The Inflation President?
From the December 13, 2016 HRA Journal: Issue 262
Vive Le Trump. Vive Le DJIA!
It’s all good. Unless you own gold stocks. We’ve endured a couple more weeks of pain. All bottoms have been false bottoms so far. We may have to survive a couple more but the FOMC meeting tomorrow should set the tone. I’m betting on higher gold prices going through year end. I am hedging my bets a bit though. Note that most of the “”buys” and “strong buys” in the update section are predominantly exploration stories. Those can buck the trend if they deliver and move even more if gold puts the wind at their back.
The other buys are base metal deals. Those markets look much better than precious metals of course, especially zinc. I expect more strength from The Galvanizer in 2017 and think you should trade accordingly. I’m a little less confident about copper but China keeps buying it so perhaps the worst is over there. Most of the updates for copper stories involve companies that are either fundamentally strong or that have exploration potential so I don’t think they would be harmed if copper softened a bit.
The chart on this page paints an interesting picture, one that goes against the political orthodoxy in Washington. The numbers in the chart aren’t unknown to legislators. Anyone can build a chart like that from readily available data from the Congressional Budget Office.
Republicans of the supply side/Tea Party/ Grover Norquist camps aren’t fond of this chart, especially the supply siders. It messes with their narrative that tax cuts will magically result in higher net revenues due to an explosion in growth rates. That was the argument behind the Regan tax cuts. You can see from the chart below that The Gipper was the champion when it comes to percentage increases in the US debt load. He undertook a series of legislative initiatives that sound a lot like what Trump is talking about.
Tea Party activists will of course point to Obama as number three on the hit parade and the president who oversaw the largest absolute increase in the debt load.
Fair comment, though in Obama’s defense much of that increase traces back to the Financial Crisis he had nothing to do with creating.
The US government has been deadlocked for years so I don’t think any president would have made progress on anything through that period, regardless of their political leanings.
The second biggest growth in debt came during the tenure of Bush the Younger. Bush, like Regan, instituted a couple of large tax cuts, and he had a couple of wars to deal with. Bush also tried a tax holiday for earnings of US companies held overseas, similar to Trump’s proposal. Most of the repatriated funds ended up getting used for dividends, share buy backs and executive perks. So maybe my comment in the last issue wasn’t that cynical after all.
The reason for showing the chart is that its as familiar to most bond traders as it is to legislators. There is a good reason that bonds started tanking as soon as Trump was elected. The Wall St spin is that everyone now expects much stronger growth. Perhaps, but I think its deficits that bond traders were worried about.
Bond guys tend to be cynics when it comes to growth projections. They weren’t sucked in the last couple of times Wall St projected a growth acceleration and I see no reason to think they have been this time. They’ll believe the growth acceleration when they see it.
I’m skeptical about it too, as you well know. I hope to be proved wrong. Perhaps the mad run Wall St is having will trickle down and everyone will become hugely optimistic and spend like mad. Maybe, but we haven’t seen widespread income effects from the long bull market since 2009 yet. I’m not sure why the latest up leg should be different.
That brings us to the chart on this page from Gavkal. Wall St is marking up anything vaguely related to a potential “surge” in infrastructure spending. I hope Trump pushes those infrastructure bills through. The US certainly needs the upgrades. As a guy who follows mining stocks, I’m not going to complain about a bit of irrational exuberance in the base metal markets after five years of pain. Bring it on!
That said, I do want readers to have some context for that “massive” infrastructure program. The chart above compares US government fixed investment, US private fixed investment and Chinese government fixed investment for the 2011-2015 period.
Based on these figures, Trump’s planned program of $1 trillion over ten years is a fairly large increase to existing US government infrastructure spending, roughly 50%. It pales in comparison to both private sector spending but especially to Chinese government spending.
For the 2011-2015 period the Chinese outspent the US 20 to 1 on infrastructure. That’s not surprising to anyone who follows metals market and knows where the demand is. Wall St and Main St in the US are all aflutter about Trump’s plan but its close to chump change viewed on a national scale.
Don’t get me wrong. I’m glad he’s calling for the spending, I just don’t think the actual impact will be anything like the currently perceived impact. I’m sure Premier Li is rolling his eyes and thinking “$1 Trillion? What small hands you have President Trump!”
Trump won’t be inaugurated until January 20th. We won’t know how many of his grand promises he will deliver on for months. We’re already starting to see push back from his own party though. There are plenty in the Republican caucus vowing to vote against tax cuts that don’t have matching spending cuts.
There are just as many, if not more, free traders in the Republican caucus in both the House and Senate. They’re not happy about Trump’s threats to impose tariffs unilaterally. Here again, we don’t know how much of this is just bluster. Based on tweets being fired around by the president elect he seems serious about punishing both offshoring companies and countries he thinks trade unfairly.
