Is Inflation Next?

Asia Confidential's picture

Inflation is dead. At least that's the view of the vast majority of economists, investors, policymakers and financial commentators. The view has been given further currency in recent months via various speeches from IMF director, Christine Lagarde. She's urged policymakers to fight deflation as it's the major threat facing developed economies in 2014. The latest consumer price inflation (CPI) statistics, whether it be in the US, Europe or China, seem to support her view.

There are signs though that inflation shouldn't be written off altogether. The price action of agricultural commodities and gold is suggesting as much. Oil hasn't yet followed suit but should be closely watched. There's also evidence of a tightening labor market in the US, which normally precedes wage increases and higher inflation. Admittedly, these are tentative signals rather than definitive evidence (which usually only comes after the fact).

But some of these things are indicative of mid-economic cycle behaviour - at least in the US. In this part of the cycle, there's eventually a tug-of-war between rising interest rates and improving fundamentals. And later in the cycle, the economy usually gathers steam and inflation follows, with the central bank being late in raising rates to quell the inflation.

The US has largely followed the patterns of a typical economic cycle thus far. But Asia Confidential still suspects this isn't just a typical cycle. The current economic system - where central banks can print money without constraints - is inherently inflationary. Until the system is reformed where limits are imposed, there are likely to be even greater swings in economic cycles and stock market prices.

What does this mean for inflation in the near-term though? Your author has previously suggested that deflation would precede inflation and this has proven correct. Our view now is that investors should probably be leaning the other way, preparing for inflation to take hold by the first half of next year. Keeping in mind that whether this proves right or not, today's monetary regime almost guarantees inflation in the long run, as well even more extreme economic booms and busts.

Hints from Q1

The first quarter of the year is over and it's time to take stock. Let's have a look at the returns of various asset classes.

Cross asset returns 1Q14

As you can see, there's the odd mix of strong performance from both bonds and commodities. This shouldn't surprise regular readers of mine. This newsletter has been an advocate of agricultural commodities on both short and long-term time frames. This based on still tight supply-demand fundamentals and the favourable weather of last year providing only a temporary pullback in prices.

I've also suggested that bonds, particularly US treasuries, were due for a bounce back too. Admittedly, this was an early call made mid-last year. Too early as it turned out. And though the good performance may continue in the near-term, the pathetic yields on offer should make for poor returns in the long-term.

As for gold, your author has consistently recommended it as a hedge against currency debasement. I suggested junior gold stocks might prove the contrarian trade of 2014, given extraordinarily depressed sentiment and valuations. In the first quarter, these stocks were up 17% (via the ETF, GDXJ).

Among the big losers were Asian markets, including Japan and China. A Japan correction shouldn't surprise given the enormous run that the market had last year. Note though that Japan has started the second quarter in style. Further out-performance, at least this year, will depend on more mass injections of printed yen.

As for China, that market has been among the worst performers for several years. It's staggering how investors and commentators swallowed China's strong economic figures from 2009 onward when the stock market was telling them all along that the economy was fast deteriorating.

The question is: what's in store for the rest of the year? And the answer to that will partly depend on what happens to interest rates and inflation in the world's largest economy, the US.

A normal market cycle?

Either consciously or unconsciously, most investors avoid reading people who have different views from their own. It's a common investor bias called confirmation bias. And it usually makes for poor investment decisions. After all, testing your own arguments against those of others should be an essential part of any decision making process.

In this spirit, Asia Confidential always enjoys reading two prominent North American economists, Richard Bernstein and David Rosenberg. The former used to be Merrill Lynch's chief investment strategist and now runs his own consultancy. The latter used to be Merrill Lynch's chief North American economist before moving to a Canadian brokerage.

Your author finds some of their latest arguments particularly persuasive, if not being wholeheartedly in agreement with them. Let's examine the persuasive bits initially.

Bernstein is known as a US economic and stock market bull. To his credit, he's been largely right since 2009. To understand his bullish stance, there's some context to get first.

Bernstein believes the US is undergoing a typical market cycle. These cycles follow a pattern cycle after cycle. And this one is no different, despite the common belief that it is.

The early part of the cycle is when monetary and fiscal policies focus on stimulating the economy. It's normally associated with depressed stock market valuations. As well as improving economic fundamentals. During the early part of the cycle, financials and consumer cyclicals typically outperform as they're most sensitive to lower rates and credit creation (and this has proven right since 2009).

