Orlando's Outlook: Tuesday with Charlie


Bottom Line Just as we were starting to notice that inflationary pressures were beginning to perk up again inside the U.S economy, we attended the Economic Club of New York’s breakfast meeting this past Tuesday with Dr. Charles Plosser, president of the Federal Reserve Bank of Philadelphia and a voting member of the Federal Open Market Committee (FOMC). A well-known inflation hawk, Dr. Plosser believes economic growth and inflation are rising faster and the unemployment rate is falling more quickly than most members of the Federal Reserve expect. Consequently, given the admitted imprecision and uncertainty of economic forecasting, he believes that the Fed may begin to play catch up sooner than the market currently expects, perhaps lifting the fed funds rate earlier and at a somewhat sharper trajectory. If true, this realization among both stock and bond investors may result in some near-term instability in the financial markets. But Dr. Plosser’s forecast of more robust inflation, employment and economic growth will ultimately drive more powerful end-market demand for goods and services, generating stronger revenues and profits. In combination with rising Treasury yields, disintermediation from bonds into stocks will likely widen price/earnings ratios and push equity prices higher.  

Inflation starting to percolate After the brutal winter, inflation trends have begun to rise across the board in recent months. That is a development much-welcomed by the Federal Reserve, which has been particularly concerned about deflation.

  • Producer Price Index (PPI) On a year-over-year basis, core wholesale inflation (which strips out volatile food and energy prices) troughed at a very well-behaved 1.1% in February. But over the past three months, core PPI levels have risen to 1.4% in March, 1.9% in April and most recently to 2.0% in May.
  • Consumer Price Index (CPI) Also on a year-over-year basis, core retail inflation troughed at 1.6% in February, rising to 1.7% in March, 1.8% in April and 2.0% in May.
  • Personal Consumption Expenditure (PCE) On a year-over-year basis, the core PCE index—the Federal Reserve’s preferred measure of inflation—also bottomed at a very benign 1.1% in February, which was near the low end of the Fed’s 1.0% to 2.0% target range and well below its recently revised 2.0% inflation trigger to reverse its current Zero Interest-Rate Policy (ZIRP). But more recently, core PCE levels also have risen to 1.2% in March and 1.4% in April, and we learned this morning that May’s reading topped out at 1.5%. The Fed expects CPI to be roughly 0.5% higher than PCE.

 Is commodity volatility impacting inflation? 

  • AGs on a roller coaster Agricultural commodity prices surged over the first four months of 2014 due to the bad winter weather and geopolitical issues. Corn soared by 20%, from $4.35 per bushel in January to $5.15 in May, before dropping by 15% over the past two months back to $4.35 because of favorable weather conditions during planting and expectations for a very good growing season. Similarly, wheat rallied by 33%, from $5.65 to $7.50, before plunging by 23% back to $5.80. Lastly, soy beans rose by 17%, from $10.80 per bushel to $12.80, before more recently slipping by 6% back to $12.00. While this roller coaster increased food inflation in the first part of the year, those pressures are clearly starting to abate now, although with a lag.
  • Crude oil prices soar Heightened geopolitical risks, particularly in Russia and Iraq, have sparked West Texas Intermediate (WTI) prices to soar by 20% thus far this year, from $90 per 42-gallon barrel of oil in January to $107 currently. Investors typically worry that instability in oil-producing nations in the Middle East, which yield more than a third of the world's oil, could spike crude oil prices back to the temporary $147 peak we last saw in 2008, which would clearly have a deleterious impact on U.S. and global economic growth. However, we don’t believe that such a scenario is in the cards this cycle, due to rising U.S. oil production—chiefly driven by shale-oil fracking—and greater energy efficiencies. But higher gasoline and home heating-oil prices will clearly serve as a quasi-tax on businesses and consumers, driving inflation higher, crowding out other discretionary consumption and slowing economic growth.

Why are bond yields so low? If inflationary pressures are perking up, why are the bond vigilantes keeping benchmark 10-year Treasury yields so extraordinarily low? Four possible explanations for this flight-to-quality-and-safety rally into bonds: 

  • Macroeconomic concerns After the brutal, weather-impaired first-quarter Gross Domestic Product (GDP) decline of 2.9%—the single-worst quarter since the Great Recession ended in June 2009—we and many others are projecting a strong second-quarter GDP bounce, which we estimate at 4.0%. But the question remains as to whether or not this bounce is sustainable into this year’s second half. We believe that it is, based upon constructive trends in employment, consumer spending, manufacturing, and auto and housing sales. 
  • Geopolitical risks Where to begin?
    • Middle East: Ongoing Iraqi and Syrian civil wars, Iranian nuclear discussions and the breakdown of the Israeli/Palestinian peace talks.
    • Russia invasion into Ukraine.
    • Concerns about an emerging-market hard landing, particularly in China and Brazil.
    • The pace of Japanese GDP growth after government officials raised their Value-Added Tax (VAT) on April 1, from 5% to 8%. 
  • Supply and demand factors
    • Less Treasury issuance due to the smaller federal budget deficit this year.
    • Though tapering, the Fed’s accommodative monetary policy is still purchasing $20 billion in Treasuries each month and the central bank holds a $4 trillion total balance sheet.
    • Chinese demand for Treasuries to reduce the value of their currency and boost their exports to lift GDP. 
  • U.S. Treasury yields at 2.50% are very attractive compared with other lower-yielding foreign bonds. For example:
    • Japanese government bonds are yielding 0.56%.
    • German government bonds are yielding 1.24%.
    • French government bonds are yielding 1.68%.
    • Swiss government bonds are yielding 0.64%. 

 Back to the Future: Is the past prologue for Treasuries and stocks? 

  • Benchmark 10-year Treasury yields rose from 1.6% in May 2013 to 3.0% in September 2013, as GDP growth began to firm and as Fed Chairman Ben Bernanke began to discuss the eventual tapering of Quantitative Easing (QE).
  • Treasury yields plunged from 3.03% at the beginning of 2014 to 2.40% at the end of May, due to the aforementioned flight-to-safety-and-quality rally.
  • Our fixed-income colleagues believe that yields on the benchmark 10-year Treasury have already begun to rise from their 2.40% trough less than a month ago to 3.50% by year-end 2014, as GDP growth rebounds in this year’s second half, inflation continues to grind higher and the Fed completes its QE taper and begins to discuss the eventual increase in fed funds rates (starting perhaps by this time next year).
  • Once stocks recovered from their initial shock last spring—when the Fed first began to discuss unwinding its extraordinary monetary policies—they enjoyed a nice second-half rally, a prospect we consider likely this year, too. 

The equity market will eventually come to realize that the Fed’s data-dependent decision to end QE and raise interest rates must mean that the U.S. economy is finally on firmer footing. So while stocks may suffer a short-term hiccup this summer, we would use that healthy correction to buy shares on weakness, positioning for a strong second-half rally to our full-year S&P 500 target of 2,100.

Research support provided by Federated summer intern Grace Chmiel.