The Gravity Of The Situation

By: Michael Ashton | Sun, Jul 18, 2010
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The sense of unease is growing almost palpable. I am not referring to the epic plunge in the Michigan Sentiment number, which has only been seen a handful of times in the three-plus decade of the survey. Certainly, we already had ample evidence that the economy was weakening and that consumer confidence was growing somewhat stretched. The stock market ended down 2.9%, but it wasn't because of Michigan: the indices fell all day, fairly steadily. Similarly, we cannot lay the market's weakness entirely at the feet of the disappointing earnings from Citigroup and BOA, and the results from a couple of other key banks that exceeded expectations only because they pulled the time-honored trick of drawing down loss reserves. These are all negatives, but I think there is something more. Investors are downright uneasy.

How otherwise to explain the curiously upbeat market outlooks we are seeing now, right when the data is looking pretty bad with equities having priced in only a fraction of that evolution in the outlook? The cover story in Barron's this week is "Google - Why the Stock Could Jump Over 35%!" Sure, and I'll also tell you why it could go to zero. (The case isn't that hard, despite the paper's blatantly erroneous claim that "Google, of course, invented online search."). That sort of cheerleading is usually reserved for CNBC, although the columnists at Barron's continue to use the P/E-excluding-losses figure for the S&P P/E ratio to claim it is around 14, even while their very own data section records the actual ratio as being near 18.

We also have Bill Gross, the Bond King, gracing the cover of Bloomberg Magazine, extolling the virtues of...stocks.

Why is everyone trying so hard to sell us on equities? It isn't like it is hard to find people to buy stocks. It is in fact the default investment for many Americans these days, as the popping of two bubbles has not created very much of the "revulsion" ordinarily seen in bear markets.

And why all the effort to convince us that the Fed has things firmly under control? Right now, there is a camp of people concerned about deflation (mostly Keynesians), with some justification (although I think they're wrong to worry about something that can be cured with the stroke of a pen, specifically adding a zero to the currency). So Richmond Fed President Lacker gets to the podium and declares (on Thursday evening) that a "double dip is quite unlikely at this point," which is so far from being a defensible hypothesis I don't know where to start. Moreover, he summons a mysterious branch of physics that involves inflation expectations as a strange attractor: because expectations for inflation are above zero, he says, this will exert a pull like "gravity" to keep inflation from actually declining into deflation.

He might actually believe that; many economists feel that inflation expectations are a key component to keeping inflation under control - despite the fact, it should be noted, that no one has figured out yet how to measure consumer inflation expectations accurately (n.b., I am working on a paper called "Quantitative Estimation of Perceived Inflation"). In 2007, Dr. Bernanke said in a speech "Undoubtedly, the state of inflation expectations greatly influences actual inflation and thus the central bank's ability to achieve price stability," but went on to highlight three important questions that remain to be addressed about inflation expectations:

(1) How should the central bank best monitor the public's inflation expectations?

(2) How do changes in various measures of inflation expectations feed through to actual pricing behavior?

(3) What factors affect the level of inflation expectations and the degree to which they are anchored?

According to the Chairman, the staff at the Federal Reserve struggle with even the first question of this triad ("while inflation expectations doubtless are crucial determinants of observed inflation, measuring expectations and inferring just how they affect inflation are difficult tasks"), although this has not deterred them from tackling the second and third questions.

By contrast, we have a pretty good understanding of how the real force of gravity actually works, which is why we have reasonably high confidence about predictions involving it.

In point of fact, he has actually probably got the right direction. The CPI print on Friday was a surprise to the upside on core inflation, although everyone seemed to want to focus on the low headline number. Core CPI over the last three months has been +0.0%, +0.1%, and now +0.2%. I certainly don't expect that sequence to continue, but the argument for inflation beginning to head up from here is pretty good and doesn't rely on mystic hand-waving about "inflation expectations gravity." The advantage of pointing to this gravity, of course, is that the Fed needn't take responsibility for inflation that turns out to be too was just gravity! Ya can't fight gravity!!

So...since I too see inflation as basically bottoming in the next few months, I guess I am in Lacker's camp on this one even though I don't believe in his version of gravity. I am, though, just a bit nervous that he feels he needs to try and persuade people not to worry about deflation. As with the equity cheerleading above: if inflation is going to be drifting up, as he claims, then why do you need to convince people of that? Well, in this case, it is because they feel they need to be sure that inflation expectations don't collapse.

I wouldn't worry about that. Ex-housing, core CPI was 2.586%; while that is the lowest it has been for a few months, that is partly because of base effects and if current trends persist core-CPI-ex-housing will be rising again in two months. 2.6% is not deflation, and it is because the whole market basket other than housing (and, lately, energy) is rising that inflation expectations seem to be fairly anchored at a higher level. It isn't gravity that is going to pull inflation higher - inflation is already higher, just masked by the unwind of the housing bubble. (See the chart below, which I have run before and doubtless will again.)

Core CPI Y/Y
Core inflation ex-housing remains in an uptrend in stark contrast to the official core CPI.

Investor inflation expectations, however, are drifting lower again. 10-year inflation swaps are at 2.25%; the measure is 1.76% or so on 10y breakevens. Moreover, one-year inflation swaps are 0.60%, which to me seems to have much more upside than downside (unless oil moves sharply lower from here). There is, as I said above, a palpable sense of unease growing. Opinion leaders are trying to convince us that stocks are a good buy at these levels. Fed officials, who recently were worried about pulling back the stimulus, now are explaining why deflation isn't a concern.

In one sense, I suppose, who am I to question? Bernanke, we are told by the Wall Street Journal, may be the new Maestro (link). (Oh thank you, thank you, thank you! The book almost writes itself.) Meanwhile, I am still selling my book about the old 'Maestro' at a discount online through this link. Get one. You need a copy.



Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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