It’s too early to tell who will win these fights but I don’t think Trump will get the free rein so many in the market assume. If he does, and if the recent exuberance translates to real spending and wage gains then higher inflation is baked in the cake. The combination of higher debt loads and higher monetary velocity would all but guarantee a move of at least a few percent in the inflation rate. I don’t know if the US economy could handle that.
Adding even 3-4% to prevailing interest rates—which would just take them back to historic norms—would guarantee trillion dollars plus US federal deficits as far as the eye can see. I don’t think even the most rabid Tea Party caucus could cut spending enough to avoid that outcome. I certainly don’t see the Fed getting in front of the curve in that scenario. They would tank the US economy if they tried.
Basically, there seem to be two potential scenarios going forward. Either the markets are right and we’re about to see a sustainable acceleration in US growth that pulls the world along with it or the markets pull back once traders realize the economy isn’t reacting the way Wall St currently assumes.
The jury is still out but I think the second scenario is more likely than the first. With markets in the grip of a massive reflation trade I don’t think we’ll get the true measure of much of anything for at least a few weeks.
Year end rallies are an annual event on Wall St. In a year like this where traders feel something “game changing” just happened they buy even harder. Things get even more frenzied when funds pile in so they can be seen to be in winning indices when they send out statements to unit holders at month/year end.
Several of the largest US equity indices are showing the highest relative strength readings in the past 10 years. So too are a number of yield tracking ETFs. Moves like that don’t last long. We could see it continue through year end but I don’t see it carrying on longer than that. Once funds have finished window dressing lot of the momentum traders will want out.
Longer term, watch the same measures that have been good growth predicters through the past couple of years, namely hourly wages and retail spending. The retail numbers last month were good but hourly earnings disappointed again.
With OPEC cutting a deal and oil prices moving up we should see the first year over year energy price increases in a long time. Keep this in mind as its likely to put some upward pressure on both inflation AND consumer spending numbers.
A large move in gasoline prices adds to the retail sales number but it doesn’t do consumers any good. Beware of false flags like this in the next month or so. I wouldn’t expect the bond market to get sucked in by that sort of move. Let’s hope not. If its taken literally and yields run up another half point things could get nasty.
That brings us to the gold price, the USD and the Fed announcement that will take place the day after you get this issue. I’ll be travelling the next couple of days. I’ll try to get an alert out post meeting but I may not have the internet access to do it.
I’m assuming the Fed raises the main discount rates by 25 bps as virtually everyone expects. The bigger question is how the markets react to it.
The key to that will be in the dot plots that lay out expectations for rates and growth in 2017 and 2018. The FOMC wants to raise rates. That’s no secret. But they don’t want to dive bomb the economy in the process. Most public speeches by FOMC members talk about the accelerating economy. That’s window dressing. They ALWAYS talk about that. Not because they are dishonest but because they realize how heavy an impact their words can have. None of them want to be fingered for causing a crash.
The dot plots are a better measure of what FOMC members really think. They are anonymous and averaged to calculate a “central tendency” number for estimate of interest rate levels and growth for the next two years.
I find it hard to believe most FOMC members are caught up in the post election euphoria. Maybe they are but I doubt it. I expect the dot plots to indicate no more than three rate increases for 2017 and it may only show two. If it’s the latter, we could see a substantial relief rally in bonds and gold. It could be stronger still if Yellen talks about rising inflation in her press conference.
Things could of course go the other way if it looks like the Fed is serious about raising rates several times. Its possible but not likely since year over year growth trends still haven’t moved up much. Even in a robust environment it takes a few months to really move year over year measures. The FOMC has been faked out by growth spikes a couple of times in the last four years but Yellen was often the one who wasn’t sucked in.
Near term, its all about positioning. Traders on Wall St REALLY want to get the Dow over 20,000 by yearend. We’re pretty close now. If the Fed sounds less that hawkish this week that may be enough to finish the job. Beware of selling as soon as the calendar page flips over though. With the current relative strength readings even moving indices higher for two weeks will be a tall order.
We have the opposite situation in the gold and USD markets. The speculative long position in the gold market isn’t as low as I’d like but it is the lowest its been since January. It’s probably moved lower since the last COT report. US Dollar longs are at multi year highs, even though the greenback has been treading water for a few sessions.
Barring a more hawkish Fed statement than I expect we seem to be set up for a “sell the news” event after the rate announcement and press conference. The selling in the gold market has been every bit as relentless as the buying of the DJIA and SPX.
I think the odds of at least a short-term bounce in gold prices is quite good. Its also possible that turns into something more lasting if the Trump rally starts to really fade as we head into and through January. Gold sentiment is near all time lows and most technical analysts are calling for a double bottom. That is a real enough risk but sentiment is often the deciding factor at bottoms. We seem to be running out of sellers.
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