Is deflation still a threat? Probably not, according to Barclays. Core CPI was flat, but prices for nondurables for producers are rising. Industrial production and retail sales data for October support GDP growth through year-end. Internet sales, especially, are up. And TIPS were auctioned to the market with a negative yield for the first time in the thirteen year history of the TIPS market, indicating fears of inflation.
Mark Luschini, Chief Investment Strategist, Janney Montgomery
Under most circumstances, TIPS issued in the marketplace will be selling with a yield at some marginal discount to the yield on a straight Treasury. For instance, if a 10-year Treasury bond were to yield 3.0%, it might be expected that the 10-year TIPS would yield 2.0% or so with the difference of 1.0% be¬ing the expected adjustment to come in the form of an increase in principal caused by inflation. If inflation, under this scenario, were to run at less than 1.0%, the TIPS holder would have been better served to own the straight Treasury yielding 3.0%. On the other hand, if inflation runs greater than 1.0%, the TIPS holder would fare better.
Recently, TIPS have seen their prices move in a fashion that seems a bit out of character given prevailing conditions. Several months ago, 10-year TIPS offered a yield that was 1.5% below that of the straight 10-year Treasury bond, implying the market’s expectation that inflation would be running at about 1.5% annually over the life of the security. However, in the last several weeks, that has changed. With talk about the Federal Reserve’s initiative to add further stimulus to the economy in the form of “quantita¬tive easing,” dubbed QE2, investors’ expectations have shifted. The 10-year TIPS are now priced with an inflation expectation, or “breakeven rate” which is the delta between the straight Treasury and its TIPS equivalent, of 2.2%. Perhaps even more interesting is what occurred in the issuance of a batch of 5-year TIPS at the end of last month. The TIPS were auctioned to the market with a negative yield for the first time in the thirteen year history of the TIPS market! The 5-year TIPS were issued with a yield of –0.5%. With the straight 5-year Treasury bond yielding approximately 1.1% at the time, that implied investors expect inflation to be running at a 1.6% annual pace over the next five years. That is not egregiously high, but it is better than a half-percent higher than today’s levels.
Combined, TIPS are telegraphing an increase in inflation expectations in the coming years. That seems reasonable given Fed Chairman Ben Bernanke’s statement that inflation is currently below the Fed’s target rate of 2%. The Fed has embarked on QE2, a second effort by the Fed following its initial program in late 2008 to purchase massive quantities of government securi¬ties. This exercise is intended to prime the markets with a dose of liquidity to engender business activity, leading to an increase in economic growth. It then follows that job growth and higher inflation are the natural course. Market participants are signaling some confidence in the Fed’s efforts to engineer such an outcome by bidding up risk assets, such as commodities and stock prices, but also by demanding to be better compensated in TIPS for the prospects of higher inflation.
For investors, the ability to defend against the loss of purchasing power parity is an important risk to mitigate. Certainly, TIPS are a means by which an investor can accomplish that, but their use is not without pitfalls. The adjustment made to a TIPS’ principal for inflation is treated as phantom in¬come, and therefore, an investor in a taxable account is taxed on it, perhaps unknowingly, since the tax is not applied to a more tangible interest pay¬ment. Also, TIPS are bonds, and should the Fed begin to raise interest rates, TIPS, like any bond, would likely lose value. Additionally, other investments offer attractive ways to protect against inflation. These include commodities, such as oil and metals, which have the added benefit of growth through global activity and infrastructure spending. Currencies can also play a role if further devaluing of the dollar is a byproduct of quantitative easing. Emerg¬ing market countries in particular have seen strengthening in their curren¬cies, and many have improving fiscal conditions. Lastly, large, high quality dividend-paying stocks often have the ability to pass on higher prices, have substantial overseas business and ample cash flow to pay investors a rising dividend. Collectively, these investment options may provide investors a diverse means by which they can manage and benefit from the prospects of our policymakers’ success—higher rates ahead.
Peter Newland, Barclays Capital
Industrial production and retail sales data for October support our view that GDP growth will pick up in the fourth quarter.
The October CPI report was weaker than expected and we have taken down our forecast modestly. However, deflation risks remain small, in our view.