The middle portion of the cycle involves a tug-of-war between rising interest rates and improving economic fundamentals. Stimulus is normally eased though investors become anxious about whether the economy can continue to grow without it.

During this mid-cycle, inventories built up during the prior crisis are run down and businesses start to invest. This usually results in outperformance from sectors such as industrials and technology.

Note that Bernstein believes the US is now entering this mid-cycle.

The latter segment of the cycle is characterised by a stronger economy and increased corporate profits. Inflation picks up and the Fed is invariably late in acting to increase rates, usually signaled by an inverted yield curve (where short-term bond yields are higher than long-term bond yields). Late cycle sector out-performers are typically energy and materials.

Bernstein thinks we're a long way from the latter stages of this market cycle and US equities should continue to perform well under these circumstances.

David Rosenberg appears to be thinking on similar lines. Rosenberg is famous for his recessionary warnings prior to the 2008 financial crisis and many were surprised when he turned from US economic bear to bull last year.

Rosenberg believes that we should now be preparing for a stronger US economy and rising US inflation over the next 12 months. He says the fiscal headwinds of last year will subside and provide tailwinds this year. The jobs market is improving and ex-finance sector, employment should hit an all-time high in coming months. Consumers are done deleveraging and are now in a position to start re-leveraging. And business spend should improve as the nation's capital stock is old and needs replacing.

Rosenberg suggests that we're in the early stages of bargaining power moving from employers to employees. He sees a tightening labor market, with the recent pick up in hourly earnings as evidence of this.

He also believes prices of rent, food, energy and health care services are all heading higher. Combined with increased wages, this should lead to sustained inflationary pressure in coming quarters.

Rosenberg says the next decade will look more like the 1970s than most people think. Though structural and demographic factors will limit how high inflation can go. He believes inflation could revisit the highs of the previous economic cycle, at close to 5% for CPI.

Like Bernstein, Rosenberg thinks the Fed will be late raising rates to quell the inflation, and an economic downturn may then follow. But that's some time away.

Rosenberg differs from Bernstein in believing US stock gains will be more muted after the large run-up in recent years. Needless to say, he's bearish on US long bonds given his views on inflation.

A system unhinged

The two economists provide a convincing case why this US economic cycle will follow previous cycles. Though I'm not entirely convinced they'll turn out to be right. There's every chance that this cycle may be even more extreme than those of recent times. Here's why.

If you look at the history of the US Federal Reserve since it was created a hundred years ago, it's been one of sustained inflation and heightened asset price volatility. Volatility has undoubtedly increased during that time.

The reason for this can be traced back to the paper money system. Before 1914, central banks couldn't print money without additional metallic reserves, principally gold (though also silver in ancient times).

With the advent of the Fed, the link with gold was gradually wound back. And in 1971, that link was broken altogether when the US floated the dollar. Since then, the Fed has been able to print money, without constraints.

This has suited the politicians just fine. With an eye always on the next election, any economic downturn has been met with substantial money printing to cushion the blow to their electorates. It's been a seemingly easy answer to the problems of the day.

However, inflation and increased economic instability have resulted. It's created the illusion of prosperity even when that prosperity may rest on increasingly shaky grounds.

If we turn to the 2008 financial crisis, the worst economic downturn in the US since the 1930s was met with unprecedented money printing. Not only from the Fed but central banks worldwide.

Thus, how much of the US economic recovery since is artificial is impossible to tell. But we're about to find out, given the Fed's planned tapering program.

There's a chance that the US economy won't be able to handle higher inflation and higher rates. There was a glimpse of this when 10-year bond yields recently hit 3% - the US housing market almost instantly stalled.

Importantly, the massive stimulus programs conducted globally have made the economies of countries outside the US more unstable. Look at Asia, where stimulus has fueled domestic credit bubbles which are starting to unravel.

The current economic system is prone to inflation and instability. Until there are limits imposed on the money printing capacities of central banks, the situation may worsen.

In other words, if Bernstein and Rosenberg are correct about this being a typical US economic cycle, inflation is on the way. And if they're incorrect, the broader system will almost guarantee serious inflation down the track anyway.

