Trumpflation? Or A Return of Deflation? - Leftback

A few days ago, members of Team Macro Man 2.0 reviewed charts for a variety of US fixed income instruments and predicted here that the steep post-election sell-off was over, and that Mr Bond had in fact carved out a tradable bottom, which would then be followed by a period of mean reversion into the inauguration. We even pointed out some gaps in the charts that might be filled, and at the time of writing, the 10y is yielding 2.37%, well within sight of the first of those targets (2.10-2.20 area).

Despite this market action, the crescendo in the media (mainly from sell side analysts) continues to proclaim the party line, namely that “interest rates are going higher”, and that there is a “great rotation” out of bonds and into equities. So why are some of us at TMM (especially those of us who are fixed income investors by trade or inclination) less than eager to follow this mantra and exit US fixed income for the siren song of growth stocks and reflation vehicles, in the time-honored manner?
The decision whether to do so comes down to one’s philosophical position about one single issue that will dominate US fixed income investing for years to come: inflation forecasting. Many market watchers reacted to the election of President Trump by reaching for inflation protection in all manner of ways (except interestingly in gold, which was sold) and by investing in all kinds of infrastructure plays. The consensus view is that Trump is a builder, and so he will build, and spend, and inflation will result, against the backdrop of a US economy growing more rapidly than anticipated, forcing the Fed to move to hike rates more rapidly than anticipated. The combination of fiscal stimulus and monetary tightening is a scenario that is also generally very positive for the domestic currency.

According to this strong dollar, reflationary view, one should therefore sell vanilla Treasuries and longer duration debt, and buy high yield bonds or TIPS. In equities, one should sell defensive sectors, such as utilities, REITs, health care and staples, avoid other rate-sensitive issues such as telecoms and technology and buy the cyclical sectors, such as the financials, materials, integrated oil stocks, the drillers and industrials. This is the traditional recovery investment playbook (think about 2009, for example).

But what if they gave a recovery and nobody came? The problems with the widely touted reflationary scenario are manifold. Some of them are independent of the party in power and the person in the White House, and even of Dame Janet Yellen in the Eccles building, (“the most powerful woman in the world”). Here we review a number of intrinsic (domestic economy and US politics) and extrinsic (foreign governments, world economy) factors that will cause the US reflationary adventure to first disappoint investors, then stall out, and perhaps even give way to another episode of outright deflation. Some of these ‘flation factors were recently reviewed by macro strategist Cameron Crise of Bloomberg (here and here). Although C.C. points out the danger posed by rising inflation, the question has to be asked: how much is priced in? and is it transitory? (as Dame Janet likes to say, usually in reference to oil or commodity price spikes).

Domestic Factors

1. Infrastructure Programs will be disappointing and delayed in execution.
Many Americans, especially those in the older East Coast cities, see a pressing need to repair the nation’s aging infrastructure. While we would love to see a massive national infrastructure program encompassing rails, roads, airports, bridges and internet access, we think the prospects for such a program are actually dim. The reasons for this are several, but the prime obstacle is the House Republican majority, led by Mitch McConnell (R-Ky) and Paul Ryan (R-Wis), who represent states that would benefit little from an infrastructure program. In addition, they are closet deflationists, whose political base benefits from low interest rates in any number of ways.

2. The Trump Cabinet is full of vulture capitalists, not social engineers.
It would be exciting to have a President with interesting ideas for rebuilding America, especially if he had a cabinet that was able to put those ideas into practice. A look at the Trump cabinet, however, reveals a group of people who are unlikely to benefit from, or support programs based on American regeneration and reflation. Wilbur Ross, for example, is the very definition of a vulture capitalist, with a long history as a distressed debt, asset stripping and merger specialist. Whether or not one sees value in this, Ross seems unlikely to be a social visionary, and he might prefer slow growth or even frank deflation to reflation (indeed, one can argue this might be healthy for US business after serial bubble financing).

