largest decline since 1945. The lasting destruction of wealth and income will take time to repair.

On Recessions:

• The World Bank indicates that a record 92.9% of the world’s countries are in recession in 2020 (Chart 1). This level is well above the previous high recorded in the Great Depression of 83.8%.
• It also exceeds the highs registered in 1914 at 70%, 1918-1921 at 70%, and 2008-09 at 61.2%. There have been 14 global recessions from 1871 to 2020. The percentage of the world’s economies in recessions was generally not highly coordinated, with an average of 54.3%.
• Based on an examination of these four previous periods of high synchronicity where the economic results are observable, a conclusion can be drawn regarding our present situation.

Recessions are either deeper or longer lasting when a very high percentage of the world’s economies are contracting rather than when they are centered on a limited number of countries.

Conclusion:

• The pandemic will eventually run its course and when that happens economies will register a noticeable improvement.
• However, the adverse consequences of an unsurpassed increase in new debt will remain for years to come as there currently exists a record domestic and global debt overhang from previous borrowing.
• Four great past economists – Eugen Bohm Bawerk, Irving Fisher, Charles Kindleberger and Hyman Minsky – all captured the two-edged nature of debt being an increase in current spending in exchange for a decline in future spending unless the debt generates an income stream to repay principal and interest.
• Using rigorous statistical techniques, contemporary economists such as Kenneth Rogoff, Carmen Reinhart, Alan Taylor, Anja Baum, Cristina Checherita-Westphal, Philipp Rother and others have documented the deleterious effects of high debt levels on economic growth. Included in this work is evidence that the detrimental effect of the debt on GDP per capita increases as the debt level rises.
• Significant research indicates that the adverse consequences start as low as a 67% gross debt to GDP ratio. In other words, the relationship between debt and economic growth is non-linear, just as is the law of diminishing returns.

[SB here: I want to quickly define what a “deflationary gap” is in layperson terms. It is “the difference between the full employment level of output and actual output. For example, in a recession, the deflationary gap may be quite substantial, indicative of the high rates of unemployment and underused resources.” Source: Investopedia.]

More from Lacy and Van:

• Deflationary Gap: Assuming a large percentage gain in economic activity in the second half of this year, the Fed, the World Bank and many economists project that there will still be a substantial gap between potential and real GDP. In economic theory, this is called a deflationary gap.
• At the end of the three worst recessions since the 1940s, the output gap was 4.8% in 1974, 7.9% in 1982 and 6.4% in 2009. The gap that existed after the recession of 2008-09 took nine years to close.
• This was the longest amount of time to eliminate a deflationary gap. Even when the gap was closing over the last decade, the inflation rate continued to trend downward, remaining near or below 2%.
• This indicates that there were even more unutilized/underutilized resources than was captured by the magnitude of the gap.
• Considering the depth of the decline in global GDP, the massive debt accumulation by all countries, the collapse in world trade and the synchronous nature of the contracting world economies the task of closing this output gap will be extremely difficult and time consuming.
• This situation could easily cause aggregate prices to fall, thus putting persistent downward pressure on inflation, which will be reflected in declining long dated U.S. government bond yields.

Source: Van R. Hoisington and Lacy H. Hunt, Ph.D.

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Trade Signals – Don’t Fight the Tape or the Fed Moves Back to -1

October 7, 2020

S&P 500 Index — 3,363 (close)

Notable this week:

Ned Davis Research’s “Don’t Fight the Tape or the Fed” indicator moved from last week’s -2 reading from -1. It combines the trend in equities and the trend in interest rates by looking at NDR’s Big Mo Multi-Cap Tape Composite and the 10-Year Treasury Yield percentage. Readings range from +2 to -2. Minus two readings occur infrequently and have been associated large market declines. Since 1980, the data looks like this:

Another look at the direction of interest rates is the Zweig Bond Model. The ZBM is in a sell signal, meaning the direction of interest rates is up. Bonds lose value in rising rate environments. Complicating matters are the ultra-low levels of interest rates. You’ll find that chart below (or when you click through to Trade Signals if you are reading this note in On My Radar). The equity signals continue to signal a bullish view on equities, high yield is back to a buy signal, and the sentiment indicators remain neutral, which is selectively slightly bullish.

Not a recommendation for you to buy or sell any security.  For information purposes only.  Please talk with your advisor about needs, goals, time horizon and risk tolerances. 

Click here for this week’s Trade Signals.

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Personal Note – Let’s Dance!

“Twenty years from now you will be more disappointed by the things
that you didn’t do than by the ones you did do. So throw off the bowlines.
Sail away from the safe harbor. Catch the trade winds in your sails.
Explore. Dream. Discover.”

– Mark Twain

“Bucket List”: A number of experiences or achievements that a person
hopes to have or accomplish during their lifetime.

I’ll be checking off a very big bucket-list item soon. Early next week, I’m flying to Oregon to golf at Bandon Dunes with dear friend Andy McOrmond. We’ll be joining clients (and more important, friends) from the E3 Wealth advisor team.

There are five links style courses, and three are ranked among the top 100 golf courses in the world. We’ll be playing Pacific Dunes, Bandon Dunes, Old McDonald, and Sheep’s Ranch.

Honestly, I feel like a kid in a candy store. Or like Rodney Dangerfield in the movie Caddyshack. Click on the picture of Rodney, turn up the music, and “let’s dance!”

Hope you’re dancing this weekend. All the best!

Subscribe to OMR

Warm regards,

Steve

Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.

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Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Executive Chairman and CIO.  Steve authors a free weekly e-letter entitled, “On My Radar.”  Steve shares his views on macroeconomic research, valuations, portfolio construction, asset allocation and risk management.

Click here to receive his free weekly e-letter.

Follow Steve on Twitter @SBlumenthalCMG and LinkedIn.  

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