Nominal growth and inflation are absolutely scorching in the United States relative to the preceding post-GFC period. As it turns out, heavy fallout from the so-called trade war has thus far been limited to Whirlpool and a select group of impacted microeconomic players. US macroeconomic data have not reflected noticeable damage other than some reversible forward-looking business confidence setbacks. The insatiable American consumer is still dishing out new spending as fast (or faster) than it arrives in the paycheck.
While pre-tariff front-running of inventory can explain a portion of the strong US Q2 aggregate economic data set, there is no reason to believe an imminent slowdown threatens to derail growth in Q3 so long as the Fed can credibly pretend the inflation containment problem at our doorstep is transitory. The international growth engine accelerator or decelerator known as China is back to moderate acceleration mode in both fiscal and monetary policy. The ECB is still creating 30 billion euros per month from thin air to purchase assets yielding negative two percent or worse on a real basis. The BOJ is still willing to make “unlimited purchases” to keep the 10-year JGB yield at 0.1%. As widely noted in the press, an ever so slight mild paring back of exceptional monetary looseness is on the cards for both the ECB and BOJ. However, anything being discussed publicly is too little too late in terms of material tightening. Don’t hold your breath for a historically significant level of monetary tightening anytime soon.
Overshoot Thesis for the Win
Assist FX was one of the first to publicly forecast a coordinated monetary policy driven inflation overshoot while most visible economists were still panicking about a phony deflation “crisis” in 2016. Our thesis was driven by fiscal math gravity facing government budgets and game theory analysis for how central planners would react to it. The global financial system cannot endure another historic deflationary crash without being exposed as quasi-insolvent. Additionally, we believe the rise of populist political forces in the western world is here to stay and highly inflationary. Globalism is deflationary, populism is inflationary. Global macro portfolios I manage as CIO or privately will continue to reflect this.
The Q2 GDP deflator indicated a pace of price inflation running at 3.2%. Keep in mind this same number was broadly expected by economists to register 2.3% after the previous 2.0% Q1 reading. It was a thundering upside inflation beat. The question from here is at what level long end DM sovereign bonds begin to do the tightening rather than central banks? There aren’t many signs of DM bond vigilantes coming out of the woodworks but that may change by 2019. When most headlines were fretting over yield curve inversion hysteria, Assist FX released several notes expecting a moderate level of curve steeping rather than flattening. Then the curve steepened.
Short Bonds, Long Equities (Non-Interest Rate Sensitive)
We still like bond shorts and equity longs for the time being. What would change our prevailing upside inflation surprise thesis would be effectively a “behind the curve” acknowledgment on the part of the FOMC by 4Q2018 and a renewed pledge to quicken the pace of monetary tightening regardless of the financial market ramifications to defend the existing inflation target and prevent more extreme imbalances. We do not see this happening once the opportunity presents itself and instead continue to see a host of ever-evolving, goalpost moving, reasons not to swing the hammer against the fragile glass locomotive of financial assets chugging up the mountain–even if CPI hits 3.5%, 4%, and many underlying measures indicate even higher numbers. They can always point to the lower, ever-trusty, preferred core PCE and a folksy list of reasons why a reasonable mind could exclude the higher subcomponents and highlight the lower subcomponents as what really matters.
We see the Fed ultimately defending a de facto quiet inflation target more in the range of 4-5% for CPI. If we are even partially correct, that means financial assets have more room to run than many expect before genuine fears of the metaphorical asset hammer should set in. We’re already at 2.9-3.0% annual CPI and merely the entire financial establishment acts like we are at 0.9% by the way most verbally discuss the topic in terms of tone. Old habits are difficult to break and the lowflation discussion in the investment world was prevalent for a decade.
Hot Stove – C’mon Just Touch It Quickly, It Will Be Fine
Continually rising assets bring in much-needed tax revenues for long enough to kick the can until a different policy-making regime can handle the unsustainability problem under a different set of political mandates. For now, the public psyche (and President Trump) believes that it wants to “let the economy run hot” and the inflation that comes with it is no big deal since the Keynesian cabal has successfully sold them on inflationary snake oil equating to “growth.” History proves otherwise and history indicates the same lessons are learned over and over again in cycles that skip a generation (or two).
A prudent trader or investor who believes in fiscal math and senses that the public is ready to touch the hot stove again with inflation will prepare accordingly with an inflation friendly portfolio. The market participant consensus seems to be stuck in the mentality of the 35-year bond market rally era where asset bubbles always correct with deflationary asset crashes. While that may be true, we see an unappreciated chance of entering a new bond bear market era where fiscal math and populist political winds provide the excuse to let the inflation genie out of the bottle again.