Fade to Gray
The good news, if the market is to be believed, is that we can forget about the inflation scare. The bad news is that it might also be time to abandon hopes for a strong reopening and economic recovery from the pandemic.
Monday saw the worst day in global stock markets in some months, driven by some combination of worrying headlines about Covid, and news of intensifying rancor in the economic relationship between China and the US. But it’s the shift in bond markets that is most important. Bond markets make the most direct judgments on inflation, and those judgments can be self-fulfilling.
That has had a big impact on the latest update of the Authers’ Indicators inflation heat map, which you can see here. While the row of official inflation data is ugly, the highest in decades, and therefore colored in dark blue, the market indicators are shading gray. As far as the bond market is concerned, the inflationary picture is actually less worrying than it has been for most of the last 10 years.
The heat map is based on 20-day moving average bond market prices, in a deliberate measure to avoid making it too sensitive to one-day volatility. If we used the most recent closing prices, the picture would be much more dramatic.
Two key bond market measures are now below their mean for the last decade (a period when for most of the time deflation was a greater concern than inflation). First, the yield curve (the gap between 10- and two-year bond yields) has dropped below 100 basis points for the first time since February. Generally, the more investors expect inflation to rise in future, the steeper the curve they will demand; in other words, the gap between long- and short-dated yields will widen. A flattening yield curve is a sign of concern about growth, and lack of concern about inflation. As the chart shows, the flattening curve now appears to be a strongly established trend.
Second, the 5-year, 5-year breakeven, which measures the expected average rate of inflation for the five years starting five years hence, or 2026 to 2031 at this point, has dropped to a fresh low; it is far below its standard level in the early years of the post-crisis decade. Crucially, this is the Federal Reserve’s favored measure of inflation expectations.
Effectively, this means the bond market is saying that inflation isn’t an issue at all. It’s no more of a concern than it has been for most of the last decade, and the pervasive problem during that period has been the lack of growth and inflation.
That’s quite something, given what appears in the rest of the heat map. The thick blue stripe for business and consumer surveys shows that businesses are already convinced they are in the grip of cost inflation, while consumers are bracing for price increases ahead. These are based on solid empirical questions. And if businesses and consumers are thinking this way, they are likely to act accordingly — which will drive higher inflation. Meanwhile, the pale stripe for economists’ estimates shows that the forecasting profession, which also has big influence over companies’ and governments’ plans and can easily come up with self-fulfilling prophecies, is convinced there’s nothing to worry about.
Something must give. Whether the map ultimately darkens, meaning inflation, or lightens will ultimately depend on shifts in the categories that are currently ambiguous — the commodity market, and the labor market. And, of course, on the pandemic.
Blame the Pandemic
Why is the pandemic causing renewed angst? It’s not just the market that is growing alarmed. President Biden’s off-the-cuff comment last week that Facebook Inc. was “killing people” by allowing the spread of misinformation on vaccines also showed that the political world is also increasingly rattled.
As is well-known by now, the vaccine has become a political issue, with many conservatives deciding to abstain from it — even though vaccine development was a signature and successful policy of President Trump. Uptake peaked in March (also a point when the bond market started to turn), and has now dribbled almost to a halt, at a point when more than half of the adult population in some states remains unvaccinated.
This is driving concern because of events in the UK, where the delta variant has sparked a new wave of cases that is fully comparable to the alpha variant at the end of last year:
Crucially, the UK has seen deaths continue to flatline, as the population is widely vaccinated. But the issue has turned “freedom day,” as pandemic restrictions are lifted, into a highly contentious event, with even the prime minister and his health minister having to isolate. In places that are widely unvaccinated, like many reliably conservative states, the UK suggests that delta could drive a full-on new wave of infections and deaths. That is a horrible prospect, but an accumulation of anecdotes and incidents now make it seem all too easy to imagine. The effect of that renewed fear can be seen in the stock market.
Fear Stalks Stocks
It’s hard to get too alarmed about a stock market that has only just started to retreat from all-time highs, and appears historically overvalued by many measures. But there are intriguing clues that the pandemic is driving the latest shift away from the reflation trade. First, look at a crude measure of “Covid fear” which I featured several times in the first half of last year. If we look at the S&P 1500 food retailing sector, relative to the S&P 1500 hotels, resorts and cruise lines sector, we have about as pure a distillation of the direct effects of the pandemic on the corporate sector as we’re going to get. As of late February, the Covid fear trade was well on its way back to where it started last year. Since then, it has gained some 38% again. As the chart shows, it is back at its level on “Vaccine Day” on Nov. 9 last year, when Pfizer Inc.’s test results transformed perception of the speed with which the economy could reopen.
