PPG Industries Warns of Intensifying Inflation Pressures and Weakening Demand

{Originally published on One-Twenty Two by Dr. Duru}

““As we look ahead, we currently do not anticipate any relief from inflationary cost pressures in the third quarter. We expect aggregate global economic growth to remain positive with end-use market activity comparable to the second quarter, adjusted for traditionally lower seasonal demand. However, uncertainties exist regarding global trade policies, which may create uneven demand by region and in certain industries. Specific to PPG, we expect that the previously announced architectural customer assortment change will lower our third quarter year-over-year sales volume growth rate by between 120 and 150 basis points. We remain confident that our leading-edge technologies and products, which are bringing value to our customers, will facilitate our growth going forward….

Currently the new tariffs are starting to add some modest cost to our raw materials. Based on the strength in the US dollar in the second quarter, we expect foreign currency exchange rates to have an unfavorable impact to our sales in the third quarter”

This was the essence of the guidance industrial paint company PPG Industries (PPG) provided in its 2nd quarter earnings report. I added the emphases because the warnings on inflation and international demand were clear precursors to the company’s pre-earnings warning tonight. The stock traded down about 10% in after market trading in response to significant cuts in revenue and earnings guidance. I was most interested in the explanation which made the second quarter’s caution come to life (emphases mine)…

““In the third quarter, we continued to experience significant raw material and elevating logistics cost inflation, including the effects from higher epoxy resin and increasing oil prices…These inflationary impacts increased during the quarter and, as a result, we experienced the highest level of cost inflation since the cycle began two years ago.

“Also, during the quarter, we saw overall demand in China soften, and we experienced weaker automotive refinish sales as several of our U.S. and European customers are carrying high inventory levels due to lower end-use market demand…Finally, the impact from weakening foreign currencies, primarily in emerging regions, has resulted in a year-over-year decrease in income of about $15 million. This lower demand, coupled with the currency effects, was impactful to our year-over-year earnings and is expected to continue for the balance of the year.”

Instead of moderating, inflationary pressures are mounting on PPG. The weakness in China is telling in the context of the trade war with the U.S. The lower “end-use market demand” points to the trickle-down impact of “peak auto.” These warnings are each important given PPG has a market cap of $26.5B and trailing 12-month revenue of $15.4B. I fully expect other industrial companies to deliver similar news this earnings season.

Interestingly, Credit Suisse downgraded the stock in late September and the market responded by taking PPG down 2.8% on relatively high trading volume. The gap down confirmed the end of PPG’s post-earnings run and breakout above 200-day moving average (DMA) resistance. Until the downgrade the stock finally looked ready to challenge its 2018 high.

PPG Industries (PPG) never quite recovered from the February swoon. The recent breakdowns below 50 and 200DMA supports now look like fresh warnings.
PPG Industries (PPG) never quite recovered from the February swoon. The recent breakdowns below 50 and 200DMA supports now look like fresh warnings.

Source: FreeStockCharts.comThe market is supposed to be a forward-looking mechanism, so it is natural to wonder why PPG was rallying so well in the first place. I do not put all the blame on investors. I assume the company itself was partially responsible through its sizable share repurchase program. For the first half of 2018, PPG spent $1.1B on its own shares: 4.1% of the company’s current market capitalization. With this kind of aggressiveness, PPG should quickly move in on the new 52-week low to add to take out even more shares.

As earnings season unfolds, I will be paying close attention to company commentary on trade woes and inflation. The stock market has spent most of the past several months ignoring risks, so there are a good group of over-priced stocks out there waiting their turn for a douse of realty. Collectively, these warnings could be the catalyst that delivers the oversold market conditions I am anticipating.

Full disclosure: no positions


Acuity Brands: Wage and Tariff Inflation and Resulting Business Uncertainties

(Originally published on One-Twenty Two by Dr. Duru)

I last mentioned Acuity Brands (AYI), a lighting and building management solutions company with $3.7B in net sales in 2018, three months ago. At that time, I described a good risk/reward setup to go long the stock post-earnings. AYI shot nearly straight up from there. The stock broke through resistance at its 200-day moving average (DMA) and gained as much as 34.7% before peaking intraday in September. While I only participated in a portion of that run-up, I am glad I did not overstay my welcome. Fast forward to last week: AYI suffered a massive post-earnings gap down. The stock lost 16.3% and sliced right through 200DMA support after the 50DMA gap down. Sellers closed the week confirming the bearish breakdown. AYI has now almost erased its entire incremental gain from July earnings.

Acuity Brands (AYI) looks set to reverse all its previous post-earnings gains after a disastrous earnings report that sent the stock crashing through its 50 and 200DMAs
Acuity Brands (AYI) looks set to reverse all its previous post-earnings gains after a disastrous earnings report that sent the stock crashing through its 50 and 200DMAs

Source: FreeStockCharts.com 

This moment is critical for the stock. AYI hit an all-time high in August, 2016 and sold off pretty steadily from there (on a monthly basis) until reaching a 4-year low in May, 2018. If AYI completes a full reversal of its gains from July earnings, then the stock greatly increases its risk of resuming the downtrend from the all-time high.

AYI’s earnings report was interesting for a lot more than the technical disaster. The company also delivered some telling remarks about today’s inflationary environment. The company begain its conference call by launching right into the bad news. From the Seeking Alpha transcript:

“While our results for the fourth quarter and the full year were records, we had higher expectations coming into 2018. Market conditions for growth were far more subdued than most had originally anticipated, especially for larger commercial projects and deflationary pricing persisted throughout the year, while cost pressures were far more significant than most had forecast, particularly in the fourth quarter.”

The general market environment hindered the business:

“Based on the information from various data collection and forecasting organizations, we believe the overall growth rate for the fourth quarter as measured in dollars for lighting in North America was flat to slightly down, continuing the sluggish trend over the last several quarters…

We believe the lighting industry will continue to lag the overall growth rate of the construction market, primarily due to continued product substitution to lower priced alternatives for certain products sold through certain channels.”

