Weekly Wrap-up: Does Decelerating Growth Slow Inflation
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Floating around in the zeitgeist is the CONVENTIONAL WISDOM, fully endorsed (if not generated) by the Bernanke Fed that if economic growth slows down, then inflation will slow down too.
Now, that's not an entirely baseless notion, especially if one holds the view that inflation is a function of too much money chasing too few goods (or services, or assets, or what have you). The underlying premise is that slower growth is roughly tantamount to diminished demand for goods (or services, etc.). And that slower growth (diminished demand) should therefore naturally lead to lower prices (or at least a slowing of inflation).
But I awoke on Saturday morning wondering whether in fact there is a correlation between the rate of real economic growth and the rate of inflation. I mean we all believe that there is, but why do we believe it? Just 'cuz the CONVENTIONAL WISDOM holds it to be true or because it IS true…is it just another big lie or does the data say, "Aye?"
Well, it turns out that, over the past 53 years there IS a correlation between Economic Growth (measured as Real GDP) and Inflation (measured as the Personal Consumption Expenditure Deflator). But it's not the correlation that all the Fed Governors and Chattering Teeth in the media would have us believe.
This chart plots Real Quarterly Y/Y GDP growth (red) against the growth of the Quarterly Y/Y PCE Price Deflator (blue).
And the amazing thing to me is that we see a -0.29 correlation coefficient for the 2 series, which means that in real time there is a moderately strong INVERSE correlation, tendency for inflation to be HIGHER while growth is LOWER and for inflation to be LOWER when growth is HIGHER.
(Note the highlight labeled A, during which time Inflation rose from a +2% annualized rate to a +5.7% rate while GDP growth sank from 8%+ to 0%. We'll return to this specific period below.)
Waaaaiiit a cotton-picken minute! Bernanke has been telling us that slowing GDP growth is going to put the kibosh on inflation! And the markets rallied hard on Friday based on the GDP Report's below-consensus 2.5% annualized rate of growth in 2Q06! And the bond market rallied, driving bond yields lower because slowing growth is going to lead to lower inflation!
Well, maybe the data on this chart are misleading. Maybe, over, say, the last 25 years things have been different!. Yes, they have. Since 1982 the correlation coefficient of the 2 series has been slightly less negative at -0.20.
Oops. Not very different.
OK, how about this! Inflation is a lagging indicator. Yes, it is. So I studied a variety of lead/lag time frames and found that if I push GDP out in front of the PCE Deflator by 4 quarters the correlation actually turns positive. By how much?
GDP and the PCE Deflator for "1 year in the past" have the most positive correlation at +0.06. Or put another way, the fluctuations in GDP account for about 6% of the change in inflation 1 year later.
Not very impressive, is it.
Sometimes discovering that an economic thesis is a blind alley is helpful. And I think this is one of those times.
As far as just how well slowing economic growth prognosticates for falling inflation, this study says, "Not at all in the present, in fact, quite the contrary. And almost not at all a year later."
What other arguments does the Fed have up its sleeve that inflation will slow? Well, the Core PCE Deflator is not nearly as hot as the Headline PCE Deflator.
Be that as it may, as we have discussed in the past, the reason that the Core numbers gained importance and became surrogates for the Headline inflation numbers is that historically the Core numbers were better predictors of the future trend in the Headline numbers than were the Headline numbers themselves. Why? Because Food and Energy prices were seasonally volatile, and tended to be misleading on a M/M basis vis-à-vis the underlying trends.
But with Energy prices having risen sharply and having held at high levels for a protracted period, and with no apparent sharp reversal of energy prices anywhere in sight (the futures markets are suggesting high energy prices for years to come), it would appear that the unprecedented sustained spread between the Headline PCE Deflator and the Core PCE Deflator is NOT meaningfully predicting that the Headline number will fall any time soon.
In other words?...There is nothing on this second chart that suggests that Inflation is on the verge of falling back into the Fed's comfort zone, below +2%.