Whichever way that you cut it, preparing for inflation ahead would seem sensible. The question is whether we get a deflationary bust before seeing further central bank intervention then leading to inflation. I've been a previous proponent for such a bust, though now see that as a less probable outcome.

In my view, the largest deflationary risk for the world isn't China but Japan. Despite being heavily shorted, the Japanese yen continues to weaken and Shinzo Abe needs it to fall a lot further if he has any hope of hitting his inflation targets. The risks from Japan exporting deflation, via a much weakened currency, shouldn't be underestimated.

An investment framework

Given the economic scenarios outlined above and the range of potential outcomes, it makes sense to have a diversified investment portfolio. This is a bit cliched so let's get more specific.

Stocks perform well during rising inflation, until the inflation rate hits a certain point. In the US, that point is 4%.Therefore, stocks should be part of portfolios at this juncture (that may change later on).

The US stock market has run hard and valuations aren't cheap. Other markets look better. On a 12 month view, I like Japan. Though highly skeptical of Japan's stimulus program, it'll likely benefit the local stock market. Hedge any yen exposure, however, as the currency could be heading much lower.

Other Asian markets are also worth owning. For instance, South Korea appears very cheap, at 1x price-to-book, with some world class companies on offer.

Parts of Europe look prospective too. The likes of Italy and Ireland appear both misunderstood and mispriced, particularly the banking sectors.

As for bonds, short-term bonds are safest as they aren't susceptible to higher interest rates. Long-term bonds in most countries are risky if inflation picks up. The problem is that even if inflation and rates remain low, many long-term bonds offer such pathetic yields that returns are guaranteed to be paltry.

Cash is probably the world's most hated asset class. People holding cash have lost out big since the crisis. The potential for higher inflation risks even greater relative losses. But I think it's still worth holding some cash in case that doesn't happen.

Commodities are an interesting one. They arguably benefit from inflation. My preferences are agriculture, silver, gold, oil - in that order. Industrial commodities should be avoided as their super cycle, turbocharged by Chinese over-consumption, is over.

Other assets which will benefit from inflation should also be considered. In many countries, commercial real estate remains reasonably priced. Official and industrial are be preferred over retail property, given the structural issues facing the latter (with the Internet taking retail market share).

AC Speed Read

-  Market consensus suggests deflation remains the greatest threat to the global economy.

- There are signs though that inflation may be on the way in the US at least, as the labor market there tightens and commodities gather steam.

- There's an informed view that the US economic cycle is following a typical pattern, which points to soon rising interest rates and inflation.

- We're not convinced this is a typical economic cycle but think the broader monetary regime remains inherently inflationary and economically unstable.

- Whichever way you cut it, it would seem sensible to prepare for inflation ahead.

This post was originally published at Asia Confidential:

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atthelake's picture

If you can, stock up on food, drink, fuel, supplies and meds when they're on sale. How can it hurt to CYA?

damicol's picture

Imagine two countries next to each other.

One large with a large population, and one much smaller with a much smaller population.

The small one owns most of the assets and businesses in the larger one  prints money at phenomenal rates and pays itself in ever escalating amounts. Inflation is enormous.

The larger country,  It has no spare cash, it ives hand to mouth and its income is crashing, businesses it owns are small and need to cut prices to survive, its inhabitants get poorer, its debts get higher, its wealth is sold off to pay for things it cannot earn enough to pay for. It is in deflation

Now imagine, how would you  hide those two facts.

Simple, use the same currency in both countries, and sperad the population from the small country throughout the larger one..

That is what the west and the US has become. There are two dollars, the rich dollar on rampant inflation and the poor dollar in deflation. Both look the same, but the rich dollars can get trillions more by printing and the poor dollar has to get debts and sell everything off  to pay for basics

Seperate countries , much like Europe, swindling  the majority by the minority, and stealing ever more to make up for their gross inflation.

How to fix that.. In principle not hard. Money is a store of labor in a poor country.

You demand more dollars from the rich country for your labor and refuse to pay more in taxes.

In other words you need to go on a widespread general strike. Not against your small local businesses, but against all big corporations and banks. Stop buying goods and services, demand lower prices  and higher wages to work for them,

But remember one thing, if your neighbor is a civil servant, they live in the rich country too.