For the fourth quarter and full-year, the company sported record revenues and diluted earnings but significantly lower operating profit and margin. The cost pressures came from multiple inflationary fronts including tariffs and wages. Emphasis mine…

“Another significant factor impacting our adjusted gross profit and margin was higher input cost for certain items, including electronic and certain oil-based components, freight and certain commodity-related items, particularly for steel. Many of these items experienced dramatic increases in price in the fourth quarter due to several economic factors including enacted tariffs and wage inflation due to the tight labor markets.

We estimate the inflationary impact of these items reduced our adjusted gross profit in the quarter by more than $20 million, lowering our adjusted gross profit margin by 200 basis points and reduced adjusted earnings per share this quarter by $0.38…

…we expect employee-related costs will continue to rise as we enter fiscal 2019 as markets for certain skills remain tight contributing to a rise in wage inflation…”

AYI also explained that it sources from China about 15% of its components and finished goods which are subject to the new import tariffs.

Freight costs are an increasing burden. The combination of rising oil prices and the rising wages that come from a severe shortage of truck drivers are driving freight rates skyward. Shipping a lower-value product mix is exacerbating the shipping burdens.

As we would expect, AYI is scrambling to mitigate these costs by finding alternative suppliers and production sources, improving productivity, and increasing prices. The company announced price hikes last month and new price increases go into effect on October 15th. Assuming the new 25% bump in tariffs on Chinese imports goes into effect on January 1, 2019, AYI will raise prices yet again. IF AYI makes these price hikes stick without losing much demand, then the stock could represent a great buying opportunity. Better margin numbers should start appearing by the second fiscal quarter 2019.

AYI cautioned that a lot uncertainty surrounds the potential impact of the cost pressures. For example, the inflationary pressures from tariffs caught the general industry by surprise as participants have experienced a deflationary environment for a “handful of years.” The demand impacts are hard to assess: “It is not possible for us to precisely determine what the potential impact tariffs will have on demand as it is a very complex situation impacted by numerous factors including currency fluctuations and political outcomes.”

As the inflationary adjustments unfold, I will watch the technicals for signs of renewed buying interest. The company itself is one source of buying. AYI repurchased 2M shares at a cost of $298.4M in its fiscal year 2018. AYI still has 5.2M shares left under its repurchase authorization. I have to assume the company will aggressively buy shares in the coming months given the current stock price of $130.99/share is well below the average cost basis of $149.20/share of the to-date repurchased shares.

Finally, it is possible tariffs could HELP AYI although the company did not specifically say so. In the conference call AYI pointed out that the Chinese government is subsidizing lighting companies who are undercutting price for lower-value fixtures. This competitive pressure is important because, as noted earlier, some of AYI’s customers are downshifting to these lower-valued products. AYI is determined to compete – “We will not yield this space for many strategic reasons” – and this competition represents one more important risk factor for the business.

Overall, AYI is one more cautionary tale about the unanticipated impacts of today’s new inflationary environment. Given that financial markets are generally ignoring most potential fallouts from the expanding trade war between the U.S. and China, this earnings season should deliver many more surprises like AYI’s.

Be careful out there!

Full disclosure: no positions


Inflation Washes Ashore

Ever since the election of Donald Trump as U.S. President, the stock market has gone into a “Trumpflation” mode of trade. The early evidence of inflation may have finally washed ashore.

U.S. January prices rose 0.6% and core prices rose 0.3% month-over-month. Both were slightly higher than expected, and the rise was the highest since February, 2013. Year-over-year the Consumer Price Index (CPI) rose 2.5%, the highest since march, 2012. The CPI incorporated some particularly strong price hikes:

“Clothing prices jumped 1.4 percent, the most since February 2009. Men’s apparel surged by the most on record. New vehicle prices climbed 0.9 percent in January, the biggest advance since November 2009.”

The price hikes were enough to push real hourly wages down by 0.5% form December and unchanged year-over-year.

This is just one month of data, yet it precedes any of the policy changes or fiscal stimulus measures which promise to introduce inflationary pressures into the U.S. economy. InflationWatch is officially back on alert for the U.S.!

https://www.bloomberg.com/api/embed/iframe?id=f020e8cd-257d-4519-85a0-ddbdd3bf1339


On the Ground Measuring Inflation

Ever wondered exactly how the government measures inflation via individual products? Planet Money ran a segment explaining the process in 2010 that was rebroadcast last year. I caught “The Price Of Lettuce In Brooklyn” sometime early last year. I was absolutely amazed to learn that the government actually sends surveyors into the field to sample prices from various stores on very specific goods. The surveyors have to exercise particular care to measure prices for the exact same goods over time. That basket of goods is then aggregated across products and locations into what we know as the Consumer Price Index (CPI).

I highly recommend this 15-minute podcast for anyone who wants an introduction to inflation monitoring at the ground level.

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Source: NPR Planet Money


Cross-Post: The Canadian Dollar’s Rapid Devaluation Presents An Inflation Predicament for the Bank of Canada

(This is a cross-post from my blog One-Twenty Two)

A year ago, the Bank of Canada (BOC) delivered the first of two rate cut surprises for the year. So with oil still cratering ever lower, I can understand why the market seemed braced for yet another rate cut last week. Instead, the BOC not only stood still on rates, but also it expressed an implied reluctance to reduce rates any further unless absolutely necessary. The result was an immediate jump in the Canadian dollar (FXC) featuring a drop in USD/CAD. USD/CAD continued to sell off right into the week’s close.

Going into the Bank of Canada January, 2016 decision on monetary policy, speculators were ramping up net short positions against the Canadian dollar.

Going into the Bank of Canada January, 2016 decision on monetary policy, speculators were ramping up net short positions against the Canadian dollar.


Source: Oanda’s CFTC’s Commitments of Traders

USD/CAD printed topping action just ahead of the Bank of Canada decision. The currency pair has shot nearly straight down ever since.

