THE POINT October 18, 2016 Bill Kennedy, CFA Chief Investment Officer Follow on Twitter: @FP_CIO What’s the Point? Inflation is gaining momentum, but economic growth is slowing Stagflation risks exist, but too much excess slack exists in the economy. A near- term inflation scare will likely be transitory. We expect 2.5% inflation by 1Q17 thanks to China and base effects in oil 10-year bond yields are expected to trade between 1.75% - 2.25% If correct about our call for a U.S. recession in 2017, then it is dangerous to be too bullish on stocks and equally dangerous to be too bearish on bonds Regime change Fieldpoint Private’s investment philosophy is founded on the principal that the best means to compounding wealth – whether over a market cycle or over generations – is to mitigate episodes of large market drawdowns that risk permanent loss of capital. By extension, we consider risk management a critical source of alpha. Our macro research is geared towards understanding the prevailing economic regime and what it means for clients’ asset returns. Large market drawdowns tend to be a function of recessions, inflation/deflation, or both, and over long time horizons the momentum for each may rise or fall many times. Identifying the prevailing economic regime helps investors gauge market risks and how asset classes may respond. For example, stocks and bonds are regime dependent in that they respond to the momentum in real GDP and inflation, while commodities respond to inflation expectations. THE POINT There are four general economic regimes in our macro framework (see table below). Our analysis shows that no single asset class dominates under all economic conditions, but in periods of accelerating economic momentum stocks tend to outperform rates and credit. The opposite is true when economic momentum decelerates. Economic momentum is decelerating. Regime I: Regime II: Accelerating Growth & Inflation Accelerating Growth, Decelerating Inflation # of quarters: 23 # of quarters: 54 Excess Return Rank Excess Return Rank Dollar -3.7% 5 Dollar 2.0% 4 Commodities 9.4% 1 Commodities 1.5% 5 Rates 2.7% 4 Rates 4.9% 3 Credit 3.9% 3 Credit 6.8% 2 Stocks 7.7% 2 Stocks 11.4% 1 Avg return 4.0% Avg return 5.3% Regime III: Regime IV: Decelerating Growth, Accelerating Inflation Decelerating Growth & Inflation # of quarters: 49 # of quarters: 46 Excess Return Rank Excess Return Rank Dollar -0.3% 5 Dollar 0.9% 4 Commodities 14.2% 1 Commodities -0.4% 5 Rates 5.3% 2 Rates 8.8% 2 Credit 4.0% 3 Credit 10.2% 1 Stocks 2.5% 4 Stocks 8.3% 3 Avg return 5.1% Avg return 5.5% Source: Fieldpoint Private. For illustration purposes only. Analysis based on 172 quarters of GDP and CPI (core) data and real returns by asset class. Excess returns shown based on median rolling price returns from Q4 1974 to Q3 2016. Asset class behavior can vary dramatically when economic regimes shift. For example, in 1987 there was a sudden shift in inflation expectations that moved the market from Regime II towards Regime I. Policy response and market uncertainty raised asset volatility, which set the stage for the October 19th “Black Monday,” when the stock market crashed nearly 23%. The U.S. has been in Regime III for over a year. Since 3Q15, GDP momentum has decelerated while inflation has slowly accelerated. This is confirmed by asset class performance. The dollar is generally weaker, bonds have outperformed stocks and stocks have outperformed cash. Regime III is typically the worst environment for stock returns. We expect regime III to persist through the first quarter of 2017. 2016 U.S. real GDP will likely be around 1.7%, followed by a disappointing 2.0% growth rate in 2017. While consumer spending and housing have been relatively robust, housing is starting to lose momentum and a weak manufacturing sector and negative industrial production are dragging economic momentum lower. Page | 2 THE POINT INFLATION SCARE “Consumer price inflation remains below the Fed’s stated objective of 2 percent. The notion that inflation can be too low may sound odd, but over time low inflation means that wages as well as prices will rise by less, and very low inflation can impair the functioning of the economy – for example, by making it more difficult for households and firms to pay off their debts.” – Janet Yellen, The Outlook for the Economy, May 22, 2015 Source: Bloomberg, Fieldpoint Private Source: Bloomberg, Fieldpoint Private China and crude oil are driving inflation expectations higher. China’s inflation picked up in September, with prices rising more than expected for both consumers (CPI) and producers (PPI). CPI rose 1.9% versus September of last year. Producer price deflation had slowed in recent months and September was the first increase in five years, as commodity prices have come off their lows. Oil recently surpassed $51 and the futures market implies a price of $54 next year. Assuming current prices hold into early 2017, the year-over-year increase next January will be ~50%. Rising inflation expectations are evidenced by several market measures of inflation. Our starting point is the Canadian dollar (CAD), which is correlated to changes in the price of oil. The chart (above, right) shows the Loonie and inflation swap rate move in tandem. Next, we look at U.S. breakevens. After bottoming in 2015, 5y and 10y breakevens rallied this spring before taking a pause over the summer. This period coincided with surprisingly little action from monetary authorities. Since September, breakevens are rising again. A sustained break-out above current levels sets up a move to the next major resistance levels of around 2.0%. Achieving that will largely be a function of the price of crude oil. Source: Bloomberg, Fieldpoint Private Page | 3 THE POINT The last part of the curve to react to inflation will be Eurodollars. Eurodollars are foreign dollar deposits outside the U.S. banking system, in European, middle-eastern and Asian banks. When the Fed eases/tightens, traders bid up/down Eurodollars. If inflation expectations rise, the Eurodollar market sells off. If the FOMC actually moves to tighten this December, Eurodollars will sell off even more. The Eurodollar futures curve is a useful tool to track the gyrations of policy expectations. A break above the trend line, similar to that seen by the 5yr breakeven rate, would signal more persistent inflation and potential for more monetary tightening. Source: Bloomberg, Fieldpoint Private Our proprietary inflation model (using 5y breakevens) points to 2.5% inflation by March of next year – well above the Fed’s 2.0% inflation target. Our expectations for higher inflation and decelerating GDP momentum in early 2017 support our view that the U.S economy will remain in Regime III for the foreseeable future. One shifting element worth watching is the strength in the U.S. dollar. There is no regime that combines a stronger dollar and rising inflation momentum. These two conditions are incompatible since a strong dollar is Source: Bloomberg, Fieldpoint Private disinflationary. We expect the dollar to appreciate another 5% from current levels, which suggests that any inflation-scare in early 2017 may be short-lived. Page | 4 THE POINT IS THE U.S. FOLLOWING THE U.K. INTO STAGFLATION? Left unchecked, negative economic momentum and rising inflation could lead to 1970s-style “stagflation.” This is the worst possible outcome. Stagflation is a toxic blend of substandard GDP growth and persistently rising inflation that erodes economic purchasing power, destroys investment values, and depletes real investment returns over time. I can think of several reasons why a 1970s-style stagflation scenario won’t materialize: There is ample economic slack, with manufacturing capacity utilization at only 75%. There is ample employment slack, with the ratio of employment-to-population below 60%. Productivity remains low. Stagflation requires persistent inflation through wage growth. While wages are rising, the number of hours worked is falling. Rents, a major contributor to core inflation, are falling. We place the probability of a recession in 2017 at slightly above 50%, supported by (a) rapid decline in corporate cash flows, and (b) our expectation the Fed will raise interest rates 25 basis points at the December 14 meeting. Tighter monetary policy will choke what little economic growth exists. Stagflation is a shift to the left in the aggregate supply curve. A recession is a shift to the left in the aggregate demand curve. In theory, a recession offsets the supply shock that causes stagflation and inflation pressures are neutralized. YELLEN’S LAST STAND According to Jim Bianco of Bianco Research, “The minute there’s a whiff of inflation, even the slightest whiff, the implication will be that all those bonds are alive, that central banks could start to sell bonds to tighten monetary policy.” At their December 14th meeting, the Fed will be faced with rising inflation juxtaposed with slowing economic growth. How does a bi-polar Fed square rising inflation, mixed U.S. economic data and the prospect that U.S. employment has peaked? If Stanley Fischer gets his way and we see a December hike, we could easily see the curve flatten as the long end’s inflation concerns are doused. It’s worth reminding ourselves of the Vice Chair’s experience as the governor of the central bank of Israel, where a bout of late-cycle inflation in 2011 forced him to hike aggressively, which he now admits killed the economic recovery. If the Fed is to meet its commitment to contain inflation, then they must act. If the Fed wants to hold onto what little credibility it has left, then it must act.