Deflationary Dynamics

No, I am not talking about the US markets directly. Do not call me a "Doomer". Today we discuss empirical data across the globe.

Nov 12, 2023

Highlights

Conditions in China are deflationary. While there is a long way to go for there to be “deflation” in Europe, given the negative PPI, such deflationary risks are present in the Eurozone.
Consensus forecasts are calling for a large deceleration in US CPI. My view is that inflation either continues to accelerate for the reported month of October or inflation does not fall fast enough for the crowd. There is a higher probability that their forecast will be wrong, which will perpetuate more US bond market volatility. Re-short HYG (high-yield credit) as a hedge.
There is a favorable setup for owning USD, and cash yields are 4.5%-5%. The currency also is a strong investment if further credit risk in US markets continues to manifest. In the US, negative FX tailwinds from 2023 will turn into negative headwinds during Q1 of 2024.

Happy Weekend!

I have been considering a re-brand for the title of this publication. The initial name “Friday Reading” came from my desire to publish before the weekend started to inspire thought throughout the weekend. Realizing that my timing recently has been somewhat inconsistent, do not sue me, life comes at ya fast! There will be a general range between Friday and Sunday publications going forward, so I will look to utilize a name that is much more suitable.

Not going to make this any longer with a monologue today, but I will briefly state the importance of having an adaptable mindset given I am talking about changing the name of the publication. The same concept needs to be applied to an investment process. Focus on what works and change what does not. It is critical to be open to new ideas and change from losing ideas quickly specifically when investing. Ride winner and fade losers.

Some of the largest US companies by market cap have a significant amount of business overseas that would be impacted by their local markets’ disinflationary and even further by deflationary conditions. These companies also face the potential for significant FX headwinds from international business in the rate of change terms on the current USD trajectory. An example would be Apple doing business in China (currently a deflationary market) where they face increased competition and may potentially lose pricing power. A stock that has already lost pricing power is TSLA (the stock has not done very well compared to the other Mega-Cap names). This discussion is a detailed thought process that tells a story based on the three highlights above in order.

Macro

Let’s start by looking at “markets” from a global perspective. Earlier this year in May, I wrote a publication named, “Particular Point 2.0”. Looking back at this piece, I recognize that my former thoughts on US Q2 GDP were dead wrong. That is fine because, by the 3rd quarter of this year, I had adjusted my views to be on the right side of this recent US Q3 GDP acceleration (talk about adapting). The reason why I am highlighting, “Particular Point 2.0”, is because this is where I first discussed the deflationary dynamics in China. Read here.

Earlier this year, the popular “trade” was China re-opening. Fundamentally, this made sense given the growth-oriented data inflecting and accelerating positively on paper. However, in May, I grew skeptical of this “trade” and growth acceleration due to the increasingly negative PPI data. My thoughts were that economic conditions would eventually turn deflationary given the deep negative deceleration in PPI data.

PPI is an abbreviation for the “Producer Price Index” and this data often front-runs CPI data (Consumer Price Index). Negative PPI historically in China coincided with periods of economic recession. Notably, 2002 and 2008. This metric has been negative for the last 12 months and most recently decelerated to -2.6% (October) from -2.5% (September).

China's PPI year over year

*Source: Tradingeconomics

China's CPI year over year

The original assumptions about the deflationary environment were correct. China’s CPI decelerated to a negative -0.3% in July of 2023. Following the most recent data for October, CPI decelerated for two straight months into negative territory once again. Since May 2023, the Hong Kong Index has been down -11.75% and the Shanghai Index is down -7.16%. The bear market continued and the Hong Kong Index has been in a bear market since the summer of 2021.

*Source: Tradingeconomics

Going back to 2000, there have been six events in China where the PPI went negative and as of July 2023, the CPI followed for now five of those six events. The only outlier was the 2015/2016 time period.

Deflationary conditions are notable because this can result in a significant loss in pricing power for companies that do business in those markets, which in turn impacts the profitability of those companies.

Additionally, will China’s central bank continue cutting rates and or providing economic stimulus under these conditions?

Eurozone’s PPI year over year

There is a similar, but different dynamic currently playing out in Europe. Perhaps the Eurozone will be impacted by similar economic conditions. I will highlight the key differences in the Eurozone circumstances below. Eurozone PPI continued to decelerate to -12.5% (September).

*Source: Tradingeconomics

Eurozone’s CPI year over year

The deceleration continued to +2.9% for October 2023.

