It’s been a long time coming, and it still might not get here much next year, but inflation is coming, at least according to a recent report from Bank of America Merrill Lynch. The December 11th BAML report is titled The Long March from Inequality to Inflation, and Chief Investment Strategist Michael Hartnett and colleagues suggest that 2016 is likely to be a transitional year as the U.S. and a good chunk of the global economy work through the vestiges of deflation and begin an inflationary cycle. They also project generally low returns and high volatility in global financial markets over the next 12 months.
The BAML team explains their perspective on inflation in the introduction to the report: “We believe in a deflationary “Transforming World” and do not recommend a wholesale flip from inequality to inflation. But positioning and event risks argue some inflation hedges must be owned in 2016 (e.g. TIPS, JGOLD, Brazil rates). Big outperformance of “inflation plays” first requires +4% global GDP, 3-4% wage growth, a bubble in “ubergrowth” tech, geopolitical & electoral events that force a policy flip to fiscal stimulus.”
Inflation – Impact of Fed rate hike
The U.S. Federal Reserve will very likely raise the Fed funds rate by 25 basis points next week, bringing to an end an amazing 84 month period where the Fed has maintained rates at zero. Hartnett et al. highlight that a great deal has changed in the global economy since 2006:
For example. U.S. housing starts were booming at 2.35 million a year in 2006, Saudi Arabia’s stock market was moving up fast, Chinese markets were just beginning to run, and Apple was still developing the iPhone.
In 2015, housing starts are down to close to 1 million per year, Saudi Arabia has just been downgraded by ratings agencies, Chinese debt deflation is reducing growth markets to babies, tourists and capital outflows. By the same token, global central banks have purchased a remarkable $12.4 trillion of financial assets since 2007, and Apple’s iPhone is now the biggest thing in retail sales.
The BAML analysts note that the impending Fed rate hike will “end an era of breathtaking central bank largesse”, and occurs “against a unique macro backdrop of deflation, default risk, tech disruption and great inequality between Wall Street & Main Street in the past 10 years.”
Volatility to return in 2016
Given that both interest rates and corporate earnings will be held back by a backdrop of “deflationary expansion”, the recommended asset allocation from the BAML team remains long the U.S. dollar, long volatility, long stocks>bonds, long DM>EM, long IG>HY and short commodities. Overall they argue that low interest rates + low earnings growth = low asset price returns. Table 2 shows that the BAML team’s projected returns for most assets classes are very low in 2016 (except for Japanese stocks (+10%) and EM stocks (-10%)).
Hartnett and colleagues offer a warning on the risks of extreme volatility as the Fed rate hike cycle unfolds in 2016: “We believe these future returns are likely to be associated with higher volatility in the form of “pain trades” and “flash crashes” as an era of zero rate policies comes to an end, and rising rates clash with rising regulation for the first time in the post-Lehman era.”
Capitulation of the 4 “Cs”
The report also highlights near-complete agreement on a Fed rate hike and ongoing Chinese currency devaluation are “causing capitulation into and out of the “4Cs”: commodities, cyclicals, credit and California.”
In terms of capitulation out of commodities, high-yielding Master Limited Partnerships are down 23% in six trading days, the South African rand is down 6% in just five trading days, and the BCOM commodity index has broken down to levels not seen since 1999.
Capitulation out of cyclicals can be seen in that the TRAN (U.S. transportation) index has plummeted 10% in the last 12 trading days, and the ADXY index (Asia FX) is also approaching six-year lows.
Moreover, capitulation out of credit can be seen in CCC high yield bond yields skyrocketing to 17% (the highest levels seen since 2009) before the first Fed rate hike is even official.
Finally, the BAML team highlights “capitulation into California”, highlighting that the “net worth of Silicon Valley’s top 4 executives = $180bn, a figure in excess of the Rio de Janeiro’s GDP and 6,500,000 population (Chart 4 shows the relative performance of Amazon versus the Alerian MLP ETF).”
Wall Street is increasingly polarized
Another consideration is current investor positioning reflects secular and social trends which do not encourage optimism that the economic recovery will continue to move forward much in the near future.
It boils down to the fact that in a “world of rapidly rising processing speeds, the virtual dominating the physical, lengthening lifespans and shrinking labor forces is deflationary.”
Moreover, the general decline in stability across the globe is resulting in consequences such as migration and terrorism. The current state of economic inequality and insecurity in many electorates is leading to populist policy proposals designed to restrict the free flow of people and capital to raise wages, or to significantly raise taxes on the wealthy (such as California’s Proposition 30).