3. Aggregate Demand will continue to be slow – the output gap remains. 
The demographic changes that began in the US around the year 2000 continue to grind inexorably onwards, as the Baby Boomer generation retires, clutching its ill-gotten gains, real estate and stock portfolios  - or else eagerly anticipating decades of life on welfare support from working age Americans. None of this will be changed even slightly by the election of President Trump, and it will ensure that aggregate demand stays modest, and growth averages 2% rather than the 4-5% that characterized previous expansions. Even massive fiscal spending probably would not increase aggregate demand by much, perhaps elevating GDP by 0.5-1% at most. The much-derided “New Normal” of Bill Gross is very much alive and well.

4. Inflation expectations (of the US public and markets) remain modest.
The problem with reflationary investing is that at some point the inflation really has to actually show up, otherwise capital will begin to cycle out of the reflation trades and back into the yield universe of fixed income and defensive equity sectors. A look at real-time indices of US inflation expectations shows that neither the bond markets nor the population are actually expecting much of a bump in inflation, with both 1y and 5y inflation expectations remaining anchored below the Fed’s target of 2%. This is important, because traditionally both markets and everyday Americans have been far more accurate inflation forecasters than the Fed.

5. Wage growth remains slow due to the slack in the US labor market.
One of the reasons people see little inflation ahead is that they are realists, and they are also better real world economists than that old fraud Milton Friedman, who proclaimed to much fanfare that “inflation is always and everywhere a monetary phenomenon”. Friedman even won a Nobel Prize for his theories on beating inflation by restricting M2 and other measures of the money supply. However, Milton Friedman never met QE and thus he could never have accounted for its deflationary effects or the co-existence of monetary expansion and low price and wage inflation that has characterized the US economy since the housing bubble burst. The Japanese experience since the 1990s has been analogous.
In fact, the true genius and US economic pragmatist in this case was Paul Volcker, and it was higher interest rates (painfully high in 1982) that finally whipped inflation (“Whip Inflation Now” badges were popular), with an assist from the union-busting strategies of Reagan (and Thatcher) that emasculated organized labor and curtailed collective bargaining agreements in the ensuing decades. This controlled the real culprit for cost-push inflation, i.e. wage inflation. In the US labor market of 2017, a large pool of unemployed and underemployed assures that both hourly wages and hours worked are relatively static, ensuring both low wage growth and low US inflation for the foreseeable future. Believe the 5y5y break-evens!

6. The strong US dollar is already choking off manufacturing industries. 
A lot of rubbish has been written about how access to cheaper raw materials from other markets will make US manufacturing more competitive, but the fact is the stronger dollar raises the price of US-made goods in the rest of the world and eventually leads to a slowdown in new orders to US factories, that will eventually feed through to lower growth and corporate earnings for multinationals and large exporters.

7. Housing and Mortgage Markets are already in the deep freeze.
One of the most obvious consequences of the 10y moving up by 100 bps in the last 2-3 months can already be seen - in the mortgage markets. Mortgage and refinancing applications have plummeted since September, and the value of mortgage-backed securities has also fallen as rates have risen. This will have two effects on the US housing market (unless it reverses promptly). First, failure to gain credit will result in a frozen housing market in the Spring, and second, house prices will inevitably fall. Given that the banks and the Fed have a huge amount of housing-related paper on their portfolios, we think that rates will probably begin to decline once more in 2017. The recent spike in interest rates can be survived by most financial institutions, but another 50-100 bps would cause a lot of pain. Just as a 10y note yielding 4.0% was a great buy in April 2010, we think that a 30y US bond at 3.20-3.25% was a really fantastic buy near the end of 2016.

8. The Fed will not hike more than once in 2017.
It should be obvious from the above that we do not believe that the Fed will hike rates three times in 2017, despite the apparent consensus and intent of the voting members, as indicated by the latest “dot plot” in December. As in prior years, slowing of the US economy in 2017 will see the FOMC scale back their growth projections for the year, along with their plans for interest rate hikes. In fact, if 2017 goes well for the US economy (2.5% GDP), then the next hike will be in December 2017. If the economy stalls out this winter, then there may eventually be no hike at all. Some observers even believe that the next move will not be a hike, but a 25bp rate cut, and that this will occur as part of a strong bull flattener in the yield curve that will drive the 10y yield to new lows of 1%. We remain agnostic.