This week’s economic data releases gave the first look at prospects for Q4 for two key activity gauges (retail sales and industrial production) and two key inflation gauges (CPI and PPI). Looking through some distortions and volatility in the data, policymakers are likely to view the activity picture as generally improving, with signs of a broadening in the recovery across sectors and indications that the loss of steam in the manufacturing recovery during Q3 was a pause and not a renewed downtrend. Meanwhile, although recent softer-than expected CPI reports will cause policymakers some discomfort, the stabilisation in shelter costs and rising producer price inflation have reduced the risk of deflation.
October’s industrial production report provided support for our view that the manufacturing recovery continues, albeit at a flatter trajectory than earlier in the year (Figure 1). Manufacturing output was up 0.5% m/m, with gains across durable consumer goods (0.7%), nondurable consumer goods ex-energy (0.7%) and business equipment (1.2%). As we wrote last month, the initial strong phase of the rebound was centered on business related sectors, reflecting the rapid turn in the inventory cycle. With that process largely played out, manufacturing output will more closely track final demand, particularly for consumer goods.
October’s retail sales report was also encouraging. The strong 1.2% m/m rise in total sales was largely driven by autos and gasoline, but “core” sales (which strips out these and building materials) rose as well, for the fifth consecutive month. Total retail sales have now risen 11.2% since the trough at the end of 2008, nearly reversing the peak-to-trough decline of 11.7% during the recession. While autos and gasoline sales have led the rebound and components related to the housing market (such as building materials and furniture) have lagged, there are signs that recovery is broadening. Growth in nonstore (largely internet) sales, for example, has accelerated in recent months.
The headlines from this week’s inflation data were less encouraging (for policymakers aiming to push inflation higher). The core CPI was flat in October (for the third consecutive month) and up just 0.6% y/y. However, there are reasons to suppose that core inflation is close to a trough. One way to divide the core CPI is into goods and services. The latter is dominated by the rent and Owners’ Equivalent Rent (OER) components (together 38% of the core CPI). These have shown clear signs of stabilizing in recent months, following a prolonged period of disinflation (Figure 3). As we have written in the past, timely indicators of rental prices and our models of rents and OER (based on housing market and economic variables) point to a pick-up in these components in 2011. This should support core service prices, (The softness in recent CPI reports has been driven by core goods prices. For example, October saw declines in new vehicles (-0.2% m/m), used vehicles (-0.9%) and apparel (-0.3%). This led us to take down our CPI forecast profile a little this week. However, the back drop of an improving growth outlook, a weaker dollar and signs of some pipeline price pressures leave us comfortable with the view that the risk of outright deflation in the core CPI remains small. On the latter, the PPI provides some reassuring signals (absent the downward distortion in October from the introduction of new vehicle models). For example, within core finished consumer goods, the prices of nondurables at the producer level have been gradually picking up in recent months. This tends to be reflected at the consumer level with a bit of a lag (Figure 4).
All in all, we remain comfortable with our view that GDP growth will be stronger in Q4 than Q3. Meanwhile, although soft goods prices have led us to revise down our inflation projections modestly, a stabilization in shelter costs, a weaker dollar and signs of building pipeline price pressures have, in our judgement, reduced the risks of deflation.
Mark Pawlak, PaKeefe, Bruyette & Woods
Last Friday, China raised their required reserve ratio by fifty basis points for the second time in two weeks. Additionally, last Wednesday China's State Council announced that it would implement "...price control guidelines to reassure consumers facing inflation..." and urged local authorities to offer temporary subsidies to needy families. According to a report Sunday by official state news agency Xinhua "Chinese decision makers have made price controls a top priority as the consumer price index...rose to a 25 month high of 4.4 percent in the twelve months to the end of October...mainly due to a 10.1 percent surge in food prices...China has been moving to mop up excessive liquidity to combat inflation, with the latest move to target over-liquidity in the banking system". In our opinion, China will do its best to slow down an overheating economy without causing it to crash. We think their use of price controls and subsidies is indicative of a reluctance to be over-aggressive with monetary policy. That said, in our minds, given the common assumption that the worlds's number two or three economy (depending on your measuring stick) will be an engine for global growth and the strong correlation between the US and Chinese markets, we think the Shanghai Composite should be closely watched by US investors.
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