USD/CAD printed topping action just ahead of the Bank of Canada decision. The currency pair has shot nearly straight down ever since.


Source: FreeStockCharts.com

The Canadian dollar has been weaker but the PACE and extent of the weakening is nearly without recent precedent.

The Canadian dollar has been weaker but the PACE and extent of the weakening is nearly without recent precedent.


Source: Board of Governors of the Federal Reserve System (US), Canada / U.S. Foreign Exchange Rate [DEXCAUS], retrieved from FRED, Federal Reserve Bank of St. Louis, January 23, 2016.

Here is the key quote from Governor Stephen S. Poloz’s opening statement:

“It is fair to say, therefore, that our deliberations began with a bias toward further monetary easing.”

The on-going collapse in oil and all its destructive consequences for the Canadian economy still justify further easing. BUT…

“First, the Canadian dollar has declined significantly since October, which means that the non-resource sectors of our economy are receiving considerably more stimulus than we projected then. Let’s remember that it typically takes up to two years for the full effect of a lower dollar to be felt.

Second, past exchange rate depreciation is already adding around 1 percentage point to our inflation rate. This is a temporary effect, and is currently being offset by lower fuel prices—another temporary effect. However, we must be mindful of the risk that a further rapid depreciation could push overall inflation higher relatively quickly. Even if this is temporary, it might influence inflation expectations.”

In other words, financial markets have pounded the Canadian dollar so thoroughly that most of the BOC’s goals for easing have been accomplished already. The potential 2-year lag in impact means that the BOC must proceed with extreme caution when deciding to add more kindling to the raging fire of currency devaluation.

Moreover, this devaluation is now exerting inflationary pressures on the Canadian economy – to the tune of an incremental 1 percentage point. While current inflation may still be within tolerance, the pace of the increase could be strong enough to send future inflation expectations soaring past the BOC’s comfort zone. Given the lagging impact of the devaluation, the BOC could find itself fighting stubbornly high inflation expectations for an uncomfortably long time. During the press conference, Poloz clarified that the BOC does not think this process is underway. The Bank is simply keeping an eye on this potential – which is clearly enough to give them caution about doing anything that further drives down the value of the Canadian dollar.

Given these cautionary caveats, the BOC decided to leave rates just where they are. From the press release:

“The Bank of Canada today announced that it is maintaining its target for the overnight rate at 1/2 per cent. The Bank Rate is correspondingly 3/4 per cent and the deposit rate is 1/4 per cent…

…All things considered, therefore, the risks to the profile for inflation are roughly balanced. Meanwhile, financial vulnerabilities continue to edge higher, as expected. The Bank’s Governing Council judges that the current stance of monetary policy is appropriate, and the target for the overnight rate remains at 1/2 per cent.”

As usual, the BOC is cautiously optimistic about economic prospects. Despite a disappointing 2015, the BOC still expects the global economy to resume “gradual strengthening” in 2016. Expectations incorporate an assumed transition to a 6% annual GDP growth rate for China, and continued “solid” performance from the U.S. Even with weak exports to the U.S. in the fourth quarter, the BOC expects export activity to turn right around in 2016. While downgrading its forecast for Canada’s GDP growth in 2016 to 1.4%, the BOC emphasized that year-over-year, growth should be 1.9% for the fourth quarter of this year.

Even though the BOC did not cut rates in this last meeting, make no mistake about its bias. The BOC thinks it could take up to three years for the Canadian economy to fully adjust to the complex structural changes wrought by the collapse of the oil complex. The Canadian economy may not absorb excess capacity in the economy until late 2017. The BOC also acknowledged the growing magnitude of the shock from this collapse. The BOC called this reality a “significant setback compared with our October projection.” During the press conference, Poloz also admitted that the odds of a recession are higher than they have been in a very long time. All these realities imply a notable bias toward weakness for the Canadian dollar for quite some time.

When I wrote about the Canadian dollar’s fresh milestone of weakness, I described a small counter-trend bet that USD/CAD would return to 1.40. As the chart above shows, the USD/CAD just continued to spring higher after the 1.40 breakout. The Bank of Canada’s stasis on rates combined with the forex response was my signal to finally add to that bet. Without a promise to cut rates again, I fully expect USD/CAD to reverse most if not all of recent gains assuming oil does not resume its rapid plunge in the interim.

I will continue to try holding out for that return to 1.40, but I am perfectly fine bailing on the position if renewed strength shows up ahead of this week’s Federal Reserve’s meeting. On a technical basis, the counter-trend momentum in USD/CAD looks like it could easily retest the uptrending 50-day moving average (DMA). At the current pace, this would happen around 1.39. After I close out this short position, I will be quite eager to get back to trading with the trend.

During the press conference, Poloz would not commit to a specific level past which weakness in the Canadian dollar will no longer help the Canadian economy. He would only say that the assessment depends on the nature of the decline. If the currency is declining “on its own,” then there is a problem. An adjustment from economic realities makes sense – the current decline is mostly about the collapse in the oil complex. However, trends beget trends, and I can see several scenarios of overall financial turmoil and volatility that could send USD/CAD hurtling ever higher even independent of a fresh plunge in oil prices.

So, the Canadian dollar presents a precarious predicament for the Bank of Canada. Its devaluation is a necessary part of the Canadian economy’s adjustment to lower oil prices. The potential inflationary impact of this rapid decline could constrain the Bank’s ability to provide more assistance to a wobbly economy. Yet, without this assistance, the weakness of the economy could drive even more weakness in the currency. Currency traders will easily seize upon the trend above all else.

In coming weeks I will be reviewing the Monetary Policy Report (MPR) and a soon-to-be-released BOC paper on the complex impact of the oil shock to find any additional (tradeable) insights.

Be careful out there!

Full disclosure: long FXC, short USD/CAD


Housing Bubbles: An Ounce of Prevention is Worth a Pound of Cure

Prescription for preventing housing bubbles from the IMF…

iMFdirect - The IMF Blog

By Kevin Fletcher and Peter Kunzel

The main features of boom-bust cycles in housing markets are by now all too familiar.

