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'Is 3 the new 4?'

As inflation-rate worries rattle markets, history suggest the fears may be overdone.

Big road trip this week (with possibly one of the greatest sales consultants we have ever had) through the Carolinas, with stops in Pinehurst, Raleigh, Greensboro, Winston-Salem, Charlotte, Columbia and Greenville. Most advisors wanted to discuss inflation and volatility. At an annual forum of trust advisors in Pinehurst a gentleman said the pullbacks are all computer-based, suggesting a possible conspiracy, perhaps to disrupt the midterm elections. (I spend no time thinking about conspiracies.) A group in Raleigh knows wage inflation is real—“If you can’t go into your boss’s office and demand a raise, no inflationary pressure. But you can now.” (Interesting … I’ll be visiting with my boss this week!) Advisors in Greensboro are concerned about the housing market, where a move to a 6% mortgage rate (rates are in the 4s now) might shut down the market. But the most notable question asked of me this week was, “Is 3 the new 4?” Historically, 4% wage inflation is what would get the Fed to accelerate tightening. And 4% inflation is when the market would start to punish P/E multiples. Have rates been so low for so long, and volatility so low for so long, that the Fed will react at 3%? While this week’s report on PCE inflation put the year-over-year (y/y) core rate at a very modest 1.5%, Fed Chair Powell’s debut testimony before Congress equivocated. While he pretty much stuck to the Yellen script, the markets homed in on his statement that “some of the headwinds the U.S. economy faced in previous years have turned into tailwinds," causing fed fund futures to jump and price in four rate hikes this year.

While inflation risks are greater today than a year ago, an historical review of the data suggests a glacial, rather than abrupt change. One reason: the cyclical components of inflation, which amount to about 40% of consumption, aren’t prone to violent upside surprises. They have been remarkably steady over the past five years, contributing some 50 basis points to the core number, an outcome consistent with cyclical inflation’s behavior in prior recoveries. On the other hand, acyclical categories such as drugs, telecom and financial services are more volatile. They plunged last year. Lapping this weakness might cause a ripple in coming months, but it should carry less weight when assessing the underlying inflationary trend. Then there’s technological disruption, a key source of deflation that’s likely here to stay. Empirical Research identified 40 “disrupted” categories whose price trend is tracking well below the inflation’s core rate. It is likely that this restraining force will persist as Amazon, Google and others attack bigger categories to sustain their exceptional growth. As for fears of “imported’’ inflation, imports represent only 13% of consumption and carry an inflation weight of just 20 basis points—not much in the total scheme. True, dollar weakness creates a risk, but the stickiness of pricing means it will take time to appear. Besides, the bulk of U.S. imports are denominated in dollars or currency linked to dollars, lessening the potential for imported inflation.

Inflation does not occur in a vacuum. When stronger growth drives inflation higher, the historical evidence is unambiguous. Higher inflation has been clearly associated with higher margins and strong earnings growth. As for higher yields, the impact on equities depends on whether they reflect higher inflation, a negative, or higher real rates, a positive until they exceed 4%—a level seen only once during the Volcker disinflation era. Outside the Great Inflation of 1968-1995, core PCE inflation has remained in a remarkably narrow band of 1-2.3% the last 23 years. Deutsche Bank says it should stay there as long as inflation expectations remain range-bound as they have since 1996—a period encompassing three business cycles during which unemployment fluctuated between 3.8% and 10%; the dollar rose and fell by 40% more than once; and oil prices increased seven-fold and almost completely reversed. This stability of inflation across large business, dollar and oil cycles reflects the stability of inflation expectations, the sole driver of inflation over the long run. Inflation expectations during this period remained in a tight 50 basis-point range, one exception being the dollar and oil shocks of 2014-2015, when inflation expectations plunged. This glacial evolution of inflation and inflation expectations implies that a sustained 1 percentage-point increase in GDP to 3%, as Deutsche is forecasting, may cause core inflation to peak around 2.2% in 2020. Now, while all this may be true, the market appears determined to retest its recent lows. Advisors in Charlotte welcomed it. “I was hoping for a cleansing where you just threw up!” This time coming from trade war concerns? Might be an interesting change of subject.


Where are we in the economic cycle? February’s manufacturing ISM unexpectedly rose to its highest level since May 2004, topping 60—rare for this stage of an expansion. Ned Davis Research said there have only been four such late-cycle occurrences in the past: 1952, 1965, 1978, and 1987. All were followed by many months of continued economic expansion, particularly when accompanied by large fiscal stimulus, as is the case today. Globally, the Markit PMI held close to a 7-year high, suggesting the world economy is enjoying its best start to the year since 2011. And four of six regional manufacturing PMIs improved, with all six well into expansion territory.

