Rosie On Inflation

David Rosenberg discussed inflationary pressures "Breakfast with Dave" recreated in its entirety as it touches on many critical points:

As for the inflation-phobes, gold demand hit a six-year low in 2Q, according to the World Gold Council (-8.6% YoY). What is most interesting is that since late July, the S&P 500 has managed to tack on 20 points even as the 10-year Treasury yield has declined roughly 25bps — both markets cannot possibly be right when it comes to depicting the macroeconomic outlook. Our money is with Mr. Bond. After all, we seem to recall that between mid-June 2007 and early October of that year, the 10-year note yield fell 60bps even as the S&P 500 jumped 70 points as it made a last-gasp move to a new high. And, we know who got that story right.

As we saw yesterday, the market responded to reports that another fiscal package was about to be unveiled — even though the last package has yet to fully percolate. This sounds more like desperation than anything else, but there is no question that greed is once again testing the long-term resolve of the marginal investor. Politics is emotional. Like religion, sports, family, house prices, it is emotionally charged and therefore gets a lot more press and the general public forms a strong opinion. After all, the government is doing things that fewer people are favouring, based on the polls, because it is spending other people’s money — that is what fiscal largesse boils down to. Spending our tax dollars. That's why everyone is so crystal clear about the inflationary impact of an increase in the government balance sheet. Deflationary forces are tougher for the masses to understand.

We have said often that just as society couldn't spell ‘inflation’ in 1937, it has no clue what causes deflation now. That's beginning to change in the aftermath of the housing and credit collapse, but try to explain the deflationary forces contained in debt liquidation or global manufacturing over capacity or a socio-economic trend towards savings, and the notion of ‘deflation’ gets fuzzy for most thinkers (even Warren Buffet). That doesn't change the fact that the deflationary forces are enormous (and current) and the policy-induced reflationary forces are a partial antidote.

To be sure, if the government fails to mop it up once the private sector debt liquidation ends, it does mean that an inflationary mistake lurks down the road. But as we have seen in other post-bubble credit collapse episodes, the initial period of deflation can last for years, during which the fundamental trend in bond yields will likely remain in one direction and that is down, to the surprise and dismay of the litany of bond bears that currently populate the capital market. The fact that a year ago, when the inflation rate was over 5% but core inflation was less than half that pace, the market mantra was that we should be focused on headline only — that the core would follow the headline. There was a plethora of Street research published on the topic; we recall that all too well. Today, the year-over-year headline price trend is running at a 60-year low of -2.0%, and now we are being told by the economics community to focus on “core” (which, by the way, has slowed to 1½%) because this is all an “energy story”.


So you see, most strategists and economists and market pundits claim that they are concerned about inflation, but in reality, everyone seems to want to see it. As long as we have a lack of pricing pressure, we will see bond yields trend lower, and as long as that happens, there will be a continued lack of confirmation over the growth rate in the economy that is embedded in equity market valuation. Energy prices may, for a short time, give a kick to the headline CPI numbers but rents are almost four times more important and comprise 30% of the index (and 40% of the core). To repeat — three variables: rents, wages and credit — will ultimately determine the trend in inflation. Down, in other words. If you are not yet convinced of that in the consumer arena deflation remains the primary intermediate-term risk, then go the article on page B8 of the WSJ and see if that changes your mind — discount coupon redemptions are up nearly 20% this year (Club Stores Accepting Coupons: Sam’s Club Joins BJ’s, Costco in Issuing Discount Chits to Members).

We should probably add here that even though the moves by the Fed have provided ample liquidity, they have not stopped the underlying fundamentals from deteriorating — see Corporate Bond Defaults Hit Record on page 19 of the FT. (S&P just reported that 201 companies with $453 billion of debt have defaulted this year, exceeding the entire tally of 126 defaults covering $433bln in ALL of 2008). The 12-month speculative-grade corporate default rate has risen to 8.58%, as of July, from 8.25% in June (the rating agency is forecasting that the default rate will rise to 14.3% by the first quarter of 2010, taking out the prior record of 12.54% set in July 1991).

By the way, we are sure that for a market grasping on to any good news it can get, there is bound to be a buzz over the article on page 11 of the FT — U.S. Office Prices Raise Hopes. But turn to the Lex column on page 10 of the FT and you will see that there is less to the story than meets the eye (commercial real estate values are down 36% from the peak, which makes this downturn even worse than what we saw in the residential market!).

And lastly, this amusing anecdote from Rosenberg:

From our lens, there is always a catalyst or a spark for the next economic expansion and bull market. In 2003, it was leverage and a housing boom. What is it today? Cash for clunkers? Digitized medical technology? Chinese consumption? Government incursion into the economy and capital market? Perhaps we should also recognize that heading into the post-recession environment of 1991, there was a tailwind from sub $20/bbl oil; and heading into the 2003 rebound, we had sub $30/bbl oil; so it may pay to ask the question as to how $70+ oil is going to play in the recovery, unless we are talking about recoveries in Saudi Arabia, Qatar and the UAE?