During booms, conditions such as lax lending standards and low interest rates help drive up house prices and with them mortgage debt.

When the bust arrives, over-indebted households find themselves underwater on their mortgages— owing more than their homes are worth.

Feeling the pinch of reduced wealth and access to credit, households, in turn, rein in consumption. At the same time, lower house prices cause investment in new houses to tumble.

Together, these forces significantly depress output and increase unemployment. Non-performing loans increase, and banks respond by tightening credit and lending standards, further depressing house prices and adding to the vicious cycle.

View original post 753 more words


The Persistence of Deflationist Psychology

Seven and a half years after the financial world as we know it almost completely blew up, deflation remains the biggest fear across the land. Some major central banks across the globe have had to double down on their efforts to fight deflation. For those like me who expected central bank activism to quickly lead to rampant inflation, this world of persistent deflationist psychology is a wonder to behold.

Along this vein comes a fascinating article in the New York Times called “A Prediction Market for Inflation, or Deflation” by Justin Wolfers, a a senior fellow at the Peterson Institute for International Economics and professor of economics and public policy at the University of Michigan. Wolfers warns that the Fed’s focus on hiking rates runs counter to declining expectations for inflation:

“Something unusual is happening to prices right now: They are falling.

The recent sharp decline in gas prices is part of the story, but there is now growing fear that the Federal Reserve will undershoot its own 2 percent inflation target, hindering the economic recovery. There’s also a small but worrying risk that the economy could enter a deflationary rut.”

Incredulous, I read on….

The majority opinion marginally expects the Fed to miss its 2% inflation target in the next 5 years

Opinion is skewed to a Fed miss of its 2% inflation target in the next 5 years

After seeing this chart, I feel that Wolfers far over-stated the case for a “deflationary rut.” This chart shows that 49% of the prediction market expects the Fed to deliver. That is a pretty good percentage although we of course would prefer higher. Wolfers focuses in on the skew of expectations; that is, the people who think the Fed will miss the mark on inflation are predominantly expecting an undershoot. Note that only 1% of the prediction market currently expects deflation in the next 5 years. I do NOT equate an expectation of missing the 2% the target as a deflationary risk.

The main lesson for those of expecting Fed policy to lead to excessive inflation is that we remain a distinct minority. Very few people are worrying about inflation in financial markets.

Wolfers provides this good caveat on interpreting prediction markets:

“Of course, the specific probabilities inferred from market prices should be taken with many grains of salt. In particular, traders may not be betting that prolonged deflation is probable, but rather be buying insurance against such a grim occurrence. Thus, prediction market prices might overstate the probability of bad outcomes. Nonetheless, these prices embed a powerful message for policy makers: Just as people buy flood insurance when they’re concerned that a storm might do terrible damage, traders might be buying deflation insurance because they fear the risk of vast economic damage if the economy were to enter a deflationary rut.”

And a nice message for those of us expecting problems with inflation in the near future:

“Next time people tell you that higher inflation is coming, remind them that they can get rich in the derivatives markets if they’re willing to put their money where their mouth is.”

In the end, seeing Wolfers turn relatively mild data into a warning on deflationary risks is yet one more example of how deflationist psychology persists in economic thinking despite years of accommodative Fed policy, lots of money printing, and more printing to come…

It's a wonder sometimes that gold has been able to hold on as high as it is...

It’s a wonder sometimes that gold has been able to hold on as high as it is…

Full disclosure: long GLD


The Fed Asks “What Inflation?”

Last week, headlines and pundits were hot and bothered about the potential for the Federal Reserve to fall behind the curve on inflation. While my on-going assumption is that the Fed will indeed chose much higher inflation rather than risk ending the economic recovery with higher rates, I think the current hand-wringing by some is premature. In fact, it seems more the result of either boredom with the Fed’s business as usual policy stance and/or the anxiety on the part of some stock market bears looking for any kind of catalyst to shake the market out of its low volatility slumber

I was so surprised at all the hand-wringing over a “business as usual” policy statement that I rolled the tape on the press conference. I was wondering what I missed, I actually listened to the conference call a second time (yes, it was painful). The experience made me even more convinced the market over-reacted just as much as it did when Yellen carelessly suggested rates might increase earlier than the late 2015 market projection.

Recent inflation numbers apparently increased expectations that the Fed might show a more hawkish tone. This is reflected best in the first question of the press conference from Steve Liesman of CNBC:

“Is every reason to expect, Madam Chair, that the PCE inflation rate, which is followed by the Fed, looks likely to exceed your 2016 consensus forecast next week? Does this suggest that the Federal Reserve is behind the curve on inflation? And what tolerance is there for higher inflation at the Federal Reserve? And if it’s above the 2 percent target, then how is that not kind of blowing through a target the same way you blew through the six and a half percent unemployment target in that they become these soft targets?”

 

This was a leading question, especially considering that Yellen made it very plain in her introduction that the inflation readings remain benign. Moreover, long-term expectations for inflation remain tame (also see the Fed’s latest projections). Most importantly, the year-over-year change in the PCE, the Personal Consumption Expenditure, reached the 2.0% target in early 2012 only to quickly plunge from there. Not only might it be premature to project a 2% reading for next week’s release, but there is nothing to suggest that this time is different. The Federal Reserve has the least control over the non-core prices of food and energy, so the escalation of violence and turmoil in Iraq is definitely not the kind of event that the Fed would try to offset with monetary policy.

