We’ve been publishing like demons this summer, so I thought it was a good idea to let the most recent Epsilon Theory notes (“The Arborist”, “Horsepower”, “Gradually and Then Suddenly”) breathe for a bit. I’ll be out with a new note next Friday, but because I can’t help myself I’ve got a few things to say today in this email, basically a where-are-we-now summary of my macro views presented without metaphor or movie quotes (I know, I know … takes all the fun out, but everyone needs a Cleanse now and again).
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Inflation And Interest Rates
I think that inflation and interest rates are headed up, and will be moving up for a long time, with all the caveat emptor implications that brings for investors. Here’s my argument, based on my answers to the following Big Questions.
1) Is the relationship between employment and inflation structurally broken?
This relationship goes by different academic names, like the Phillips Curve and NAIRU (Non-Accelerating Inflation Rate of Unemployment), but the basic idea is that there’s a supply and demand of labor, and if the demand for labor (jobs open) is marginally greater than the supply of labor (job seekers), then the price of labor (wages) has to go up. So at some point the unemployment rate gets low enough that wages start to go up pretty quickly, and that point is NAIRU. If you’re asking whether NAIRU is structurally lower today than it was last cycle, my answer is yes, absolutely, and for all the reasons people talk about, including me. But is NAIRU no longer a thing? Unless you’re willing to say yes to that second question, and I’m not, then you have to expect wage inflation to pick up significantly over the second half of this year as the unemployment rate continues to decline.
2) Is the clown show in Washington going to get better over the next few months or few years?
Unless you’re also willing to say yes to that question, and I don’t see how anyone in their right mind would, the dollar remains weak. That means commodity prices continue to rise and emerging markets continue to inflate. BTW, if you want my take on the current state of American politics, where the GOP is now a giant Robert E. Lee statue and the Dems are now a giant Brezhnev statue, read “Virtue Signaling, or … Why Clinton is in Trouble”. I wrote this last September, and it’s aged pretty well, I’d say.
3) Is the Street begging for Gary Cohn as Fed Chair and the creation of a reflation/rotation narrative? Is Trump desperate for a reflation/rotation narrative going into the 2018 elections?
YES and YES. The hallmark of a reflation/rotation narrative is a yield curve steepening for the right reasons. Because, you know, tax reform is just around the corner and the real economy is strong and bank stocks are going to rock. Mark my words, that’s going to be the Wall Street story around Cohn when the White House anoints him as the next Fed Chair, as the anti-Yellen in image if not in policy. That narrative then becomes a self-fulfilling prophecy as small businesses embrace the story with loan demand and as banks reduce lending standards to push, push, push that high net-interest-margin money out the door. That’s when the velocity of money gets up off the floor, as do inflation expectations. It will happen fast, and everyone will be shocked – shocked! – that inflation still exists in the world and that Fed policy normalization will push the inflation genie out of the bottle faster, not stopper it up.
4) How can you have inflation when auto sales (and maybe home prices) are rolling over, when telcos and pharma are cutting prices, when technology is doing its deflationary thing, etc.?
Look … I agree with everything that the deflationistas have been saying for all these years. Massive global debt is a millstone around our collective neck. The reality of this world is a long gray deflationary slog just as far as the eye can see. But that doesn’t mean you can’t have wage and commodity inflation, too, or at least enough to create a reflation story when it is politically necessary. Narratives have trumped reality (no pun intended) for a long time now. And for a long time to come.
As always, you’d be doing me a favor if you spread the word about Epsilon Theory, where we’ve got a new Markets + Technology piece up this week from our AI guru @NevilleCrawley. Also, now would be a good time to catch up on the latest installment in the serial magnum opus from @WRGuinn. As my partner Jeremy Radcliffe likes to say, if you’re not reading Rusty’s notes, you’re doing it wrong!
All the best,
W. Ben Hunt, Ph.D.
Chief Investment Strategist