Goldman's Clients Are Confused About Inflation: Here's Why

In his latest weekly kickstart, Goldman's chief equity strategist David Kostin (who has maintained his year end S&P price target of 2,400 of -3% from current levels), says that the one topic most confusing (and important) to Goldman's clients in the past week, was what happens to inflation next: "the US inflation outlook and its equity investment implications were key topics of discussion during recent visits with clients in Boston, Chicago, and New York. Core Personal Consumption Expenditures (PCE) data released [on Friday] showed a year/year inflation rate of 1.5% in 2Q. Wednesday’s Fed statement acknowledged that inflation was running “below” its 2% target, a revision from the “somewhat below” description used previously."

Kostin points out that while fixed income managers have always had to take a view on inflation, now that the Fed's "reaction function", to use an IMF-ism, is entirely driven by concurrent and future inflation expectations, and as a result "equity investors must also take a stand and position portfolios accordingly. The anticipated path of inflation is an important determinant of the trajectory of Fed policy tightening. Bond yields will be affected in turn via expectations of future hikes and the term premium, and stock prices by extension will be influenced through the equity risk premium."

As for why Goldman's clients are "confused", Kostin points out something we have discussed on several occasions recently: depending on what indicators one uses, inflation can be expected to rise, drop, or stay the same: 

"Looking forward, will the rate of inflation in 2018: (a) decelerate, (b) accelerate, or (c) stay about the same? The answer depends on the information source. Treasury Inflation Protected Securities (TIPS) imply inflation will decelerate; Goldman Sachs economics forecasts an acceleration (to 1.9%); while corporate pricing varies both across and within industries. For example, branded pharmaceutical prices are rising by 9% (offset partially by rebates) while generic drug prices are falling by 9%."

Some more details behind these perplexing numbers:

  • The TIPS market implies inflation will average 1.3% annually during the next two years and 1.8% annually through 2027. As a result, fed funds futures currently imply just a 50% probability the FOMC will hike once more by year-end 2017 and expect just two hikes in total through the end of 2018.
  • In contrast, Goldman Sachs economics believes underlying inflation will trend towards the Fed’s 2% objective. Specifically, our economists forecast core PCE will reach 1.6% by year-end 2017 and climb to 1.9% by the end of 2018. The trend in inflation will prompt steady policy tightening starting with a 25 bp hike in December followed by four hikes in each of 2018 and 2019 that will lift the funds rate to 2.4% and 3.4%, respectively.

In a humorous swipe at his own economics team, Kostin writes that "we have met no equity investors who subscribe to this forecast."  So much for Goldman's once legendary ability to shape and sway investor sentiment. 

Then there are the government's own measurements of inflation:

The components of measured PCE inflation are split 25% in Goods and 75% in Services. The goods category has shown consistent deflation for several years and our economics team forecasts that trend will persist in 2017 and 2018 (see Exhibit 5). A leading driver of disinflation has been the Video, Audio, and Computer category where prices dropped by 5% in 2015, by 10% in 2016, are declining at an average pace of 7% YTD, and we forecast will fall by 4% and 7% in 2017 and 2018, respectively.



However, Services PCE inflation is the more important category and the trends are mixed, which is why market participants have such divergent views on the underlying pace of inflation. The four largest Services categories account for 65% of core PCE inflation and include Medical Services (19%), Housing (19%), and Financial Services (9%).

Separately, what inflation information can investors glean from corporations and the equity market?

Confirming what the latest Census data showed last week, namely that asking rents across the nations just fresh all time highs...

... Goldman flags that apartment owners suggest rental inflation remains above the Fed’s overall inflation target of 2%. Six public apartment REITs own 357,000 multifamily units (AVB, ESS, EQR, AIV, CPT, UDR). Same-store rental growth in REITs has been a leading indicator of the change in owner’s equivalent rents (OER) in the government’s housing inflation measure (Ex. 3).

Average rental growth for these REITs equaled 5.6% in 2015 and 4.8% in 2016. More notably, Kostin writes that "because analysts forecast rental growth will slow to 2.9% this year and 3.1% in 2018, housing inflation represents a fading tailwind to core PCE inflation." To be sure that would be great news to a middle class that has never had to pay more out of pocket for the monthly rent...