*Source: Tradingeconomics

Notably, these exaggerated downside movements in both CPI and PPI can be attributed to very difficult/ steep base effects from 2021 and 2022. What this means is that both CPI and PPI accelerated in epic proportion during those prior years, and gravity takes this down on the other side with minimal effort required.

These anomalous accelerations were caused by last year’s natural gas and energy crisis which was a result of the Russia-Ukraine conflict. The squeeze in energy prices sparked a massive rate of change acceleration, and the newly reported data is being compared to that period, so the data is skewed to some degree.

However, starting with next month’s reported data for both CPI and PPI, these base effects will be easing.

This means the future reported data over the next several months will be compared to a line with a negative slope.
The falling slope of the comparable data points theoretically would create easy conditions for acceleration in these data points. Similar to what was seen for US CPI data from June 2023 through the end of this year.
If Eurozone CPI and PPI data continue to fall against the easier base effects, then that would be a very large signal about their poor economic conditions.

Eurozone’s GDP year over year

Their GDP is on the verge of going negative and has been six consecutive quarters.

*Source: Tradingeconomics

Why am I highlighting these conditions?

First, decelerating economic growth and decelerating inflation create a negative economic environment for local asset prices.
Next, disinflationary or deflationary conditions create pricing power problems for companies who do business in those markets.
Lastly, if the economic growth conditions continue to deteriorate and inflation does not rebound against easing base effects, then would the Eurozone Central Bank need to start cutting rates?

US Inflation Data and Consumer Expectations

Meanwhile, the circumstances are different in the United States. We are coming off a recent acceleration in US Q3 2023 GDP and a re-acceleration of inflation. Below I will highlight this dynamic and why it is important for an immediate term basis. The thoughts on inflation are currently very short-term and will be explaining what may change in the future during this week’s Macro Madness Live discussion. Sign up with the link here.

Speaking of “particular points” in time, there is a CPI report next Tuesday, November 14th. According to Morningstar, “The Consumer Price Index report for October 2023 is forecast to show a continued overall decline in inflation, led largely by moderating energy prices”.

The CPI year over year is forecast to rise 3.3% in October after rising 3.7% in September. This would be a 1-month deceleration.
As of Friday morning, bond markets were pricing in a roughly 91% chance that the central bank will keep interest rates steady at its December meeting.

Now that the stage is set, time to look at some numbers. First, it is important to note that Oil prices generally flow into CPI at a one-month lag. This means that this next CPI report for October will largely be impacted by Oil prices from September. I understand that the price of Oil has since fallen from the local September peak but for this upcoming report, the Price of Oil ended the month of September accelerating to $89 on average for the month.

What is also interesting is that according to the University of Michigan Consumer Report, 1-YR and 5-YR inflation expectations accelerated for both the months of October and November.

There is not a clear lead-lag relationship but historically there have been periods where 1-YR consumer inflation expectations lead CPI reports. The University of Michigan reports are also higher frequency. In the case of right now, consumer inflation expectations for October and November (2 reports) have been released before the singular October CPI data.

Going back to 1978, there is an R-squared relationship of 0.83 between 1-YR consumer inflation expectations and reported CPI. This is a very strong positive correlation between the two data sets.

Additionally, see the charts below indicating that the University of Michigan 5-YR Inflation Expectations are making a new 10-YR high.

United States Michigan 5-Year Inflation Expectations

*Source: Tradingeconomics

Key Takeaways

US Consumer Inflation Expectations are currently entrenched or “well anchored” into society as the Fed would say.
Both 1-YR and longer-term 5-YR inflation expectations are continuing to move farther away from the Fed’s objective 2% inflation rate.
Why wouldn’t US rates be higher for longer? At least on an intermediate-term basis.
The consensus is basing their forecast for a deceleration in this next report based on “moderating energy prices”. If the October report is considering September Oil prices at a one-month lag, then will the consensus be majorly caught offside on Tuesday?
Regardless if the report accelerates or does not decelerate as fast as the consensus hopes, anything short of their expectations in this case creates volatility in the bond market with the current pricing of “no hike” in December at 91%

I am not here to argue whether there will be an additional hike or not in December. What I do think is interesting is that the current short-term setup seems very easy for there to be additional US bond market volatility. Outlining the market uncertainty below.

→ Bad economic data → The Fed is done hiking→ Rates go down

→Deficit spend increase→ Translates to short-term GDP growth→ Rates up

→ Bad economic data → The Fed is done hiking→ Rates go down

→Bad 30-YR UST auction from deficit and inflation expectations→ Long rates up

→Inflation higher or more persistent than consensus expectations→ Rates up

→ “Bond market: nothing makes sense”→ More rate volatility

FX: USD and Rate of Change

Above I have highlighted a few core dynamics.

