Inflation Is Rising – and That’s Great. Guild Investment Management, Jan. 12, 2017

January 12, 2017
 
Executive Summary

1.  Inflation is here.  Inflation is on the rise around the world.  Skeptics assert that inflation is visible only because of a “basing effect” — that is, because commodity prices are stabilizing and lapping the sharp declines they experienced until early 2016.  We disagree, and see fundamental reasons why the global policy sea-change that began in 2016 could help snap the global economy out of its low-growth doldrums.  In any event, inflation on a moderate path such as we are now seeing develop is bullish: bullish for nominal economic growth, bullish for stocks, and bullish for precious metals.  Bondholders should beware:  we believe that in hindsight, we will see that 2016 marked the peak of the 30-year bond rally.  Inflation and interest rates will rise.

2.  Bullish prospects for commodities, thanks to the Chinese yuan.  At some point, the Chinese government will decide to scale back its defense of the yuan against the dollar and against the currencies of its other trading partners.  Since 2014, that defense has been costly in terms of draining China’s foreign reserves.  If a weaker yuan becomes visible on the horizon — in late 2017 or in 2018 — that will provide a powerful incentive for China to lock in prices now for the commodities it needs to support its aggressive urbanization program and keep its rising middle class content.  Potential woes for the yuan could be bullish for commodities.

3.  Market summary.  We remain positive on U.S. stocks.  The U.S. market is prepared to be more choppy moving ahead.  We are optimistic that the longer-term trend in U.S. stocks is up, but small to moderate corrections are possible in any market environment.  We remain optimistic about gold and silver for the intermediate term as inflationary news is popping up all over the world.  Germany, which has negative short-term interest rates, saw consumer prices rise 1.7% year-on-year in November, up from negative last year.  Rising inflation creates demand for gold and other precious metals.  Many argue that it will be hard for gold to rise if the U.S. dollar keeps rising; certainly a strong dollar can slow the ascent of gold, but it has not been able to stop it.  We remain bullish on Japanese stocks on a currency-hedged basis.  We note that in local currency terms, both the UK and German stock markets are doing well.  Once adjusted for the decline of the pound sterling and euro versus the dollar, their performance is not so impressive.  We are watching both markets, and will recommend them if they have a small price correction.  If we do recommend them, it will be on a currency-hedged basis.


Inflation Is Rising — and That’s Great
 
All around the world, inflation is heating up, lending more credence to the thesis that the global economy may at last be emerging from the long, slow-growth post-crisis doldrums.  

Last week, data were released showing a sharp uptick in consumer prices in Germany.  They rose 1.7% year-on-year, the fastest pace since 2013.

Data were also released showing that euro area producer prices continued the breakout from a downtrend that had started in 2011 — finally peeking above zero (that is, out of outright deflation) for the first time since 2013.

German Consumer Prices Rise Sharply

Source: Bloomberg

 

Euro Producer Prices Rise Out of Deflation

Source: Bloomberg


Although Japan’s producer price index is still negative, its consumer prices turned positive in October and continued to rise in November, as the Bank of Japan’s governor Haruhiko Kuroda relished a weaker yen and expressed “stronger confidence” in the country’s inflation path.

In the U.S., the minutes of the Federal Reserve’s December policy meeting showed a committee that is alert to the increasing chance that inflation will rise faster than it has been anticipating.  (Historically, the Fed has often been behind the curve.)

Analysts point out that some of this upswing in inflation is nothing more than a “basing effect” — that is, that many commodity prices have now lapped their recent steep price declines and are rising only compared to their lows.  While this observation is accurate, we don’t believe it’s the whole story.  As we have noted many times, we never bought the “secular stagnation” hypothesis; we believe that the economic slow-growth era from which the global economy is beginning to exit was an artifact of the financial crisis and of the high-tax, high-regulation response that the world’s governments made to it — and of the extraordinary monetary policies that central bankers resorted to as their governments shirked their growth-encouragement responsibilities.  From another perspective, we could say that commodity prices are stabilizing because the outlook for global growth is improving thanks to a changing policy landscape.