On the other hand, a conflicting picture emerges from the deflation observed in certain parts of Financial Services. The Investment Company Institute (ICI) reports that average fees for active equity management have dropped from 108 bp in 1996 to 82 bp today, although we doubt that one can seriously claim with a straight face that there is delfation because millionaire LPs are paying not 2 and 20 any more but 1 and 10 or less.

Meanwhile, inflation and interest rates affect equity valuations. The gap between the S&P 500 earnings yield and ten-year Treasury yield represents a short-hand measure of the equity risk premium. The gap in the “Fed Model” currently equals 320 bp (5.5% less 2.3%), below the average of the past 10 years (460 bp) but above the average of the past 40 years (250 bp).

Which brings us to Goldman's summary: based on all the initial assumptions, Kostin's S&P 500 price target of 2400 suggests the yield gap will narrow to 300 bp by the end of 2017. The yield gap has narrowed by 300 bp since February 2009.

Our economists forecast the Treasury yield will rise by 50 bp to 2.75% at year-end. Higher interest rates coupled with a slightly lower risk premium is consistent with our S&P 500 year-end target of 2400 (-3%). However, if inflation remains subdued and the bond yield hovers near the current level, the Fed Model would imply a S&P 500 fair value of 2650 (+7%) (see Exhibit 4).

Finally, and going back to the original underlying confusion, Goldman concludes that "whether they are bullish, bearish, or neutral, every equity investor is implicitly or explicitly taking a view on the inflation outlook." That... or simply taking a view that no matter how this latest inflation vs deflation debate plays out, the Fed and central banks will always be there, ready to bail out the wealth effect that they have so carefully cultivated over the past 9 years with $15 trillion in liquidity injections, and which nobody seriously thinks they will let go to waste just to make a statement that the market can levitate on its own without constant central bank manipulation.


CJgipper Sun, 07/30/2017 - 10:42 Permalink

It's quite simple.  When the majority of your income goes to house, food, car, and insurance, inflation is SKY HIGH.  When the majority of your income goes to services (e.g., lawn service, legal service, construction services, labor, etc.) there's deflation.  People will do real work for peanuts and you can sell the results.   There's a massive split in our economy between those who spend on goods and those who spend on services.  One is inflating while the other is deflating.  It's that simple, and that's why they can't figure it out.

nsurf9 CJgipper Sun, 07/30/2017 - 11:38 Permalink

And wage price inflation is a critical component (if you can believe them) for not raising interest rates that have kept this hot air balloon of a market and government afloat.  And, all the while, the US Government has looked the other way when 20 million migrants come in as illegal undocumented competition who will gladly work for unreported peanut shells that are overwhelming our social other systems that we've paid into our entire live.  This allows the US Government to deprive the savers of a fair return (yet, predatory credit cards find many ways to increase their rates with the help of credit bureaus).  And, the low wage inflation rate allows the Fed to say, with a straight face, while your "house, food, car, and insurance, inflation is SKY HIGH" - nope, no inflation or bubbles here.  And, moreover, the US Government can cover its insane spending and spend even more - to shrink their past abuses - at the expense of victimizing a now disappearing middle-class.

In reply to by CJgipper

brushhog Sun, 07/30/2017 - 11:12 Permalink

Costs for health insurance, and education will continue to climb. The rest is sort a toss up. Some things will crash, others will soar, all depending on the level of government interference and money printing.

Dilluminati Sun, 07/30/2017 - 11:31 Permalink

Inflation is vastly overstated, next contraction or correction you'll wish you had locked in fixed interest for long-term out to 2027 when the baby boomers die.Get ready for some deflation.  It's simple math folks.  Long RV's and short retail.Short humainity, detroit, and the EU. 

willy up the creek Sun, 07/30/2017 - 11:32 Permalink

May I quote Bill Fleckenstein - "In a social democracy with a fiat currency, all roads lead to inflation".Has there ever been a fiat currency that did not eventually go to zero?