Demand lowrer wages and more from them and if they object refuse to pay them anything at all.





AdvancingTime's picture

 After much thought I have come to the conclusion that while inflation appears tame and is not showing up in a big way the seeds have been planted, and the number of them is somewhat shocking. Inflation lurks beneath the surface and is hidden away in the dark corners of our future. Want to know where the real cost of things is going, just look at the replacement cost from recent storms and natural disasters. The article below delves deeper into some of the ways inflation hides away.


Iam_Silverman's picture

OK, I was kinda lost there when it was posited that there would be wage inflation.  So, all of the "newly employed" part time fast food workers are going to be able to band together and demand raises?  Was this article drafted in Colorado?  I can see how a combination of thin air and cannabis could lead to strange ideas.

Pinche Caballero's picture

"Slightly off topic, but I feel somewhat related, and not all of my assumptions/understanding below may be entirely correct. (Yep, got it.)

In keeping with my own efforts to educate myself further on matters often discussed here, I recently finished reading "When Money Dies". Not having a finance or economics background, I feel this was a sort of primer/intro to actually understanding effects of rampant fiat printing (Inflation 101), the end-of-the-road result of the Bank/GOV exploitation in the article above. It took me a bit to muddle my way through.

I need one of you ZHer's (mental giants surrounded by us midgets) who easily and clearly understand "When Money Dies" but take for granted that others should be easily able to, as well, to draw me a picture (some sort of graph/timeline) that will be worth 1000 of my inarticulate words. I need the picture to be the equivalent a modern day thirty second sound bite to share with other Sheeple.

What I gather from the Weimar inflationary event is that at various points along the time-line, the inflationary and subsequent deflationary periods had both economically rewarding as well as deleterious effects at different times upon different segments of the population. I had always thought everyone suffered equally.

the first to suffer during the inflationary period were those on fixed incomes, .i.e, pensioners, etc. whose purchasing power was lost

the next to really feel the pinch were government employees whose incomes did not keep pace with the devalued (-ing) currency

labor was able to strike, or threaten strike, to receive ever increasing wages as the currency was being devalued

industry at first benefitted tremendously

speculators/forex traders benefitted greatly during the inflationary period

then the deflationary cycle, and everything happened in nearly reverse order

What I think key is I had always previously believed there was a scarcity of tangible items and food across the board. However, that was not necessarily the case, and in fact, one segment of the population fared better during the Weimar inflation/deflation period. Farmers were at first able to pay off mortgages and debt for equipment and machinery much more quickly with the inflated proceeds from sales of what they continued to produce as before. Then, when farmers refused to accept the debased currency for what they produced, they instead received tangible items from others needing to eat just to survive.  Moreso on the flip side, only during the deflationary period and once their was a then true scarcity of tangible items in the urban areas, did the farmers begin to suffer due to pillaging across the countryside by bands of marauding and starved city-dwellers.

This Weimar period is what has been happening in slow-motion up to this point, I feel, due to exactly what the article above describes has been happening in the U.S. due to Banker/GOV/Industry statist control over the course of a couple of generations now. And, then suddenly for many and seemingly without warning, it is soon all going to spin out of control...

Can anyone here put this concept all into a single, easy to understand graph or chart for mass consumption by the less economically (a-hem!) astute? I want to be able to share it with others, in a way they can see it and not be overwhelmed with needing to think too much for themselves. I feel there could be many fundamental points illustrated for other Sheeple based on such a representation."

I just submitted this elsewhere moments ago, and am doing so again, here.


Free Bird's picture

There is no deflation in the grocery store. Or at the gas pump. Or in the phone bill and utility bill. Period.

CHX's picture

True, but those don't count, bcs they are not in the inflation basket. /sarc

moneybots's picture

"In other words, if Bernstein and Rosenberg are correct about this being a typical US economic cycle, inflation is on the way. And if they're incorrect, the broader system will almost guarantee serious inflation down the track anyway."


As well as serious deflation.  Inflation causes deflation.  inflate a financial bubble, it bursts and deflates.

moneybots's picture

"Rosenberg says the next decade will look more like the 1970s than most people think. Though structural and demographic factors will limit how high inflation can go. He believes inflation could revisit the highs of the previous economic cycle, at close to 5% for CPI."

