Disco (Inflation) Inferno
October 18, 2005: Today's Events:
It's a darn shame that we launched the concept of an inflation-focused investment manager a few months too early. The numbers, such as today's +1.9% headline PPI (+0.3%) which raised the year-over-year rise to +6.9%, are certainly raising eyebrows so that strategic entrants into the space are being joined by tactical entrants (the people who think that real return is a good business only when inflation is going up). The result is a busier marketplace, or one that is gearing up to be busier.
Yesterday I ran a chart pointing out that PPI has rarely run this much faster than CPI. With the worse-than-expected numbers today, headline PPI over the past year has now outpaced headline CPI by 2.2%. That is the least-favorable spread (for industry) since the mid- 1970s! The updated chart is below.
I don't want to sound totally alarmist about this picture (just somewhat alarmist). The simple spread of PPI to CPI is a very rough notion of the cost of materials inputs versus outputs; clearly, every business has a different mix of inputs and a different mix of outputs, so the effects are felt differently by each business. Moreover, as one reader pointed out, for most businesses labor is a more important input than materials.
Of course, the spread between PPI and CPI implies that labor is adding less value to the process than it was previously, implying that real wages are low for a reason. And, of course, that's problematic for any creditor - it's very hard to pay money back out of a growing real wage if your real wages are not increasing. (And, to the extent that labor and capital are substitutes, a low marginal return on labor implies that a low marginal return on capital - for example, in the form of low real rates - is no conundrum).
Moreover, it's not as if the spread of CPI to wages has been much more agreeable for companies. The chart below shows Y/Y core CPI versus Y/Y average hourly earnings. Gosh, it's near the best levels of the last decade...and still wages are outpacing CPI. Good for workers, but bad for employers, no? If prices of materials and labor are both rising faster than the prices of outputs, then the result is what we've seen: downsizing, resulting in a "productivity miracle" because output/hours worked rises (due to a declining denominator!).
I would think that these big-picture ruminations are too much of a long-term consideration for investors to focus on at any given time, but in the long run value does win (and a complete lack of value tends to lose).
As a side note: I took these charts only back to 1975 because any further and, with wage and price controls in place, the spread is enormously negative. It is not surprising that the stock market virtually died in the 1970s!
In other news, the latest projected tracks for Hurricane Wilma show the storm taking a hard right hand turn towards Florida. This calmed frayed nerves a little, and caused Crude and distillate products (as well as Nat Gas) to sell off. TIPS breakevens widened 1- 2bps, which is a bit unimpressive given the PPI spike. Overall, bonds rallied marginally with 10y yields down 0.8bps to 4.481%. Equities continued to ignore some halfway decent earnings reports and slid further with the S&P off -1%. I don't think this is a direct reaction to the fact that Refco declared bankruptcy today in the fourth largest U.S. bankruptcy ever, serving as a reminder that no, merely saying after Enron that "we learned our lesson" is not as good as actually learning the lesson. But the ugly headlines from that debacle cannot help sentiment.
Stocks Are No Help From Inflation
But the stock market travails are more than just a sentiment story. It is a popular myth that equities represent a good hedge against inflation. In the days before inflation-linked securities, this was an attractive myth but it is still a myth. The reasoning is that as inflation rises, a company's expenses, revenues, and therefore income all scale with the rising price level, so that - assuming the number of shares remains constant - the value per share must rise. This is a seductive theory, and over the really long term it probably plays out. However, in the short, medium, and long term there tend to be bigger effects that wipe out any marginal kicker from scaleof- enterprise effects. The proof is in the pudding: the following two charts show the performance of the S&P when there is an inflation surprise. The first chart covers the 20 years between 1983 and 2003, most of which was a massive bull market. The x-axis is not the level of inflation, but the degree of surprise in inflation.1
Obviously, with a huge bull market in force these are all positive, and a modest disinflationary surprise was quite good for stocks.
The second chart covers a shorter period, when stocks were already close to fully valued or at times even overvalued. Again, notice that disinflationary effects (not deflationary, mind you...this is, again, a relative measure of what we got versus what we expected) were positive for equities while inflationary surprises were not. A good hedge against inflation? I don't think so!
Wednesday's key data is the 8:30ET Housing Starts data (Consensus: 1870K from 2009K). Recall that last month, the supply of houses for sale in terms of months of sale rose to the highest level since the year 2000, as a result of a continued rocketing higher of the number of houses available for sale (see chart) without a concomitant increase in actual sales. We had warned of this two months ago: if sales drip lower again in tomorrow's data, the place where you'll hear some alarm expressed is in when the "months supply" number reaches the highest level in 8 years. That Rubicon is 4.8 months; we're at 4.7 months now.
The Beige Book will also be released, at 2:00ET.
It is hard for me to feel confident that a "base" is being formed in fixed income, but the first part of a rally is the part where the market stops going down so this is an important development. I don't see any obvious triggers for a leg higher unless it's the stock market coming unglued, though.
Question of the Day: What group originally sang 'Disco Inferno?'
Answer to Prior Question: The question was, "At what internationally-renowned educational institution was Mick Jagger enrolled before he dropped out to become a rock star?" Lots of people knew the answer to this one: Jagger was a student at the London School of Economics.
1 Inflation surprise is defined here as per Fama & Schwert (1977) as the 3m TBill rate minus the average real rate of interest over the period, minus actual inflation over the next 3 months. In other words, if TBills were priced to produce their average real yield, we can infer something about inflation expectations. Approximately one third of all observations in the period fall in each of the three bars.