In this brief excerpt from our “Healthcare Earnings Recap” call earlier this week, Hedgeye’s Tom Tobin explains why Healthcare earnings trends don’t bode well for the industry’s stocks.
Takeaway: Reported inflation is set to rise materially over the next 3 quarters. This has important implications for investors and policymakers alike.
Earlier this week Keith and I had a dialogue with some über-thoughtful macro investors regarding our outlook for inflation and how the Fed is likely to respond to it. Below is a detailed summary of the key takeaways, which we think are especially pertinent for all investors.
Q: "Do you agree with our belief that inflation is being systematically underreported in order for the Fed to remain hyper-accommodative and make rich people richer? Also, any thoughts on the GS analysis which shows a historically-elevated divergence between reported inflation and inflation expectations?"
A: The GS analysis you cite conspicuously omits commodity prices – energy prices in particular. Our analysis has shown fluctuations in commodity prices have been the primary driver of the marginal rate of change in reported headline inflation (which breakevens are designed to track) for nearly a decade now. As such, the ~15% decline in WTI from its early-JUN peak can explain away much of the -32bps decline in the 5Y breakeven rate since its late-APR peak.
Your assumption that inflation is being systematically underreported is more than likely correct, though it’s difficult to prove. Even the PriceStats aggregate inflation series is not showing much of a spread between its calculus and the official data.
I think what we intuitively feel is the systematic underreporting of big-ticket core services inflation (i.e. housing, healthcare, education, transportation, etc.) relative to core goods inflation, but because prices are sticker and less volatile in the former category, the latter category has an outsized impact on the marginal rate of change in headline CPI.
Source: Bloomberg L.P.
And yes, the Fed is well aware of where the U.S. economy’s proverbial “bread” is buttered (i.e. high-end consumer spending). This is why they aim to protect the stock market at all costs (e.g. in lieu of their policymaking credibility, bank NIMs, the active fund management industry, etc.).
Q: "At the same time we still believe in a crisis/risk premia decompression scenario with the 10Y Treasury yield going to 1%. Are we talking out of both sides of our mouths? Is it possible to believe in both scenarios and how would you reconcile that? Also, do you agree with us that demographics are the primary driver of lower yields across many advanced economies?"
A: There's no question that demographics is the tail wagging the dog here. Slides 4 and 6 of our #DemographicYields presentation cite and IMF study that empirically shows how population ageing is inversely correlated to trend rates of both GDP growth and inflation to a statistically significant degree.
Given these dynamics, I do not think you’re talking out of both sides of your mouth. Specifically, trend rates of GDP growth and inflation have continue on their secular path lower in order for the Fed to remain perpetually accommodative, which we’ve learned is bullish for the SPY until it isn’t (i.e. during recessions).
Q: "Crude oil really has to fall hard in Sept and onward to keep pace with the move last year. Our energy team sees it unlikely that prices will fall to the degree they did last fall/winter – we're thinking the price floor is in the low 40s/high 30s. If that’s the case, reported inflation will rise simply due to the mechanical effect of lapping easy compares. How are you incorporating energy price dynamics into your forecasts?"
A: We’re largely on the same page here. In terms of when we’ll see the impact of higher YoY energy prices on CPI, our models point to t-minus “now” and the effects should intensify markedly over the next 6-8 months. Specifically, the YoY rate of change in crude oil prices linearly trends from -22% in JUN ‘16 to +36% in JAN ’17.
All else being equal, we could see headline CPI more than double from here; the high end of our forecast ranges expect CPI to average +1.2% YoY in Q3, +2.1% in Q4 and +2.7% YoY in Q1.
For reference, the low end of said forecast ranges are +1.2%, +1.4% and +2.0%, respectively.
My gut feeling is that the latter set of numbers is too low, given our quantitative view on the ultimate floor in crude oil – which, at $36/bbl. is within your target range.
Q: "It's amazing that a pickup in reported inflation could have a real effect on monetary policy given we are seeing the lowest nominal GDP growth rate since the 1950s including all other recessionary periods ex GFC. Assuming the preconditions are met and NGDP does not pick up materially, then we will be in recession technically. Thoughts on this?"
A: Regarding how this will play out in recession probability and policy response terms, there are three very important things to keep in mind here:
- The Fed sees all major changes in the rate of headline CPI as “transitory”;
- The Fed’s preferred measure of inflation (i.e. PCE Core Price Index) won’t capture much of the aforementioned base effect dynamics; and
- The Fed’s “price stability” mandate is very much secondary to its “maximum employment” mandate and are likely to let inflation run a little hot if they don’t see a commensurate acceleration in wage growth (Hedgeye's very own Don Kohn – former Vice Chairman of the Fed – confirmed this on his latest call).
