Inflation Is The Main Story Of 2018

Retail Sales Hurt GDP

As it turns out, Q1 2017 had poor GDP growth because of weak consumer spending growth. The poor January retail sales means Q1 2018 might have weak GDP growth. As a result of the retail sales report and the CPI report, the Atlanta Fed GDP Now estimate for real consumer spending growth fell from 3% to 2%. This pushed the GDP growth estimate down from 4% to 3.2%. As I mentioned in the last article, consumer spending growth in Q1 2017 was 1.1%. The Q1 2018 result will be determined by the next 2 months of reports. It’s too early to tell what the final number will be, but based on this retail sales weakness, I think the 3.2% forecast is too high. The ISM reports are usually too bullish. They shouldn’t be taken seriously by the Atlanta Fed forecast model.

Inflation Is Here

CPI increased 0.5% month over month in January. This beat expectations for 0.3% growth. As you can see in the chart below, this is the highest rate since September 2017. The September report catalyzed further hikes by the Fed, so this report will also be important to setting monetary policy. Core inflation was up 0.3% month over month which beat estimates for 0.2%. The headline CPI was 2.1% on an annualized basis which beat expectations for 1.9%. Core CPI was up 1.8% which beat estimates for 1.7%. As you can see, the Fed’s goal of 2% core inflation still hasn’t been met. It’s notable how global growth and a fiscal stimulus did more to boost inflation than the dovish monetary policy this cycle. The worry about runaway inflation is overblown. I’m expecting 2% core inflation to be hit this year, but I’m not worried about inflation getting too high.

Energy prices were a big driver of headline inflation as fuel oil was up 9.5% and gasoline was up 5.7%. On a year over year basis gas was up 8.5% and fuel oil was up 22.5%. One notable issue, which I’ll keep an eye on, is that some are proposing an increase to the gas tax to pay for infrastructure improvements. On the one hand, the economy doesn’t need anymore stimulus. On the other hand, improvements to roads and bridges doesn’t boost the economy like new infrastructure does. The best way to improve growth would be to invest in internet accessibility. Food prices were up 0.2%. Food away from home was up 0.4%, which is its biggest gain in a year. It was up 2.5% annualized. Clothing prices were up 1.2%.

Monetary Policy

The inflation increase shows us that monetary policy isn’t the only aspect that affects inflation. This report shows Yellen was right that the inflation deceleration in 2017 was transitory. The report boosted the odds of a March hike from 78.9% to 83.1%. I think the rate hike is guaranteed. There will be a hike even if the February CPI disappoints. There is now a 62.7% chance of at least 3 rate hikes in 2018. I think there will be either 3 or 4 hikes.

Powell’s first meeting, which is in 36 days, will be very important to understanding what direction policy will go in. I think the Fed will be positioned very hawkishly in 2019 which is why I think a 2020 recession is possible. Speaking of recession predictions, the yield curve recently flattened to 72.5 basis points. I think the peak of 78 basis points will be highest rate in years. It will flatten to an inversion in the next few quarters. When it starts steeping again in 2019 or 2020, that will be the final recession signal.

Using The 1960s As A Model

As I have mentioned for a few months, I think 2018 will be the year where inflation increases. We can see this play out with the CPI results and the 10 year bond yield nearly hitting 3%. It’s worth noting that stocks have rallied after the correction which was supposedly caused by the increasing 10 year bond yield. This shows us that rates weren’t the cause of the decline. It was caused by the short VIX trade unwinding and the shift in sentiment.

It’s important to have a working model to forecast where various asset classes and stock sectors will go when a certain catalyst is triggered. The catalyst for 2018 is higher core inflation. The chart below shows the core inflation in the 1960s compared with the core inflation in the 2010s. The speed at which inflation can pick up is notable. We’ve been so used to low inflation, that it seems almost impossible for it to get above 3% let alone cause serious problems. That mind set needs to be avoided because it has recency bias. While I don’t think runaway inflation will be a problem in 2018, it can be a problem further down the road.

If inflation increases like it did in the 1960s, the chart shows how various sectors could perform. The overall market was only up 2% from 1966 to 1969. That’s disconcerting. With valuations so high now, I could see a cool off period occurring. As you can see, yields increased dramatically, utilities and telecoms went down, and bank stocks went up. Unfortunately, this chart leaves out technology. That might be on purpose because the technology stocks of today are nothing like the firms in the 1960s. It will be interesting to see how the sector reacts to inflation. Tech drives the direction of the overall market.

Conclusion

The theme of 2018 being a year where inflation heats up has been reinforced by the CPI report. We’re far away from inflation causing stocks to underperform, but it’s something to watch out for in 2019. I think 2019 will be a rough year for stocks because of the ECB and Fed QE tapering and the increasing interest rates. For now, investors get to watch stocks go up on great earnings which are boosted by synchronized global growth and the tax cut.

Spread the love

Comments are closed.