This note was originally published January 25, 2013 at 16:41 in Macro
- After several meetings on the road with clients and prospective clients this week, it became clear to our team that a noteworthy competitor of ours is making noise about a demonstrable pickup in inflationary pressures that will slow inflation-adjusted GDP growth across the globe.
- While we would agree that CPI readings are going to, on balance, trend higher here in 1Q and perhaps through 2Q as well, we completely disagree with the premise and conclusion of the aforementioned view.
- Broadly speaking, we think reported CPI readings are poised to continue their rocky path lower over the next several quarters, fully equipped with a transient bounce(s) to demonstrably lower cycle peaks relative to their 2008 and 2011 highs.
- Our call for reported inflation to broadly continue making a series of lower-highs is backed by our call for the DXY continue making a series of higher-lows while the global commodities basket (via CRB Index) continues to make a series of lower-highs.
At Hedgeye, we have developed a proprietary modeling process that allows us to front-run both consensus estimates of and the actual reported growth and inflation readings of any country, region or economic bloc (such as the world, on a GDP-weighted basis). In the note below, we walk through what this rigorous analytical process is signaling to us right now.
STEP #1: QUANTITATIVE SIGNAL(S)
Unlike many researchers who impose their theses and theories upon the market – usually the “smartest guys in the room” types – our research process remains grounded in uncertainty. We use a proven, three-factor quantitative overlay to consistently guide us to the most appropriate places to “fish”.
Right now, those signals are suggesting the US Dollar Index is poised to continue making a series of higher-lows over the intermediate-to-long term. That view is underpinned by our uber-bullish bias on US housing, our street-leading expectations for US employment growth and our call for a currency crisis in Japan.
We have been vocal about our call for the domestic housing market and the yen in recent weeks/months, as culminated in our 1Q13 Macro Themes of #HousingsHammer and #Quadrill-yen. Our updated thoughts on the domestic labor market can be found in the notes below:
Moving along, we anticipate that the confluence of the domestic factors highlighted above will result in the FX market pulling forward its expectations of the culmination of QE (which, on the margin, would likely be functionally equivalent to a rate hike).
That’s explicitly bullish for America’s currency and bearish for commodities and international inflation hedges – which are broadly priced in and settled in US dollars internationally.
At least for now, domestic interest rates are confirming this view:
STEP #2: GIP MODEL
Now that we know where to look from a quantitative perspective, we turn to our predictive tracking algorithms to guide us to hard numbers on the economic data front. With respect to Bloomberg’s GDP-weighted world CPI YoY index specifically, our algorithm backtests with an r² of 0.76 on the median estimate.
For background, the model is purposefully designed to produce a high, mid and low estimate and we use the respective market-based quantitative signals to guide our expectations to the higher or lower of the two economic data risk ranges.
Applying the same algorithm to a particular country, region or economic bloc’s GDP growth figures allows us to triangulate the associated sequential deltas and monetary/fiscal policy implications on our GIP chart. Currently, the world is entering Quad #2 on this analysis (i.e. Growth Accelerates as Inflation Accelerates).
Taking a broader perspective of what the model is signaling to us, we can rest assured that any near-term pickup in reported inflation across the world (again, generally speaking) will be both transient and to absolute levels that we would consider not threatening to economic growth.
As the chart above highlights, our model has been better than bad at calling for major inflection points and trends in global inflation readings for the past 4-5 years, so we feel comfortable with its summary outputs in the absence of disconfirming evidence.
STEP #3 THE SEARCH FOR CONFIRMING OR DISCONFIRMING EVIDENCE
It would be intellectually lazy to rest our call on the confluence of quantitative signals and the output of our modeling of economic data. Rather, the appropriate exercise – which is what we spend all day doing when not publishing research or engaging with clients – is to constantly vet confirming or disconfirming evidence.
With respect to commodities specifically – which we think holds a slightly leading relationship with reported CPI readings globally (varies by country based on index weights) – we are coming up with some particularly muted YoY gains when you streamline current prices throughout the year, which is in and of itself a generous assumption.
In fact, the current estimate of a JUN ’13 peak of +10% is well off the peak YoY growth rates of we saw in the summer of 2008 (+45.4%) and the summer of 2011 (+37.2%).
Our Global Macro team continues to hold the view that commodities – particularly food and energy price inflation/deflation - have become the largest contributors to the direction and magnitude of global inflation readings in the post-crisis era of muted/nonexistent labor and income growth across the key developed markets. Slack capacity utilization also remains a headwind for the economic growth-driven inflation policymakers have been desperately searching for across much of the developed world.
You can see the obvious aforementioned relationship in the following chart of median YoY CPI readings of the US, Eurozone and China overlaid with our commodity price sample:
Net-net-net, it’s really tough to get to anything more than +3% inflation in the world’s three largest economies on a median basis by mid-summer without some meaningful degree of commodity price inflation from here – which is precisely what we do not expect to happen. If anything, further weakness across key commodity markets should augment our call for lower-highs in global reported inflation readings throughout the year.
Looking to the previous chart, we don't find it at all ironic that the universal view of "price stability" across developed central banks anchors on +2% YoY CPI when considering that the same +2% happens to align with neither inflation nor deflation in international commodity markets. The deep simplicity of chaos theory strikes again...
On the disconfirming evidence side, both Oil and the EUR are outliers here; each looks good quantitatively at the current juncture and both stand completely counter to our call for strength in the DXY and weakness across the commodity complex (energy prices are a key driver) over the intermediate term.
While it’s rather difficult for us to endorse a rock-solid fundamental call on either asset class at the current juncture, we think our non-consensus fundamental thesis regarding the USD and international commodities prices will ultimately prevail. For now, however, both crude oil and the EUR remain the two largest financial market-based risks to this view.
All told, our models, signals and the data all suggest global inflation readings should trend higher in the short-term, but to low absolute levels relative to their prior peaks. As such, the current disinflationary trend across the world economy is very much intact.
Have a wonderful weekend,