China's deflationary conditions and need for further government stimulus to boost their economy. This would mean more rate cuts (US rates more attractive) or further debasement of their currency.
Eurozone deteriorating economic conditions and deflationary risks potentially result in faster ECB policy easing and potential rate cuts. Setup: one, the ECB does not cut rates and Europe's economy continues to tank causing the Euro to down. Two, the ECB cuts rates and US currency rates are more attractive which devalues the Euro, so the Euro goes down against the USD.
US inflation expectations are well anchored and there is a possibility for a continued short-term acceleration of US inflation. Also, the possibility for US inflation to remain persistent until year-end. US rates are higher for longer (at least for now).

This is a favorable setup for owning USD, and cash yields are 4.5%-5%. The currency also is a strong investment if further credit risk in US markets continues to manifest.

In rate of change terms, US corporations have largely benefitted from FX tailwinds during the first half of 2023 and marginally in Q3 of 2023. Other notable recent tailwinds for equity prices in this data set were 2019 and 2020/ H1 2021. However, USD prices on a year-over-year basis are beginning to stabilize after almost a year of decelerating to the downside.

All else equal (in a vacuum), if the USD prices remain the same through Q1 2024, then FX becomes a headwind in the rate of change terms. Other recent periods with notable FX headwinds were 2018 and 2022. Specifically, there is a large acceleration year over year for the price of USD starting next week even if the actual price of USD does not move at all to the upside.

Earlier in this publication, we were talking about easing base effects, well this is also a great example. The slope of the comparable prices is beginning to go negative, and even if the price of USD remains the same or does not fall as fast as last year, then it will be an acceleration in the rate of change terms for the price to the upside.

Why is this important? Lower Sales Revenue from international markets and additional headwind/ cost for USD exchange compared to last year.

Given the favorable conditions for the continued strength of the USD over a longer-term duration, there is potential for this rate of change movement to be magnified to the upside with further increases in USD prices compared to other global currencies.
Deflationary conditions in China and disinflationary/ potential deflationary conditions in Europe impact the pricing power of companies doing business in those markets.
Loss of pricing power is magnified.
→Companies unable to push prices of goods higher or forced to discount
→Sales volumes lower or revenues lower from discount
→Local currency is weaker
→Higher cost of USD exchange in comparison to last year

Conclusion

Conditions in China are deflationary. While there is a long way to go for there to be “deflation” in Europe, given the negative PPI, such deflationary risks are present in the Eurozone.
Consensus forecasts are calling for a large deceleration in US CPI. My view is that inflation either continues to accelerate for the reported month of October or inflation does not fall fast enough for the crowd. There is a higher probability that their forecast will be wrong, which will perpetuate more US bond market volatility. Re-short HYG as a hedge.
There is a favorable setup for owning USD, and cash yields are 4.5%-5%. The currency also is a strong investment if further credit risk in US markets continues to manifest. In the US, negative FX tailwinds from 2023 will turn into negative headwinds during Q1 of 2024.

We cannot ignore the narrowness of performance within the US stock market. The Russell 2000 is -30% since November 2021 and -3.88% year to date. Additionally, the RSP (S&P 500 equal weight index) is down -0.93% year today. By this point, this is not news to most readers and is a popular talking point, but it still matters. Everyone owns the same seven Mega-Cap stocks that are currently considered “the US stock market” by many participants. Concentration risks exist and I have highlighted the FX and international business dynamics. I am not making a case against any company in particular (maybe Apple). What happens if everyone needs to exit through a narrow door at the same time?

The majority of the aforementioned “Mega-Cap Stocks” are still in a bullish trend. Confusing right? If these are owned, ride the winners and consider selling “some” into cash on strength. Keep owning USD and take the +5% cash yield. Do not be short companies whose stock price continues to make higher highs. For most of the Mega-Caps, will need to wait for the “particular point”. Keep hedging the long positions in the equity portfolio through IWM (-3% this past week vs. SPX +1.3%) and HYG (high-yield credit) as credit risk continues to manifest. Short US equities losers into Strength.

Best of Luck,

Aaron David Garfinkel

Resources

Particular Point 2.0

Macro Optics

China PPI (Tradingeconomics.com)

China CPI (Tradingeconomics.com)

Eurozone PPI (Tradingeconomics.com)

Eurozone CPI (Tradingeconomics.com)

Eurozone GDP (Tradingeconomics.com)

Morningstar CPI Forecast

University of Michigan Consumer Reports