Consumers remain very confident Michigan consumer sentiment hit its second-highest level since 2004, and Conference Board consumer confidence jumped to its highest level since November 2000, reflecting strength in both household perceptions of present conditions and the future. The labor differential—the difference between the percent of respondents saying jobs are plentiful and those saying jobs are hard to get—hit a 16-year high. The index is consistent with above-trend expansion.

Here come the tax cuts Disposable personal income jumped 0.9% in January as the tax bill slashed current taxes by $115.5 billion annualized. It was the biggest increase in disposable income since December 2012, when a scheduled tax increase accelerated the payments of dividends and bonuses ahead of the change. Income also got a lift from an estimated $30 billion in one-time bonuses that businesses paid to their employees.


Where are we in the economic cycle? Contrary to the robust manufacturing and confidence readings (above), several reports suggested moderating activity. February sales of cars and light trucks fell a second straight month to a 17.1 million annualized rate, well off last October’s 18.6 million cycle high. January durable goods orders declined the most in six months, with core orders (ex-transportation) slipping for the first time since last June. January construction spending was flat vs. expectations for an increase. And January’s trade gap widened for a fifth straight month to its highest level since July 2008 and its second-highest level on record.

If we’re ever going to get inflation, this would be the year Like existing sales last week, new and pending home sales fell unexpectedly in January, with a lack of adequate inventory the primary culprit for the pending sales decline. Some blamed the new tax law for lower new home sales, citing a 33% plunge in the Northeast where the $10,000 SALT cap hits the hardest. With shortages driving up prices—the monthly Case-Shiller gauge continued its uninterrupted upward streak dating to March 2012 and the FHFA index rose at annualized 6.5% pace—and mortgages rates on the rise, the National Association of Realtors projects sales for the year will be flat.

If we’re ever going to get inflation, this would be the year Revised real Q4 GDP growth came in a tick lower as expected but also reflected increasing price pressures, with the PCE Price Index rising at a 2.7% annual rate, the most since Q2 2011. The ISM manufacturing price index hit a 7-year high, while half of Chicago PMI respondents said they expect input prices to be challenging over the next 12 months. Adding to cost pressure is a tightening labor market—the latest weekly jobless claims hit a 49-year low. January core PCE also rose at nearly its fastest pace of this cycle, although at 1.5%, the y/y rate remained modest and well below the Fed target.

What else

A stable Trump? He is stable as far as polling goes, with unprecedentedly consistent approval ratings that give him the highest floor but lowest ceiling. The average spread between Election Day and 1st-term midterm approval ratings dating to Reagan is 25.4. Trump’s is nine. Could be midterm trouble as his most recent Gallup approval rating of 38% falls between Truman in 1946 and Clinton in 1994, when the Democratic Party lost 55 and 54 House seats, respectively. The Democrats need a net 24 seats to recapture the majority in November’s midterms.

Trump tops Dubya and Obama Per Pew Research, Trump finished his first year with more substantive legislation than either of his predecessors, George W. Bush or Barack Obama, including the biggest rewrite of the tax code in 30 years. As a sequel to the $1.5 trillion in tax cuts, he signed a $500 billion stimulus/sequester/debt ceiling bill. He also was busy deregulating—from 2016 to 2017, there was an 82% plunge (95 to 17) in so-called “economically significant regulations,” defined as having an impact of over $100 million. This represents the lowest yearly total since 1982 and 60% decrease in the 32-year average of 42 going back to Reagan’s first full year.

Millennials, pets and chalupas Pittsburgh-based Campos Research says 44% of millennials view pets as “practice children,” are staying home at night to be with them and are buying homes not for children or marriage but for their pets. High on the list of their must-haves in a house? A fenced-in yard. As for food, Ad Age says Taco Bell has surpassed Burger King to become the fourth-largest restaurant brand in large part because of a $1 menu that appeals to budget-strapped millennials. 

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Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices.

Gross Domestic Product (GDP) is a broad measure of the economy that measures the retail value of goods and services produced in a country.

Personal Consumption Expenditure (PCE) Index: A measure of inflation at the consumer level.

Price-earnings multiples (P/E) reflect the ratio of stock prices to per-share common earnings. The lower the number, the lower the price of stocks relative to earnings.

The Chicago Fed Midwest Manufacturing Index is a monthly estimate of manufacturing output in the Seventh Federal Reserve District states of lllinois, Indiana, Iowa, Michigan, and Wisconsin

The Federal Housing Finance Agency's (FHFA) seasonally adjusted purchase-only price index is a gauge of prices of existing homes.

The Institute of Supply Management (ISM) manufacturing index is a composite, forward-looking derived from a monthly survey of U.S. businesses.

The S&P/Case-Shiller Home Price Indices measure track changes in the value of the residential real estate market in major metropolitan regions.

The University of Michigan Consumer Sentiment Index is a measure of consumer confidence based on a monthly telephone survey by the University of Michigan that gathers information on consumer expectations regarding the overall economy.

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