That is not the 1970's.  Greenspan had Whip Inflation Now buttons and double digit inflation ensued.

daveO's picture

Right. We're already at nearly 9% according to ShadowStats. Structural and demographics won't matter if the Petro Dollar is successfully abandoned.

moneybots's picture

"Keeping in mind that whether this proves right or not, today's monetary regime almost guarantees inflation in the long run"


It also guarantees deflation in the long run.  A cycle always has two phases.  In the long run is a useless term.

moneybots's picture

"Inflation is dead. At least that's the view of the vast majority of economists, investors, policymakers and financial commentators."


100% of bubbles burst and deflate.  They can't get around the laws of math.

semperfi's picture

"Inflation is dead. At least that's the view of the vast majority of economists"

The vast majority of economists are brain dead and/or paid shills of the govt lie factory.  They use the govt inflation numbers, which are lies.  ~8% is the real inflation rate per Shadow Stats and has been for a long time.

daveO's picture

Paid Shills of the FED fiat machine, to keep the sheep corralled in wasting dollars.

AdvancingTime's picture

The modern economy that has evolved over the last several decades is loaded with interwoven contracts reeking of contagion. I contend that if faith drops in these intangible "promises" and money suddenly flows into tangible goods seeking a safe haven inflation will soar.

In a recent article I wrote "never before has mankind diverted such a large percentage of wealth into intangible products or goods and made the claim this is the primary reason that inflation has not raised its ugly head or become a major economic issue in recent years." Like many of those who study the economy I worry about the massive debt being accumulated by governments and the rate that central banks have expanded the money supply. the article below delves into an inflationary collapse.

drstrangelove73's picture

Shameless plug for your blog#2 in this thread ,Bruce.
Bad form

Mr Giggles's picture

Dofenism, the kids aint gona help you now.

whidbey-2's picture

Burnstein and Rosenberg do sell stock, which discredits both. 


 In the long run we chump voters are not in control. the IMF fears deflation and should in the EU (-Germany), and maybe the US too, if we ever can see and understand what the Fed is doing. Janet scared herself and me too. She appears to be inept at best. She will detaper if the elects appear to going wrong.

 The mid-term election is coming so we should expect crazy spending soon, Congress, the Fed and heavy hitters.  Keeping some cash is not only wise, but useful to follow the market up or down. No one is driving the bus except maybe Putin. Secty of State has left the building - naked.

buyingsterling's picture

This time it _is_ different, if only because of Obama, the ACA, and the growing corruption on all levels.

disabledvet's picture

i still think the great risk is plain old default as the bulk of humanity simply goes belly up here.

not a good time to be a State with a load of unfunded largesse....let alone new largesse on the way.

nightshiftsucks's picture

This is a joke right ?

Singelguy's picture

Definitely a joke. This is anything but a normal recovery. Consider the following factors;
1. Worldwide debt has increased $30 trillion since the financial crisis began.
2. Labor participation rates have dropped to levels not seen since the 1990's.
3. Wage growth is stagnant or declining.
4. Populations in Japan, Europe, and the USA are aging, putting more pressure on social welfare and healthcare costs.
5. Central banks continue to print money albeit at a reduced rate.
6. Real inflation is running between 8 and 10% despite the official numbers to the contrary.

As consumers are taxed more, pay higher food and energy prices, with stagnant wages, resulting in declining disposable income, how can the economy recover? Where is the demand coming from? The money printing is boosting asset prices but that only benefits the 1%. The economy is likely to worsen before it gets better.

Seeking Aphids's picture

The elephant in the room is the lack of wage long has it been? 40 years since there has been real wage growth? There can be no real recovery until wages rise and labor participation rates improve, imo. The race to the bottom has taken US workers there...the bottom. Expectations that they will live and spend like it was the 80's or 90's derives from a failure to understand the reality of the majority of people in NA....the ivory tower and 1% do not see this and make projections based on a flawed view of the true state of the economy. What will it take to improve the conditions of the average person? I suggest we start taxing multinational corporations and use that money to fund infrastructure and education.

TheReplacement's picture

It would seem so but is not funny.  Any market forecast that completely ignores the geopolitical situation is pointless.  There are lots of sabres rattling but it's all good until inflation hits next year?

RevRex's picture

Next? As in a 20% increase in food prices already this year?