By
The
Inflation Trader
:
To know that you're standing before a cherry tree, you needn't
have cherries; cherry
blossoms
suffice. The seasons are long, so if you want to be able to harvest
the fruit you need to look early for the signs.
So it is with inflation, and some would say it is with markets
in general. We look for the early hints (a less-poetic scribe might
call them 'green shoots') that signal when the season has turned.
With inflation, indeed,
the season has turned long ago
, when core inflation bottomed in Europe, the U.S., and Japan in
2010 (and in the UK even earlier). But as we have seen, markets
have not yet internalized this turning, or in some cases (as with
nominal yields) have begun the recognition and then reversed
it.
Consider now the humble 7.5% gain this month in the DJ-UBS
commodity index (and comparably large moves in many other indices).
It isn't the size of the move, or its consistency, that is
interesting to me; rather, it is that the movement has come
partnered with a break of commodities' relationship to the
dollar.
Since commodities for the most part are priced in dollars, it is
natural that they tend to move in the opposite direction from the
greenback. When the dollar strengthens, then commodities are more
expensive to non-dollar consumers, and they demand less. Yes, of
course there are other factors, but when there are no stronger
underlying currents then commodity indices tend to move inversely
to the dollar. The chart below (Source: Bloomberg) illustrates the
strong coupling of the dollar index (here inverted) and the DJ-UBS
Commodity Index in yellow, both normalized to August 1st, 2011.
But note that this recent movement in commodities has come not
in conjunction with a weakening in the dollar, but in spite of a
strengthening (albeit a modest one) of the unit. This, I think, may
be the first blossoms of spring in commodity-land.
Some may object that the rise in commodity prices is primarily
driven by grains, but this is not the source of this divergence.
The chart below (Source: Bloomberg) shows the dollar index again
(and again inverted) against the DJ-UBS
ex-Agriculture
Commodity Index.
I am not a disinterested observer of the Commodity Spring, as
readers well know; our models have for some time now indicated that
commodities were the only outright-cheap major asset class and our
main strategy has been heavily overweight them for quite a while.
So perhaps I will be accused of seeing blossoms where none have yet
bloomed. But as commodity indices approach their highs of the year,
they are still only 14-15% off their lows, and far below their
highs of a few years back. They remain the cheap asset class.
Moving to inflation more-broadly, it seems the market is growing
comfortable with the notion that core inflation may have topped
since it hasn't risen appreciably in a few months. It is certainly
useful for those expecting QE3 - as am I - if that perception gains
currency (no irony intended) since de-fanging the hawks on the
Federal Reserve Board would seem to be a
sine qua non
for loosening policy appreciably. But I believe that comfort is
ill-placed.
I had been expecting, based on the lagged effect of the large
inventory of unsold homes last year, for the housing portion of
core inflation to ebb from its recent pace. It has merely flattened
out, and while inventories are coming down those declines shouldn't
begin to push shelter CPI
up
for another quarter or two. But long-lag relationships are
inherently difficult since the lags can shift over time. So let's
look at a shorter-lag relationship.
The housing component of CPI is driven by rents, both for
consumers who rent their residence ("Primary Rents") and for the
consumption value of owner-occupied housing ("Owners' Equivalent
Rent" or OER). The chart below shows the relationship between OER
and the CBRE index of rents on multifamily property, lagged 2
quarters (the red dot marks the last OER point). The goodness of
fit of this relationship, shown for the period 2001-present in the
Chart below (Source: Bloomberg and BLS), is quite reasonable[1] but
interestingly, the recent rises in rents suggests that OER is
significantly
under
stated.
The number for the rental series ending in Q1 suggests that OER,
which was last at 2.03% year-on-year in June, should be more like
3.4%. Since OER has a 23.5% weight in CPI and a 30.7% weight in
core CPI, if OER were to converge it would be worth 0.4% on core
inflation. And rental increases do not yet show much sign of
ebbing. In short, the flattening out of core inflation over the
last few months
may
represent the extent of what we can get out of housing at this
point.
The last piece of evidence is really more corroboration of a
speculation
I've previously mentioned here
. The sudden revival in apparel pricing this year has caught many
analysts by surprise, and most have been expecting for the series
to relapse soon (the price of cotton is often blamed, as if cotton
hasn't had any previous spikes in the last twenty years). My
speculation was that the flattening and declining of apparel prices
beginning in the early 1990s could plausibly be related to the
opening of the U.S. textile industry to global competition, but if
that is true then there must
eventually
come a time when the globalization has run its course and there are
no more gains to be had from the declining domestic labor content
in apparel. Thereafter, the rise in prices going forward should
reflect rising wages in the source economies, without the dilution
of changing composition.
Now Morgan Stanley has published a piece, by Joachim Fels et
al., called "Margin Call" (July 25, 2012). The authors illustrate
that the U.S. margins of Chinese exporters have shrunk by 20-30%
between 2004 and 2010, and argue among other things that "Price
increases for Chinese imports and the spillover effects these are
likely to generate may contribute to meaningful upward pressure on
inflation." This is not inconsistent with my speculation above, but
adds a separate potential cause for the rise in apparel prices and
other China-sourced prices (significant among them, incidentally,
resin prices).
All in all, these pieces of evidence contribute to my belief
that as consumers we ought to take time to smell the flowers,
because the harvest of cherries is likely to follow in train. And
in this case, that would be the pits.
[1]
The R
2
should be taken with a grain of salt, however, since these are
overlapping observations.
See also
Priceline.com: Earnings Preview
on seekingalpha.com