Now, if we hearken back to the last time the PCE Deflator and the Yield on the 10-Yr Treasury Note were performing in tandem as they are now, we are forced to examine the 1960s.
As the mid '60s turned into the latter '60s, the PCE Deflator (red line) jumped out of its range below +2% and began making a run for the +6% area. Meanwhile the Yield on the 10-Yr Treasury (blue line), slow to react to rising inflation data (and probably reassured by the whiz kids of that day that inflation was a lagging indicator) maintained yields down near 4% until the PCE Deflator had almost risen to that same benchmark.
How similar is what happened in the 1966-70 time frame to what we're experiencing now? We'll learn the answer to that question only in the fullness of time, but one has to wonder whether the '60s "Guns & Butter" federal fiscal policies aren't mirrored by the current "Guns, Butter, and Tax Cuts" policies.
And keep in mind, as noted beneath the first chart above, that Real GDP Growth sank from 8%+ in June '66 to 0% by mid 1970 even as the PCE Deflator rose from about 2% to 5.7% in the same time frame.
How's that supposed to work again, Chairman Bernanke? Tell us again the one about how slowing GDP growth is going to ease inflationary pressures! Maybe it will, but it hasn't particularly done so in the past, so you've gotta have "big brass ones" to start predicting slowing inflation with an "August pause."
If we learned anything in the '70s it was the danger of viewing High Oil Prices as a tax on the economy and cutting interest rates, thereby monetizing those high prices.
If the Fed is serious about fighting burgeoning inflation, then, unfortunately, the correct approach is probably to err on the side of being too restrictive for too long, exacerbating the amplitude of an economic slowdown, and flushing the economy of excess speculation and liquidity in order to set the table fresh for a new positive economic cycle. Failure to nip inflation in the bud is probably more dangerous than nipping off too much bud at this point.
THE 4-YR CYCLE
As expected, the SPX appears to be committing to our "benevolent" scenario.
This chart shows roughly the final year of the 4-Yr Cycle, plotting only the previous 4 "middling" cycles along with the SPX's current percentage gain off its October '02 low (red line).
With last week's rally the SPX appears to be trying to set a benign course, following roughly in the footsteps of the the '90-'94 cycle or the '74-'78 cycle, rallying up to test its cycle highs, failing to break them, and then dropping down to test the cycle lows in September or October.
In 1990 (green line) the SPX rallied into roughly trading-day # 956 and then collapsed to new cycle lows, but our previous valuation studies have had us leaning toward the view that the SPX will not drop down hard as it did in '90 and '67, bur rather that it is likely to remain in the 1220-1326 trading range until September.
Headline earnings trends remain robust.
Despite fears of an earnings slow-down, neither trailing numbers nor forward estimates show any signs of slowing. Corporations are, by and large, beating earnings estimates by at least as consistent and consistently large a number as is historically normal.
While forward guidance during earnings conference calls has generally been cautious for 2H06 and beyond, the forward consensus numbers have not suffered.
On a sector-by-sector basis there remains cause for concern, however, especially with regard to the inflation story discussed above.
As this chart shows, Energy (yellow line) dominates the earnings momentum story with CY06 estimates up from $27.65 a year ago to $41.24 last week. Financials' estimates have gained some modest momentum over the past couple of months, as have Materials' and Telecom Services'. However, Health Care Stocks, Information Technology, and Consumer Discretionary stocks have all seen weak to negative earnings revisions for the current year. (Note: The data for Industrials is suspect as S&P has not revised or published any data on this sector for some weeks.)
We continue to expect a choppy, trendless summer on the SPX. We continue to watch for Health Care and Semiconductors to express leadership (Health Care has begun to). And once those sectors have begun leading in serious fashion, then we suspect that the 4-Yr Cycle Low will either be close at hand or have passed.
Our view is that burgeoning inflation is probably more of a risk to the markets than slowing growth. And in that context, we would hope that the Fed will be keen enough to err on the side of being to hawkish on inflation rather than risking being too dovish.
Have a great week!
Best regards and good trading!