 

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The Fed still can’t tease the market into sustaining pre-recession inflation levels…
Source: St. Louis Federal Reserve

Perhap’s Yellen’s poor response ignited the flames of disappointment. Yellen did not address PCE directly and instead talked about the noise in the Consumer Price Index (CPI) while reiterating the Fed’s standard guidance on inflation:

“So, I think recent readings on, for example, the CPI index have been a bit on the high side, but I think it’s–the data that we’re seeing is noisy. I think it’s important to remember that broadly speaking, inflation is evolving in line with the committee’s expectations. The committee it has expected a gradual return in inflation toward its 2 percent objective. And I think the recent evidence we have seen, abstracting from the noise, suggests that we are moving back gradually over time toward our 2 percent objective and I see things roughly in line with where we expected inflation to be.”

Ironically, Yellen could have just pointed to the longer-term trend in the CPI. This view dominates any shorter-term noise….

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The overall trend on CPI continues to point downward
Source: St. Louis Federal Reserve

The most bizarre part of the buzz on the Fed’s supposed willingness to ignore inflation is that Yellen re-affirmed, re-emphasized that the Fed is all about meeting its price target. It will not tolerate deviations in EITHER direction for long:

“…we would not willingly see a prolonged period in which inflation persistently runs below our objective or above our objective and that remains true. So that hasn’t changed at all in terms of the committee’s tolerance for permanent deviations from our objective.”

This was Yellen’s response to Liesman asking about the Fed’s tolerance for higher-than-target inflation.

I feel irony in my skepticism about a Fed ignoring a budding inflation threat: this is the core scenario that has kept me long-term in the gold (GLD) and silver (SLV) trades. My thesis/assumption back in 2009/2010 was that the Federal Reserve would be extremely reluctant to tighten policy even as the economy strengthened out of fear that rate hikes would quickly kill the economy. By the time the Fed was ready to hike rates, the “inflation genie” would already be out the bottle. Granted, I am not nearly as rabid about this view, especially since I have come to appreciate the deep entrenchment of the lingering post-recession deflationist psychology in the economy.

 So, overall, I am very skeptical that this episode is the long-awaited lift-off of inflation and a lagging Fed. I actually think the Fed is right to look through the current “warming” in inflation readings, and I think it will find vindication just as the Bank of England did during a similar episode under former Governor Mervyn King. When the Fed asks “what inflation”, I find myself surprisingly agreeing for now…

To me, the data do not support the notion that broad-based inflation is taking hold in the economy. We do not even have wage pressures, not to mention all the slack that remains in the economy as evidenced in part by extremely low levels of housing production. Just do a web search or read mainstream financial magazines to see anecdotally how many people are still worried about the sustainability of the so far very weak housing recovery. I find it hard to believe we will get strong inflation with all this weakness and deflationary fears. On the commodity side, copper and iron ore have experienced major price declines in recent months that also fly in the face of any kind of sustained inflationary pressure in the economy.

Full disclosure: long GLD, SLV.


The IMF Launches “Global Housing Watch”

Housing prices are on the march again across the globe, and the International Monetary Fund (IMF) is concerned. In response, the IMF has launched a site it calls the “Global Housing Watch.”

Here is the introduction:

“Housing is an essential sector of every country’s economy, but it has also been a source of instability for financial institutions and countries. Understanding the drivers of house price cycles, and how to moderate these cycles, is important for economic stability.

 

The new indicators are an important step in assembling country-level data on housing trends in one location, allowing for more transparent cross-country and historical comparisons. The hope is to prompt actions by policymakers to moderate housing cycles.”

Housing has been a natural beneficiary of loose monetary policies. The irony or dilemma in extremely expensive countries like the United Kingdom, Canada, France, and Australia is that overall inflation readings are low. Accordingly central banks are maintaining extremely accomodative monetary policies in these countries. Thus, the traditional brakes for the housing market, higher rates and tighter monetary policy, are absent and nowhere on the horizon. It is no accident that the Bank of Canada and the Bank of England are now talking more loudly about using macroprudential policies to contain housing markets and enforce standard of financial stability. Here are the related recommendations coming from the IMF: 

“We do have a set of policy tools that can help – sometimes these are referred to as “Mip-Map-Mop.” Microprudential (Mip) policies look at an individual bank’s balance sheet, for example to determine if it is making too many real estate loans. But it could be that the individual banks are doing what seems healthy for them, but what the banking system as a whole is doing needs results in an unhealthy growth in lending.

 

So, in addition, macroprudential regulations (Map), operating at the level of the financial sector as a whole, come into play. The most commonly used measures cap how much individuals may borrow relative to their income. These prudential measures are being increasingly used by countries to prevent an unsustainable build-up in debt.

 

Finally, there is the monetary policy (Mop) that involves the central bank raising interest rates if they want to cool off the housing sector. This can be tricky, because sometimes the economy is weak but the housing sector is booming, and raising the interest rate can harm the overall economy.

So, basically, we need to share experience across countries, to look at trends, use our judgment, and apply policies that that may help prevent problems in the housing sector.””

I will be keeping an eye on this website and the twitter hastag #HousingWatch. I expect some revealing and fascinating data to flow through here. Here are the charts posted on the site showing the relative valuations of housing across the globe. I highly encourage the reader to go directly to the website and browse for yourself.  I also hope to write some pieces covering the housing markets in the UK, Canada, and Australia in particular in coming weeks and months.

Note well that the U.S. is NOT in bubble territory (in the aggregate)….

 

 

 

 

 

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Over-stretching the case for inflation

I continue to think it makes more sense to fear inflation than deflation, but I cringe when I read “inflationists” who continue to over-state the case for inflation. Two recent pieces that appeared in Project Syndicate are case in point: “When Inflation Doves Cry” by Allan Meltzer and “The Ghost of Inflation Future” by Brigitte Granville.

Allan Meltzer wrote “A History of the Federal Reserve” and is considered an expert on the Federal Reserve. He wrote recently to complain about a cover story in the Wall Street Journal that declared victory for the inflation doves over the hawks. Meltzer essentially called the doves lucky. He insisted that the lack of inflation despite the Federal Reserve’s massive growth in its balance sheet was something no one on either side of the divide predicted. I actually seem to recall plenty of deflationists from 2008 to this very day who have scoffed at the notion that the Fed can do anything to stop an eventual deflationary collapse. So, I think Meltzer is too broad in trying to excuse himself for being wrong all these years about the immediate inflationary consequence of quantitative easing (for Meltzer’s dire warnings on inflation early in the crisis see his 2009 interview on EconTalk).