RE: #1: The Fed did the exact opposite of what headline inflation implied they should be doing by easing in 2008, easing in 2011 and then tapering and tightening in 2014-15. Last price in the SPY is a more relevant indicator than headline CPI in terms of their propensity to adjust monetary policy.
Source: Bloomberg L.P.
RE: #2: In the face of some fairly material deltas in commodity prices, the PCE Core Price Index has been remarkably stable in the +1.3% to +1.8% range for over three years now. The U.S. government appears to have found a great deal of “stability” in [suspected] price manipulation.
RE: #3: The wild card here is that we just might start to see an acceleration in wage growth over the next 2-3 quarters. That would be consistent with previous cycles that show a consistent decoupling of employment growth and wage growth into the onset of recession.
All told, I don’t know what the catalyst is for nominal GDP to pick up materially this late in the economic cycle – absent a big run-up in energy prices that permeates throughout the manufacturing sector. That said, however, improving inflation dynamics – even if largely a function of receding base effects – is supportive of not necessarily seeing lower-lows for now.
Your point that we’ve never seen nominal GDP this low outside of recession is well-taken. This largely explains the disconnect between all-time highs in the SPY and pervasively negative sentiment among all-types of fundamentally-oriented investors who see the corporate profit cycle for what it is – recessionary with a ton of downside risk if we actually enter a real economic downturn.
Q: "Just to crystallize this, how do you think about CPI impacting Core PCE? You note Core PCE has been remarkably consistent. Should we expect it to stay consistent? Is it too difficult to predict PCE given the Fed’s apparent discretion?"
A: Core PCE is likely to move higher from here, given its historical correlation with headline inflation on both an absolute level and delta basis:
Source: Bloomberg L.P.
Source: Bloomberg L.P.
That said, however, it would be unwise to expect a material jump in the PCE Core Price Index over the next 2-3 quarters. Assuming our most aggressive scenario for upside in headline CPI (i.e. an average of +2.7% YoY in Q1) only gets you to about +1.9% on the PCE Core Price Index, assuming little change to the historical relationship. That’s only +30bps higher than the most recent print and still below the Fed's +2% "price stability" mandate – where it has been for 50 months and counting.
To your question regarding the difficulty of forecasting the PCE Core Price Index, the series is not particulalry volatile, which makes it easier to predict than headline CPI. Specifically:
- Standard error (trailing 5Y): 10bps for PCE Core Price Index vs. 31bps for headline CPI
- Directional hit rate (trailing 10Y): 73% for PCE Core Price Index vs. 70% for headline CPI
- Correlation between the high end of our forecast range and the actual reported data (trailing 10Y): 0.86 for PCE Core Price Index vs. 0.85 for headline CPI
- Correlation between the low end of our forecast range and the actual reported data (trailing 10Y): 0.86 for PCE Core Price Index vs. 0.73 for headline CPI
Q: "It looks like “Quad 3” is going to become more pronounced given sustained weak nominal GDP and rising inflation. What sectors typically do best at “Quad 3” extremes?"
A: The sectors which have historically performed best in #Quad3 are as follows (in descending order):
- Utilities (good in both relative and absolute performance terms)
- REITS (good in relative performance terms; decent on an absolute basis)
- Energy (good in relative performance terms, but not necessarily on an absolute basis)
- Health Care (good in relative performance terms, but not necessarily on an absolute basis)
The sectors which have historically performed worst in #Quad3 are (in ascending order):
- Materials (bad in both absolute and relative performance terms)
- Financials (bad in both absolute and relative performance terms)
- Consumer Discretionary (bad in both absolute and relative performance terms)
We hope you found this discussion helpful to expanding upon your respective investment motifs. As always, feel free to email us with any follow-up questions.
Happy Summer Friday,
If you believe this ends well, you also have to believe the Fed’s next ease will involve buying of corporate bonds and monetization of debt.
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Given the nasty reality of underperforming corporate earnings, Wall Street's earnings estimates for coming quarters look downright ridiculous.
Takeaway: A closer look at global macro market developments.
Editor's Note: Below are complimentary charts highlighting global equity market developments, S&P 500 sector performance, volume on U.S. stock exchanges, rates and bond spreads, key currency crosses, and commodities. It's on the house. For more information on how Hedgeye can help you better understand the markets and economy (and stay ahead of consensus) check out our array of investing products.
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Takeaway: European economic growth data disappoints (again).
Got GDP Slowing? Yes! Inline with our #EuropeSlowing theme, Q2 preliminary GDP slowed across the Eurozone, to 0.3% vs 0.6% in the prior quarter. Specific country results: Germany (0.4% vs 0.7% in the prior quarter); France (0.0% vs 0.7%); and Italy (0.0% vs 0.3%). Our bearish bias on the Eurozone remains intact.
Below is the country-by-country breakdown.
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Editor's Note: The snippet above is from a note written by the Hedgeye Macro team and sent to subscribers this morning. Click here to learn more.
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