Meanwhile, the internals of the stock market continue to show increasing conservatism, even as the overall level stays near records. One giveaway of concern is the strength of quality as a factor — a factor that involves investing in companies with the best defended profits and safest balance sheets. These are the kind of stocks that you can rely on, but are least likely to blow the lights out in good times. As the chart shows, quality had been doing well for a while before going through the roof in the early weeks of the pandemic. Then it followed a familiar pattern, tumbling on Vaccine Monday, and hitting bottom in March. Since then, it has rallied, and quality is now close to the relative high it set last year. This wasn’t in the script, and suggests that equity investors are as worried about growth prospects as bond investors.
The way the stock market is behaving, in short, suggests concern about growth, and specifically about the prospects for a swift reopening after the pandemic.
Oil provided the other reverse for inflation psychology. The OPEC+ cartel has patched together a compromise on raising production that the United Arab Emirates can live with, and crude prices dropped. This was predictable, and a falling oil price will in its own right help to bring down the headline level of inflation (although as Liam Denning has pointed out, OPEC+’s power looks to be ever diminishing as the talk turns to Peak Demand for oil, scarcely a decade after researchers were full of speculation about Peak Oil (that supply had crested) to justify a big increase in the price.
Meanwhile, copper also shed a bit after a long rally. China drives much demand for industrial metals, and the latest fall in copper has much to do with concern about a Chinese slowdown.
Commodities have a complicated effect on inflation. If companies and consumers have to pay much more for the basics, they will be forced to spend less on other stuff, so the long-term effect of a commodity price spike is deflationary. But the short-term effects are directly inflationary. Many say that the rise in oil over the last 12 months artificially distorts the headline inflation number, and they have a point. To remove that base effect, here is how copper and Brent crude futures moved over the last two years:
Over the last 24 months, oil has inflated at an annualized rate of a little less than 5%; not the material for a major upward secular shift in inflation. The rise in copper price does look rather more significant, however, even after removing the base effect. Industrial metals prices do register concern about the Chinese reopening at this point; they don’t suggest any significant shift toward deflation.
Another problem with raw materials is that their prices are volatile, and linked to sentiment in other markets. For example, traders in inflation-linked bonds will use crude futures as a hedge, so bonds and energy markets can have a direct effect on each other. To combat this, the indicators include the Thomson Reuters CRB Raw Industrials index, generally referred to as the RIND, which includes a range of basic materials that aren’t covered by the futures market. The constituents have an “old school” feel about them: Industrials include burlap, copper scrap, cotton, hides, lead scrap, print cloth, rosin, rubber, steel scrap, tallow, tin, wool tops and zinc; while foodstuffs include butter, cocoa beans, corn, cottonseed oil, hogs, lard, steers, sugar and wheat.
The theory of including this index was that it would reflect underlying supply and demand in the economy, and would be less prone to distortion by futures market trading. If that theory was right, then the RIND is sending a signal that there is real inflation out there. The one dark square in the commodities row, the index has been rising almost uninterruptedly for more than a year and is close to its all-time high. It is very different from the mainstream CRB index, which is based on futures prices:
For a number of reasons, the case for inflation in the short term has weakened in the last few weeks. The risk of more Covid shutdowns and a Chinese slowdown will have that effect. The indicators capture this. But the point of the heat map discipline is to force us to pay attention to all the relevant developments. And the RIND index, combined with the complaints about higher costs from corporate executives in surveys and in earnings calls, shows that there are some genuine inflationary pressures out there. If the effects are transitory, we should expect to see the RIND index, and the business surveys, calm down over the weeks and months ahead. If they don’t (perhaps because Covid doesn’t return as fiercely as feared), then we should prepare for another dose of inflation angst. Keep watching this space.
I enjoyed a long weekend in the leafy confines of Western Massachusetts. The clouds opened several times, but not before we got through an entire family concert in the shed at Tanglewood, which is where the Boston Symphony Orchestra retreats for its summer season. It was that rare concert that every member of the family genuinely enjoyed, led by a great and charismatic trad jazz musician I had never heard of before called Byron Stripling. This is his account of St James Infirmary, one of the greatest of the New Orleans jazz standards. For comparison, you can try the same song by Louis Armstrong, Cab Calloway (with a guest appearance by Betty Boop), Arlo Guthrie (who talks for a while at the beginning of the clip), The Standells, the remarkable Hugh Laurie (on both solo piano and vocals), and the Preservation Hall Jazz Band, the guardians of New Orleans jazz. It's a song about seeing a body in the morgue, and yet it gives rise to endless reinvention and inspiration, which is joyous for all the family. Thank you, Mr. Stripling.