Even more problematic for me is that Meltzer calls on the Federal Reserve to stop paying interest on reserves, the very thing that is containing the kind of increase in the monetary supply that will surely boost inflationary pressures. Meltzer also seems to imply that the Fed should simultaneously raise interest rates and work down the reserves on the balance sheet. These two prescriptions strike me as deflationary. I suppose there is some formula whereby all these can be done in a harmony that can spur non-inflationary growth and avoid deflation, but Meltzer does not make it specific. (It is also possible that the strict limits on article length in Project Syndicate made it impossible for him to clarify).

In 2010, Mletzer wrote in the Wall Street Journal that eventually banks would start loaning out the money currently held in reserves. The only reason to do this would be if banks felt they could make more money than simply accepting the free money from the Fed. Meltzer did not say what would motivate such lending except to suggest that the Fed would get the rate on reserves wrong. Now, three years later, to advise that the Fed drop the rate altogether is to ask for a free pass to make a prophecy come true.

Mind you, I am sympathetic to the case that says the Fed will not be able to contain inflation when it finally starts up again, but the specific mechanism for a reignition of inflation is still not quite clear yet in my opinion. The Fed seems inclined to maintain an accomodative stance well into an economic recovery in order to ensure that the recovery has firm roots. That bias is certainly the seed from which inflationary pressures can (will) grow…but we need that recovery first!

Brigitte Granville wrote “Remembering Inflation” which makes the case for establishing inflation targets as a tool for maintaining the inflation-fighting credibility that central banks need to foster stable prices (see summary at Princeton University Prcess). In her piece on Project Syndicate she concludes by warning that Europe will soon go from depression to high inflation. It is a bewildering prediction given she acknowledges that the European Central Bank cannot raise its inflation target, and its program of “outright monetary transactions” must be accompanied with tight fiscal policies. In many ways, the ECB is acting as if it fears inflation more than deflation. Moreover, Granville notes that as a consequence heavily indebted nations in the eurozone will eventually be forced to restructure their debt with creditors (instead of attempting to inflate away the debt with a devalued currency). Without a devlation in the currency, I have a hard time understanding how such restructuring will trigger inflation. Instead, it is likely to make it even more difficult for borrowers in these countries to access the credit markets, sterilizing an important inflation-generating mechanism.

We inflationists have been premature and even wrong on our inflation expectations. Here on Inflation Watch, I finally acknowledged back in June that it was time to cool my inflation expectations. I still promise to maintain vigil and write related pieces, but it just does not make sense to write in such expectant tones…at least not until something fundamentally changes in the inflation picture. In the meantime, inflationists would do well to avoid predictions of inflation until they (we) can specifically describe exactly how (and when?) the inflationary threat will manifest itself. The odds for an imminent inflationary spiral are NOT 100%, probably not even 80%…


Inflation May Be Dead, But Inflation Watch Is Not

Things have been pretty quiet around here. Every now and then I see a story about rising prices somewhere in the world and think the story would make a great quick post for Inflation Watch. However, I usually do not feel the same sense of urgency I had from 2008 through about 2011 when I felt that rapid inflation was the imminent result of extremely accomodative monetary policy. Everywhere I look, commodities continue to decline in price. Most commodities reached a peak in 2011 and that peak of course had me convinced more than ever that inflation was soon to be a big problem.

Now, thanks to a friend, I am ever closer to accepting that inflation may not be a problem for an even longer time than I expected. He sent me a link to an article called “The Fed won’t taper as long as inflation is low” (by Rex Nutting at MarketWatch) that makes the convincing case that not only is inflation low, but the Federal Reserve has so far seemed powerless to generate the inflation it wants. (I recognize the limitations of government data on inflation, but I do not subscribe to theories that they are concocted specifically to hide true inflation). Incredibly, core inflation is apparently at its lowest point since 1959 (the core PCE price index):

Rex Nutting uses this graph to make the point that all the Fed's QE have failed to go reflate according to the Fed's goals

Rex Nutting uses this graph to make the point that all the Fed’s QE have failed to go reflate according to the Fed’s goals

Nutting also links to a paper from the Federal Reserve Bank of New York called “Drilling Down into Core Inflation: Goods versus Services.” In this paper, authors M. Henry Linder, Richard Peach, and Robert Rich demonstrate that more accurate inflation forecasts come from breaking out CPI into a services and a goods component. Nutting uses this as reference for the claim that the Fed is failing because of global disinflation. This global disinflation is responsible for a decline in the prices of the goods component. Services inflation is much more sensitive to domestic forces (we all know about skyrocketing healthcare and education costs). However, I am not sure where housing sits on this spectrum. It seems to provide a crossroad of forces given housing is not tradeable but foreigners are certainly free to overwhelm a housing market with cash. Foreign demand is reportedly helping to drive up housing prices in some of America’s hottest housing markets like in California and some parts of Florida.

All this to say that, for the moment, inflation is all but dead. But “Inflation Watch”, this blog, is NOT dead. I remain vigilant because I believe that when inflation DOES come, the Federal Reserve will either be ill-equipped to handle it and/or unwilling to snip it early for fear of causing a severe economic calamity. I am a gold investor, and I am eager for another chance to invest in the midst of a commodity crash (I am LONG overdue for an update to my framework for investing in commodity crashes/sell-offs).

The chart below from the Reserve Bank of Australia (RBA) shows that commodity prices remain at historically high levels, mostly thanks to rapacious demand from China. The current relative decline is what is helping to drive goods inflation down. The 2011 peak was well above the pre-crisis peak where prices have fallen now. Also note that prices are much more volatile. I suggest that this chart should remind us that commodity prices are a tinder box that can flare up at anytime. Aggressive rate-cutting by the RBA should also help keep prices aloft.

