This note was originally published
at 8am on June 27, 2014 for Hedgeye subscribers.
“Keep it simple. Tell the truth. People can smell the truth.”
-Steve Wynn, Chairman & CEO of Wynn Resorts
I ran over a skunk on the way to work this morning. Accidentally, of course. But regardless it still did not smell very good. That’s the thing with skunks; they sort of surprise you with their malodorous nature.
For those of you that don’t know him, Pepé Le Pew is a French cartoon character that was first introduced in 1945. Pepé is a French skunk who strolls around Paris looking for love. Unfortunately, he has two big things going against him. First of all, he’s a skunk, so he smells. Second, he’s a tad bit aggressive and reluctant to take no for an answer.
Now if that sounds a little bit like the U.S. equity market right now, it probably should. As we’ve been flagging here at Hedgeye (somewhat “aggressively” at times) volatility in the U.S. is at a level that is signaling that all is well in the world. Between you and me, that kind of stinks.
I read an interesting article in the Wall Street Journal (Media 1.0) yesterday discussing the volatility and the VIX. It quoted Robert E. Whaley, a professor at Vanderbilt University’s business school, who is credited with developing the VIX for the Chicago Board Options Exchange in 1993. Here’s what he had to say about the VIX being literally at an all-time low:
“I wouldn’t be worried about it.”
Indeed. And if an aggressive skunk happens to be pestering you in Paris, no need to worry about that either.
Back to the Global Macro Grind…
While Professor Whaley, aka the “Father of the VIX,” isn’t worried, that’s not necessarily a reason for us not to be worried, despite the fact that this morning, the global equity markets are decidedly not worried. China is down -0.11%, Europe is up small, and the U.S. equity futures are down small. Frankly, the only excitement overnight is that the Nikkei in Japan is down just over a -1%.
So, what gives in Japan? Are you sitting down? Inflation! Yup, Japan, the home of generational deflation, is actually experiencing inflation. In fact, CPI in Japan accelerated +3.4% year-over-year. This was the highest pace in 32-years for Japanese inflation. The Japanese bureaucrats wanted inflation. Now they've got it.
The fact of the matter is that the Japanese will tell you that once you factor out the sales tax impact, there was actually a slight drop in CPI. That said, even the Japanese labor market is showing inflationary signs as the jobs-to-applicants hit a 22-year high at 1.09. In theory, a tight labor market should lead to increased wages and eventually more purchasing power for the consumer. Translation? Organic inflation.
Ultimately, the challenge with either inflation driven by a tight economy or, conversely, driven by overly dovish monetary policy is that inflation slows growth. In the U.S., the counter argument to our view that inflation will slow grow is that even though the CRB Commodities index is up double digits on the year, commodities are a relatively small portion of the consumer’s annual spend. In part this is true, although much less so in emerging economies.
In fact, the WSJ this morning referenced the “fragile five” economies of Turkey, India, Indonesia, South Africa, and Brazil as economies that are particularly subject to the negative impact of commodity inflation. The challenge with trying to fight inflation for the central banks in these countries is that growth is not at abnormal levels, so any rate hikes would slow it even more. Yes, indeed, monetary inflation stinks!
Speaking of inflation, the Fed’s balance sheet continues inflating at an almost staggering rate:
- Holdings of US Treasury securities were $2.4T on 25-Jun, +$5.5B w/w and +$469B y/y;
- Holdings of mortgage-backed securities were $1.7T on 25-Jun, ($4.5B) w/w and +$456B y/y; and
- Holdings of federal agency debt securities were $43.7B on 25-Jun, unch. w/w and ($27B) y/y.
In total, the Fed’s balance sheet is at an astounding $4.4 trillion. Certainly, tapering is slowing the growth of these assets on the Fed’s balance sheet, but what, exactly, happens when the Fed starts to sell these assets? At over 25% of GDP, it is worth sniffing around this question.
As it relates to GDP, my colleague Darius Dale wrote a very thoughtful note earlier this week that again emphasized that the Fed is “always wrong on growth.” Specifically, since 2012 the Fed has been wrong on growth by an average of 113 basis points. No small potatoes. The takeaway from the Fed (and virtually all of Wall Street) being wrong on growth is that Fed may actually surprise us with its dovish policy. As Darius writes:
“As it relates to actual macroeconomic analysis, the doves are definitely starting to cry at the Fed. In a fantastic article today, Reuters journalist Howard Schneider walks though the current debate being held amongst members of the Federal Reserve and its regional banks. Specifically, the Yellen-led institution is openly debating pushing out their forecasts for labor market tightness, citing both new and old analyses in the process.
The key takeaway is that the FOMC is setting up to surprise both buy-side and sell-side consensus to the downside with respect to tightening monetary policy. A less-tight labor market in the interim means the Fed can remain “accommodative” for longer – which is exactly what is being priced into the interest rate markets. Expectations for a 2015 Fed Funds Rate hike are down -27% on average, across the curve, from when we correctly introduced this bold prediction back in JAN.”
Slowing U.S. growth… accelerating inflation… low volatility… Yup, it might make sense to your nose right now.
Our immediate-term Global Macro Risk Ranges are now:
UST 10yr Yield 2.46-2.60% (bearish)
SPX 1934-1971 (bullish)
VIX 10.61-12.94 (neutral)
USD 80.01-80.45 (bearish)
Brent Oil 112.38-115.49 (bullish)
Gold 1289-1345 (bullish)
Keep Your Head Up,
Daryl G. Jones
Director of Research