“During the 1970s, inflation expectations rose markedly because the Federal Reserve allowed actual inflation to ratchet up persistently in response to economic disruptions — a development that made it more difficult to stabilize both inflation and employment.” — Janet Yellen
Japanese Banks
On a price-to-book basis Japanese banks look cheap (top panel). Adjusting the price-to-book ratio for return on equity, Japanese banks are trading at their long-term average. (bottom panel).
The Semiconductor to Software Flip
The below chart is the ratio of S&P Software GICS Level 3 Index to the Philadelphia Stock Exchange Semiconductors Index.
A potential trade to hedge out some risks from a further escalation in the trade dispute would be to be long software short semiconductors.
US REIT Spreads to 10 Year Treasury Yields
The top panel in the below chart is the absolute gross yield of the S&P US REITs Index and the bottom panel is the yield spread relative 10-year US Treasury Securities. REITs are not benefiting from the recent drop in bond yields but yield spreads are not showing any real signs of concern (unlike in 2016).
If there is a deterioration in US economic activity yield spreads on REITs could spike. Alternatively, if inflation expectations pick up absolute yields could pick up.
An inflation neutral, US economic deterioration hedge could be long US 10-year Treasury Securities short US REITs. The negative carry, i.e. the higher yield on REITs means that the payout of coupons on the short side relative to the receipt of coupons on the long side, might make it a difficult trade to hold on to.
The Long Run S&P 500 to Silver Ratio
The below chart is the very long-run ratio of the S&P 500 Index to the dollar price of silver. (We did not use gold as the dollar was pegged to the barbarous relic for prolonged periods of time during the twentieth century.)
As the chart below suggests, we are getting close to bubble territory in terms of the value of the S&P 500 relative to silver. (Bubble territory being two-standard deviations above the long run average — the very top orthogonal line in the chart.)
The below chart, a bit messier one than the above, includes the year-over-year change in the US urban consumers price index (CPI) and the and the 4-year moving average of CPI.
The periods of benign or sharply declining inflation have generally been favourable for stocks relative to precious metals. While periods of sharply rising or persistently high rates of inflation have been
Members of the Federal Reserve have, in recent months, been talking up a monetary policy framework called average inflation targeting, which would entail accepting overshoots of the targeted two per cent price goal to make up for times when inflation was too low.
The concern we have, taking inspiration from the Janet Yellen quote above, is that a change in the monetary policy framework by the Fed causes “actual inflation to ratchet up persistently in response to economic disruptions”. The yield curve is sending a signal that the world will be unable to escape from the current deflationary / low-inflation trap that it has been stuck in. And the consensus view seems to be that trade wars are deflationary.
What if, however, the ongoing trade war between the US and China is about to cause an economic disruption that leads to a persistent ratcheting up of inflation?
Globalisation has been a deflationary force over the last three to four decades. The accession of China to the World Trade Organization (WTO), in particular, allowed 750 million workers, whose wages were estimated be as little as 10 percent to those of workers in developed markets, to enter the global trade system. The central bank policy response to the deflationary wave of globalisation and the abundant availability of low cost workers in China was that of lowering interest rates.
Low interest rates and juicy returns on investments made in China, and emerging markets in general, created a positive feedback loop.
Large US Corporations borrowed at low interest rates -> invested the capital in emerging markets and reduced capacities in developed markets -> developed market consumers benefited from lower prices -> central banks lowered interest rates -> rinse repeat.
Low interest rates beget lower interest rates. That is, until the capital being invested starts to get impaired and the cost to corporations is not just interest but also loss of principal. The victory of the Trump Administration in deterring the flow of capital into China by multinational corporations has been that, unlike previously, there is real concern now about loss of principal. And when corporations are sufficiently worried about loss of principal they do not invest.
Businesses, however, can only postpone investing for so long. A prolonged trade dispute is going to result in capital being invested in jurisdictions other than China. Executives and company boards, however, are likely to be sufficiently worried about other jurisdictions being targeted by the Trump Administration’s protectionist push. And so a portion, a significant one, of corporate investment budgets is going to be allocated to the US.
Labour markets in the US are tight. While capacities are not constrained, there is little slack. What if protectionism is the economic disruption that causes “inflation to ratchet up persistently”?
This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.