From the Australian perspective, commodity prices remain historically high although they have returned to their pre-crisis peak.

From the Australian perspective, commodity prices remain historically high although they have returned to their pre-crisis peak.

So stay tuned. Just when everyone finally concludes that the world has reached a golden age of disinflation where surpluses abound across the planet…that could be the exact moment the tide turns.

Be careful out there!

Full disclosure: long GLD


The UK’s CPI inflation to remain stubbornly high for the next two years

On February 7th, The Monetary Policy Committee (MPC) of the Bank of England (BoE) decided to leave interest rates at the rock bottom rate of 0.5%. In doing so, the MPC acknowledged that it was assuming that the current stubbornly high inflation would eventually return to the target 2%. The MPC is expecting productivity gains and the reduction in external price pressures to do the trick.

“Inflation has remained stubbornly above the 2% target. Despite subdued pay growth, weak productivity has meant no corresponding fall in domestic cost pressures. And increases in university tuition fees and domestic energy bills, largely resulting from administrative decisions rather than market forces, have added to inflation more recently. CPI inflation is likely to rise further in the near term and may remain above the 2% target for the next two years, in part reflecting a persistent inflationary impact both from administered and regulated prices and the recent decline in sterling. But inflation is expected to fall back to around the target thereafter, as a gradual revival in productivity growth dampens increases in domestic costs and external price pressures fade.”

I took particular interest in the claim that external price pressures will fade. To do so, the global economy would have to remain weak. If so, then it is unlikely that growth in the UK will fare much better, even at the projected “slow but sustained” pace. The other possibility is that the British pound or sterling – CurrencyShares British Pound Sterling Trust (FXB) – appreciates enough that external prices go back down. If so, then Mervyn King’s hopes of rebalancing the economy with a reduction in demand for imports and an increase in exports surely will not be realized.

Adding to this conundrum for the UK economy is the stubborn persistence of weak economic growth (mainly flat) along with strong employment growth. The UK economy is getting less and less productive and thus less and less capable of offsetting inflationary pressures. This is a dynamic that I will be watching ever more closely given the BoE projects a two-year horizon over which the economy will continue to suffer high inflation and weak economic growth (aka stagflation). The implication for the currency is mixed, and I continue to expect “more of the same” for the pound.


Hong Kong Property Market Defies Tame Inflation

The Hong Kong Monetary Authority just published its Quarterly Bulletin on economic conditions in Hong Kong and around the planet. The HKMA concludes that inflation is tame overall:

“Inflationary pressure eased further, as the underlying inflation rate tapered to a year-on-year 3.8% in October from 4.5% in June. The sequential pressure moderated slightly to an annualised 3.1% on a three-month-on-three-month comparison. This reflected waning food price inflation and moderation in price increases for other major CPI components.”

The slowly growing economy is expected to continue to keep inflation at bay. However, this calm surface masks a still roiling property market. Indeed, the HKMA believes the property market is well ahead of the economy given meager gains in income:

“In the property market, the disconnect between housing prices and economic fundamentals appeared to have become more acute. In contrast to tepid income growth, housing prices surged by a cumulative 23.2% in the year to October. Housing affordability deteriorated as a result, with both the price-to-income ratio and the mortgage payment-to-income ratio rising to their post-1997 highs.”

This is likely a matter of cheap money finding a home somewhere. In this case it is the property market. The government has responded to the growing problem with a series of taxes that seem to be moderating demand.

The HKMA places partial blame for inflationary pressures in the property market on the the Federal Reserve’s recent rounds of quantitative easing:

“Risks to inflation have also increased with additional quantitative easing in the US, through its potential impact on global commodity prices and local property prices.”

Note that the HKMA recognizes that QE in the U.S. will drive commodity prices higher. This dynamic is something Ben Bernanke has refused to acknowledge. With the Federal Reserve adding a “stealth” QE4 in the December statement, I will look to commodity prices to catch bids in 2013…and for central banks to work to try to counter-act the moves of the Federal Reserve.


Wages on the rise in China

Several reports have been published this year documenting rising wages in China. In “Wage Rises in China May Ease Slowdown“, the WSJ notes that these increases may help lower the impact of a slowdown in China as workers have more money to purchase goods (although it is not clear to me how much this helps if a lot of the money goes into buying foreign goods as the article suggests could happen).

The current and projected jumps in labor costs are dramatic:

“…wage income for urban households rose 13% year-on-year in the first half, and average monthly income for migrant workers rose 14.9%, according to data from China’s National Bureau of Statistics. A labor ministry survey of 91 cities in the first quarter showed demand for workers outstripping supply by a record amount, pointing to low unemployment…

…At current rates, China’s private-sector manufacturing wages will double from their 2011 levels by 2015, and triple by 2017, eroding competitiveness and denting the exports that have played a key part in China’s early growth.”

These wage hikes are coming off low levels. For example, as of February of this year, Hon Hai Precision Industry Co, the company that manufactures Apple (AAPL) iPads, reported a 10% increase in base salary for its factory workers to 2,200 yuan ($345) per month.

Moreover, the supply of new, young workers will decrease thanks to China’s one-child policy:

“In 2005, there were 120.7 million Chinese people aged 15-19, according to United Nations estimates. By 2010, that had fallen to 105.3 million, and by 2015 it is expected to dip to 94.9 million.”

Finally the government is forcing the minimum wage and benefits higher:

“China is committed to sharply raising minimum wages, which puts pressure on employers to raise salaries for higher skilled workers. Beijing also has increased requirements for severance payments, which discourages layoffs unless business drops severely.”

It will be interesting to watch what happens to China’s economy as its manufacturing competitiveness declines slowly but surely with the increase in wages.


