Thursday, October 23, 2014

September Inflation

Core minus Shelter inflation still looks pretty weak, while shelter inflation remains strong.  My position is that shelter inflation reflects a negative supply shock and core minus shelter inflation reflects a negative demand shock.  The economy might be strong enough to limp along with no help from the housing sector and with negligible core minus shelter inflation, but the downside risk is significant if it can't.

Looking at the 1 year inflation indicators in the next graph, it might be worth noting that core minus shelter inflation was this low in 2004 when short term rates began increasing and the economy continued to recover (along with inflation).  But, inflation expectations were rising then, while they are falling now, and mortgage markets were flying then and are dead now.

We now have 4 months with no cumulative core minus shelter inflation.  I think the best hope at this point is coming from FHFA.  Clearly the implicit regulatory liabilities banks now have for mortgage credit are stifling.  If this can be corrected, maybe it will pull out some pent up housing demand and we will see home prices begin to climb again.  If that happens, it's smooth sailing.  If it doesn't, it's hard to tell how things will work out in the near future.


  1. TravisV here.

    Today, I am a huge huge huge fan of this analysis Marcus wrote 1.5 years ago of inflation expectations:

    And a week ago, Marcus wrote an update:

  2. TravisV here.


    Please take a look at this graph:

    For the next ten years, I feel it’s reasonable to forecast the S&P 500 P/E ratio (TTM) to average well above 17, maybe even higher than 20.

    What is your gut feeling for the appropriate forecast?

    1. Here is a post I did last year.

      I'm not sure I got everything right. After doing my series on risk & valuations, I'm less convinced that required returns are declining over time. So I don't know if I still hold to the empirical expectations of that post, but I think the logic mostly still holds.
      Part of what happened in the 90 s and 2000 s is what Bernstein gets at in the article in my old post. We lived through a revolution, and in economic revolutions, much of the gains go to entrepreneurs and innovators (contra Picketty) so equity indexes don't pick up all the gains, since legacy capital isn't the primary recipient of gains from disruptive growth. The scale of the revolution caused valuation measures during that period to go crazy. And I suspect that much of the growth went to consumer surplus. So the measures of wealth in the late nineties weren't that out of line. It's just that in the end the wealth went to consumers and entrepreneurs. We don't measure the wealth of consumer surplus at all, and the entrepreneurial gains show up as income inequality and share dilution.

      Have you seen this nice summary of inflationary effects on CAPE?

      So, I agree with Alan Reynolds that the CAPE isn't as worrisome as it seems. But there are a lot of things wrong with the analysis and the comparison of earnings yield and nominal bond yields, I think, which I have outlined in my recent posts. Real unleveraged total expected returns to equity appear to be pretty stable over time, so the relative expected return to equities relative to bonds can be inferred from the real interest rate without referencing the earnings yield. The earnings yield is not informative here.

      While I do agree with him that the perma-bears are wrong, I will defend them a little bit. If you had taken Shiller's advice in 1992, you wouldn't have done that bad. You would have lost out if you traded equity for near cash. But if you traded equity for bonds and kept the same duration exposure, you would have done fine. We think of the 90 s as a big equities bull market, but there were also tremendous capital gains to bonds throughout the last 20 years from falling rates, without the volatility. It's surprising, but bonds wouldn't have been a bad choice. I think I have a chart showing equity vs. Long term bond returns in one of this week's posts.

    2. And, yes, I agree with you. Demand risk is higher now than valuation risk. I agree that PE ratios can remain somewhat elevated.

  3. TravisV here.

    Looking at the data in FRED, U.S. stocks might have celebrated stabilizing inflation expectations this week. I'm hoping this really is stabilization and 5-year inflation breakevens won't fall much farther than the low of 1.37 last week........

  4. I don't know, Travis. 5 year breakeven inflation hit this low in 2003, and the Fed implemented their last Fed Funds Rate decrease down to 1%. The 5 year breakeven hit this level in 2010, and the Fed implemented QE2. I think it's pretty risky to be sitting here now with the Fed simply saying they won't tighten as quickly. I suppose if expected inflation moves sideways, it could be ok. But, I don't think this qualifies as stabilized yet.

    1. TravisV here.

      So glass half-empty, Kevin! :) At any rate, Sumner pointed out another factor that could be crucially helpful for U.S. equities:

      “Next year’s FOMC membership is much more dovish, or expansionary, than this year’s membership. Taking that into account, if there’s any doubt next year about the strength of the economy’s recovery, the very dovish committee next year will probably want to err on the side of waiting to make sure that the economy is strong enough to raise interest rates.”

    2. I'm optimistic by nature. I'd say it's 1/3 full. :-)
      The market knows about the new doves and still says 1.4% is the breakeven. The danger is that holding back on rate rises isn't enough. Like 2008, I suspect few expect 1.4%. Some expect 2.5% and a growing number expect <1%. And that's when you get potentially big problems.
      I'm still hoping new FHFA rules help prime the mortgage pump. And I'm not even projecting a recession for the real economy. But, thin ice.....