Salmo trutta Sun, 07/30/2017 - 11:54 Permalink

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Aggregate monetary purchasing power = M*Vt, volume Xs velocity (money flows).  AD does not precisely equal N-gDp as the Keynesian economists define it, e.g., the Treasury’s General Fund Account.… See my “Surrogates” post:… The "unified theory" is: (1) that the non-banks are the customers of the commercial banks according to Dr. Leland James Pritchard (“Chicago School” - 1933). Thus (2) all demand drafts originating from the NBFIs clear thru the DFIs. (3) “Bank reserves are driven by payments” (bank debits, former G.6 release) according to Dr. Richard G. Anderson, world’s leading guru on reserves. And (4) legal reserves are based on transaction type deposit classifications 30 days prior see: “Quantitative Easing and Money Growth: Potential for Higher Inflation?” according to Dr. Daniel L. Thornton. Scientific evidence "is proof, which serves to either support or counter a scientific theory or hypothesis. Such evidence is expected to be empirical evidence and in accordance with scientific method" - Wikipedia Scientific method is "a method or procedure…consisting in systematic observation, measurement, and experiment, and the formulation, testing, and modification of hypotheses" – Wikipedia See my “The Distributed Lag Effect Of Monetary Flows” (akin to: Yale Professor Irving Fisher’s pioneering calculation):… I haven’t extrapolated this data, so the levels are obviously somewhat off, but the trajectory (based on 100 years of history) is clear.  The “credit impulse” says almost the same thing: Original article, definitions and calculations: Parse: dt; inflaton: dt; inflaton:01/1/2017 ,,,,, 0.1902/1/2017 ,,,,, 0.1603/1/2017 ,,,,, 0.1304/1/2017 ,,,,, 0.1805/1/2017 ,,,,, 0.2306/1/2017 ,,,,, 0.2107/1/2017 ,,,,, 0.2008/1/2017 ,,,,, 0.2409/1/2017 ,,,,, 0.26 oil peaks10/1/2017 ,,,,, 0.2511/1/2017 ,,,,, 0.2312/1/2017 ,,,,, 0.1501/1/2018 ,,,,, 0.2102/1/2018 ,,,,, 0.2203/1/2018 ,,,,, 0.1804/1/2018 ,,,,, 0.1505/1/2018 ,,,,, 0.1606/1/2018 ,,,,, 0.1307/1/2018 ,,,,, 0.1308/1/2018 ,,,,, 0.1009/1/2018 ,,,,, 0.1110/1/2018 ,,,,, 0.1011/1/2018 ,,,,, 0.0912/1/2018 ,,,,, 0.00 - Michel de Nostredame

Pollygotacracker Sun, 07/30/2017 - 12:12 Permalink

I shop, if at all, very carefully. I was at Kroger this morning. A bulb of garlic went from .49 to .69 in one week. A bulb of garlic!! Peaches are $1.79 a pound. It only takes two or three to make one pound. Crazy! Many people have food stamps, so they are sheltered from the prices as the government gives them a hand-out. I never eat out. I can imagine that restaurants are feeling the pinch with the crazy prices. The government lies. We have inflation. I can't think of any prices that are dropping. Can you?

BigCumulusClouds Sun, 07/30/2017 - 13:46 Permalink

According to the Feds own data, it has been expanding, that is inflating, the money supply at a rate of 6-7% per year. They are thus way beyond their 2% target. The fact that the CPI may be less than 2% is meangingless. Just because prices are not increasing as much as the money supply is no excuse to rob granny of her savings to give to CEOs via cheap money stock buybacks. Granny most likely did not cause the productivity increases that made prices increases less than the rate of money supply expansion. And even if she did, productivity improvements are not something that should be punished. But tell that to a government that doesn't give a shit how it raises the money to fund itself.

MrBoompi Sun, 07/30/2017 - 14:33 Permalink

Maybe Goldman's clients don't understand inflation and how it's measured.  20 years ago you could buy filet mignon for $5/lb, but now you can buy ground beef for $5/lb.  Therefore there is no inflation.  

SMD Sun, 07/30/2017 - 14:37 Permalink

The Jewish central banks are printing money and giving it exclusively to their Jewish friends. There is no stimulus outside the Jewish vig so the CPI is holding under 2% despite the vig to Jews of 10%/year. And Trump will continue this with Gary Cohn.