KB Home faces rising input costs

In its latest earnings report, KB Home (KBH) reported rising input costs. Prices for labor, material, and land are all on the increase. In “KB Home ‘On Offense’ As Its Housing Markets And Pricing Power Strengthen“, I reported the following, including quotes from the Seeking Alpha transcript:

“While KBH is bullish about its business, it is wary about its costs. Costs increased about $1,200 a house, but KBH was able to offset that with pricing. I was a bit surprised that business is strong enough that KBH can actually wield some pricing power, passing on increased costs to its customers. Here is how KBH described the source of the cost increases and their likely impact:

‘We are starting to experience higher costs for labor and direct construction materials such as lumber, concrete and drywall. Through the end of the second quarter, the impact of these higher costs has been offset by sales price increases, which we have implemented in a majority of our communities during the first 6 months of the year. We believe incremental price increases can continue to offset any further cost increases for the remainder of 2012, which should not result in margin erosion but maybe a headwind in relation to our margin expansion plans.’

Moreover, land prices are also on the rise. KBH says that land sellers were the first to detect the improvement in the housing market and they are now able to exert some pricing power:

‘While there’s no question the housing markets are getting better, the land sellers figured it out first. So land prices are going up every bit as fast, if not faster, than home prices are.’

These are signs that the housing market is finally starting a sustained recovery, starting in select markets. For more details on earnings for KBH see “KB Home ‘On Offense’ As Its Housing Markets And Pricing Power Strengthen.”


The costs of raising children in the U.S. continue to climb

On June 14th, the United States Department of Agriculture (USDA) released its 2011 cost estimates for raising children in the U.S. (see “A Child Born in 2011 Will Cost $234,900 to Raise According to USDA Report“). According to this report, the average cost of raising a child in the U.S. rose 3.5% from 2010 and rose 22.5% from 1960 (in 2011 dollars), the first year these data were collected. (Note the USDA cautions that its methodology has changed over the years so comparisons between now and 1960 are not “precisely comparable). The share of expenditures has changed dramatically in certain categories like child care and education, food, and health care. The following chart is from the end of the publication (click image for a larger view), and it demonstrates the big differences in how children are raised now versus 50 years ago:

Expenditures on a child from birth through age 17, total expenses and budgetary component shares, 1960 versus 2011

Expenditures on a child from birth through age 17, total expenses and budgetary component shares, 1960 versus 2011

The amount families spend on children varies greatly based on household income, so these averages hide even more interesting stories. For example:

“A family earning less than $59,410 per year can expect to spend a total of $169,080 (in 2011 dollars) on a child from birth through high school. Similarly, middle-income parents with an income between $59,410 and $102,870 can expect to spend $234,900; and a family earning more than $102,870 can expect to spend $389,670.”

It is clear from the report that the costs increase according to income because of choices families make. Thus, it is not quite accurate to say child-rearing gets more expensive with income. Instead, families tend to choose to spend more on their children the more income at their disposal.

Read/download the full report here.


Olive oil prices continue to drop

In January of this year, olive oil prices fell to 2009 levels. Four months later, prices have fallen to ten year lows. Consumption has plummeted in olive oil producing nations Greece, Spain, and Italy, together responsible for 70% of the world’s production. In parallel, a supply glut has hit the market due to a bumper crop in Spain. Meanwhile, struggling consumers have substituted cheaper oil like sunflower oil.

This price drop has put additional pressures on some of Europe’s poorest regions.

For more details see “Europe’s (olive) oil crisis

 


Hike in minimum wage goes to the ballot in San Jose

Residents of San Jose, CA will vote in November on whether to raise the city’s minimum wage 25% from $8 to $10. The proposed law includes annual adjustments for inflation. This law will be similar to a minimum wage ordinance put into law in San Francisco.

I expect to hear a lot of economists weigh in on this issue, but it was interesting to read one councilwoman say that this is an economic AND a moral issue. Given these higher wages will be paid by businesses and consumers (that is, the law will nt suddenly create new money that was previously non-existent), I think introducing morality will cloud proper analysis.

I am also now interested to know whether anyone has studied the impact of the minimum wage law in San Francisco. It seems strange to me that cities in the same metro area could have dramatically different minimum wages. For low margin businesses that can move, they will prefer to go to lower wage cities. Workers will tend to look for work in the higher wage city but will also face impossibly high housing costs, resulting in commutes that can nullify wage gains. These are just a few examples of things that economists might study.

For more details see “San Jose City Council leaves minimum-wage hike to voters” in the San Jose Mercury News.


Bank of England Admits Currency Depreciation Contributing to Stubborn UK Inflation

Inflation in the United Kingdom has been stubbornly and persistently high since the recession ended –  it is currently 3% and above the Bank of England’s (BoE) target of 2%. The UK has been unique amongst the major economic partners in experiencing high inflation and slow growth since the recession. Through this period the BoE has insisted that it expects inflation to eventually (and soon) decline towards target. Every year that passes without the target getting hit, produces another year of frustration and impatience. Now that the UK has recorded two quarters of negative GDP growth, stagnation has  descended upon the economy.

In last week’s Inflation Report, the BoE made an admission I do not think I have heard before. A reporter asked the expected and on-going question about  the inflation problem. A BoE member answered that the depreciation of the British pound has contributed to driving inflation higher than expected. He noted that the BoE expected currency depreciation to behave as it did in the 1990s when it seemed not to contribute to inflation. Instead, the UK is getting the experience of the 1970s and 1980s. There was no discussion about the lessons learned or what features of all these periods are similar or different. However, I think this is huge progress that at least the BoE has officially recognized that a less valuable currency can still contribute to high inflation.


2012 Illinois State Fair Increasing Prices 40-50%

The price of attending the Illinois State Fair is skyrocketing again. This summer, it will cost $7 for adults to attend for a day, a 40% increase from last year’s $5 admission price. In 2009, prices increased from $3 to $5 in 2009 and broke a 19-year run at the $3 admission rate. It looks like Illinois is playing some bigtime catch-up. Children and senior citizens will pay an extra 50% at $3 per person.

For more details see “State Fair releases concert lineup; admission price increasing.”