Extrinsic Factors

1. Chinese Credit Crisis. A trade war with China may lead to deflation. 
It is by no means clear what the true rate of growth is in China at present. The official estimates of 6-7% etc are clearly principally of comedic value. Electricity usage data, etc suggests that China’s GDP may be as low as 2-3%, and this is just one reason why we have seen USDCNY soaring and capital flight becoming a significant problem for PBoC. The Chinese economy also has an enormous overhang of bad debt that threatens to take large sectors of the banking system underwater at some point. Nobody knows what will trigger a major meltdown in Chinese credit, equities (and by extension, most emerging markets), but it is certain to happen at some point. One of the “Black Swans” for 2017-8 is that President Trump sparks a trade war with China that provides the trigger for a Chinese credit crisis, leading to a deep recession in China, a trade freeze across the world and a wave of global deflation that might rival the Great Financial Crisis of 2008.

2. Oil Prices Continue to Fuel Disinflation. 
The OPEC agreement may not hold (“after all, we tend to cheat” observed one major producer). There are also large non-OPEC producers (US, Russia) that make OPEC increasingly less omnipotent. US rig count and production have both continued to rise recently, even as stockpiles of crude and refinery products are close to all-time highs. Added to these fundamental considerations the fact that we are in a strong dollar environment. Speculative episodes may drive the spot price of crude oil higher for a month or two, but clearly, the longer–term pressure on the oil price is such that the risk remains to the down side.
In the US, the oil price is the major determinant of the Producer Price Index and a major input to the CPI.  At least for the next 3-5 years, the declining use of oil by China and the US, combined with ample supply and storage suggest that oil prices are likely to continue to provide disinflationary inputs to the US economy.

3. Another European banking and currency crisis is never far away.
Whether it is BMPS (Banco dei Monte Paschi di Siena) this month, another Italian bank tomorrow, or one of the Portuguese or Spanish lenders next month, we know that there are an awful lot of institutions with a book full of non-performing loans. On any given day, the promise of Draghi’s bazooka (“I can promise, it will be enough”) can keep these problems out of sight and out of mind. At some point, in an unpredictable way, one or more major European banking institutions will become visibly insolvent (perhaps because of a run on deposits), interbank lending will dry up, and counter-party risk will elevate the situation to the level of a banking crisis. The only possible solution to such issues involves bail-outs, bail-ins and the creation of more special facilities by the ECB, effectively expanding the ECB balance sheet even further and placing additional strain on the €.

4. Emerging Market Debt Crises. 
Emerging market debt crises can occur locally at any time. Venezuela provides an obvious example. A more serious situation might arise if Turkey undergoes a full-blown debt crisis. The strategic importance of Turkey, as well as the size and inter-relatedness of its economy would make this a serious regional problem (Greece and MENA are all important trading partners of Turkey). Debt crises might also occur elsewhere in the Middle East if oil prices crash once more, especially in Saudi Arabia. If any emerging market does suffer a serious crisis, a flight to the dollar might create knock-on effects in vulnerable economies in Latin America (Brazil, Argentina) and emerging Asia (Malaysia, Indonesia).

5. Japan sells the yen and buys US Treasuries, keeping US rates low. 
The BoJ has, for 25 years or more, oscillated between the risks posed by deflation and a government bond market meltdown and currency crisis. Yet a major crisis has been largely averted for 15 of the last 25 years, as a succession of prime ministers and central bankers has alternately used QE and under Kuroda, QQE (Abenomics) to attempt to delay and defray the strong deflationary pressures that grip an aging nation in the later (but not final) stages of a demographic disaster of epic proportions. In the latest round of stimulus, the BoJ has pledged to peg the JGB10y rate at or close to zero. As a consequence, Japanese fixed income fund managers, banks, pension funds and even the government itself must search for yield in the rest of the world. One of the most stable investments available is found in the US Treasury market, where yield differentials for 10y notes are currently in excess of 200 bps. This yield-seeking by Japan is just one reason for the strong demand from “indirect bidders” for US government paper, seen in the recent December auctions of 5y, 10y and 30y Treasurys.

This post was written by “Leftback”