Now, at last, thanks to unexpected political developments, the growth baton seems to be passing from monetary to fiscal policy.  In response, inflation — and inflation expectations — are rising.

Those with memories of the 1970s may think inflation is a bad thing.  In the present environment, it’s a very good thing.  As long as inflation remains on a moderate upward path and as long as economic fundamentals are strengthening — which is how conditions are currently developing — it is bullish for nominal economic growth, and therefore bullish for stocks.  It is also bullish for precious metals.

It is, however, decidedly bearish for bonds.  As inflation arrives, interest rates will rise from their negative levels in Europe, and bondholders who bought at negative rates will be hurt.  

Investment implications:  Inflation is on the rise around the world.  Skeptics assert that inflation is visible only because of a “basing effect” — that is, because commodity prices are stabilizing and lapping the sharp declines they experienced until early 2016.  We disagree, and see fundamental reasons why the global policy sea-change that began in 2016 could help snap the global economy out of its low-growth doldrums.  In any event, inflation on a moderate path such as we are now seeing develop is bullish: bullish for nominal economic growth, bullish for stocks, and bullish for precious metals.  Bondholders should beware:  we believe that in hindsight, we will see that 2016 marked the peak of the 30-year bond rally.  Inflation and interest rates will rise.

How China Could Boost Commodities 

In mid-2014, China’s foreign exchange reserves peaked at nearly $4 trillion.  Since then they have been declining as China defends its targeted exchange rate against the U.S. dollar, and increasingly against a trade-weighted basket of its trading partners’ currencies.  Reserves now stand at slightly more than $3 trillion.

China Spends Down Its Foreign Reserves to Defend the Yuan

Source:  Bloomberg

At some point, the Chinese government’s economic calculus will shift, and it will decide that allowing the yuan to decline further or faster is preferable to a continued bleed of reserves.  

If a lower yuan is becoming visible in China’s future, later in 2017 or in 2018, it the Chinese will be buyers of commodities now before such a currency decline gains momentum.  They need to secure supplies of the commodities essential for fueling their massive and ongoing urbanization — and the continued contentment of their new middle class.  (Remember that one of the Communist Party’s key fears is public discontent, which is why they continue to pursue growth relentlessly, even though they may ultimately create a financial crisis in China because of the means they’re using to pursue it.)

The message in brief?  China’s currency woes could be a boon to global commodities.

Investment implications:  At some point, the Chinese government will decide to scale back its defense of the yuan against the dollar and against the currencies of its other trading partners.  Since 2014, that defense has been costly in terms of draining China’s foreign reserves.  If a weaker yuan becomes visible on the horizon — in late 2017 or in 2018 — that will provide a powerful incentive for China to lock in prices now for the commodities it needs to support its aggressive urbanization program and keep its rising middle class content.  Potential woes for the yuan could be bullish for commodities.

Market Summary

We remain positive on U.S. stocks.

The U.S. market is prepared to be more choppy moving ahead.  We are optimistic that the longer-term trend in U.S. stocks is up, but small to moderate corrections are possible in any market environment.

We remain optimistic about gold and silver for the intermediate term as inflationary news is popping up all over the world.  Germany, which has negative short-term interest rates, saw consumer prices rise 1.7% year-on-year in November, up from negative last year.  Rising inflation creates demand for gold and other precious metals.  Many argue that it will be hard for gold to rise if the U.S. dollar keeps rising; certainly a strong dollar can slow the ascent of gold, but it has not been able to stop it.

We remain bullish on Japanese stocks on a currency-hedged basis.

We note that in local currency terms, both the UK and German stock markets are doing well.  Once adjusted for the decline of the pound sterling and euro versus the dollar, their performance is not so impressive.  We are watching both markets, and will recommend them if they have a small price correction.  If we do recommend them, it will be on a currency-hedged basis.

Thanks for listening; we welcome your calls and questions.

 

Tim Shirata
Executive Vice President
Guild Investment Management, Inc.

12400 Wilshire Blvd. Suite 1080
Los Angeles, CA 90025
Tel: (310) 826-8600 Fax: (310)826-8611
email: tshirata@guildinvestment.com
http://www.guildinvestment.com