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The Reflation Deflation Tussle

The Week Ahead:
A quieter week on the data side. Look to Europe.

Last week was heavy on data with the Fed taking center stage. Housing, inflation, industrial production, and retail spending came in at or slightly below expectations. Producer prices were a little high at 2.2% but some of that is because we’re in the middle of a four-month stretch where oil prices are rising nearly 100% year on year. On Friday, we also had the so-called Quadruple Witching day when four types of options expired. But this happens like clockwork every quarter, so you would think the market prices this sort of stuff in. The upshot of the week was that the Atlanta GDP Now forecast was again revised down to 0.9% growth for the first quarter. The Fed thinks it’s going to be 2.1% for the year and the administration thinks it’s going to be 3%. So there’s that reality/belief gap going on.

Stocks held up well with the S&P 500 hitting another all-time high on Wednesday but giving some of it back by the end of the week. Emerging Markets had another strong week. They're up 12% this year. Germany and Japan, while both below their all-time highs (Japan especially) also had good weeks and are up 10% and 13% this year.

1.     Oh yes, they did: The Fed signaled the latest increase clearly and loudly over the last few months. You know, dropped hints, speeches, dot plots. So, when they announced the 25bp increase, bonds rallied with the 10-Year Treasury yield down 10bp. While the move seemed hawkish, everything else around it was on the dovish side.

  • First, Neel Kashkari, (yes the same one who smashed up a train but is quite a decent Governor at the Minneapolis Fed) dissented…the first dove dissent in almost three years. Keep an eye on him. It’s possible he’s the next Fed Chair.  
  • Second, the infamous (short may they live) dot plots barely moved for 2018, clustering around a 2% Fed Funds rate.
  • Third, no mention of any balance sheet unwind. 
  • Fourth, they revised up economic growth by a whopping 0.1% in 2018. That’s $16bn of growth in a $19 trillion economy. Or one SNAP. Or what Americans spend on ice cream. Anyway, it seems suspiciously accurate and irrelevant.

The big question: is the Fed dovish? The chart says, “Yes”. It shows the change in nominal GDP and the Fed Funds rate. The gap between the two is 2.5% right now. The last two times they were this “easy” the gap was around 3% to 5% but, crucially, for much shorter periods. It doesn't mean that they are about to tighten. It just means we’re in an easy phase and they don't last forever.

2.     Meanwhile, the winner this year: Emerging Markets. Recent articles here and here, remind us that this asset class has less to do with the dollar or relative valuations than 1) sovereign creditworthiness 2) commodity prices and 3) the growth differential between developed and emerging market economies.

On the first, look at the spread between Emerging Markets sovereigns and the U.S. They are falling, so check to that one.

On the second, we’d note the oil price we discussed above but add in copper (+17%), nickel (+13%), steel (+54%) and Iron Ore (+62%). And on the third, we’d point to a) U.S. growth at 2% providing there’s a strong tail wind and a big spike in Q2 through Q3 and b) Emerging Markets, which are still at the 5% plus region. So the first two are done. The third seems to be happening. And across all, we see more optimism than we've seen for years.

3.     Deflation or reflation? As we’ve noted before, the market is hoping on reflation, which is the deregulation, growth, lower taxes trade. That story got a bit of jump last week with the Fed, inflation levels in shelter and housing and the quit rate on the JOLTS report. The deflation forces are a strong dollar, lower oil prices and budget cuts. And the deflation forces got a bit of boost as well last week with two bills.

First, the American Health Care Act, which from a strictly economic point, cuts the deficit by over $300bn over 10 years. In the next two years alone, they would cut government spending by twice the amount the Fed just raised their growth forecast.

Second, the America First budget, which takes off around $30bn in discretionary spending in year one alone (back to those Fed forecasts again) and some pretty fierce cuts of 6% to 18% in Agriculture, Commerce, Education and Health. Put together, these are the only detailed bills we’ve seen from the administration. The talk of huge tax cuts and growth policies has dimmed.

Apparently, both are dead on arrival. But as a Season 7 addict of the Walking Dead, the dead are a menace. 

Bottom Line:
We mentioned the recent low volatility in the U.S. market last week. Well, it’s in Europe as well.


And that’s despite a run of European elections. But Europe looks attractive mainly because it’s coming from such low expectations. Remember, markets have some of their greatest returns when they turn from truly awful to not-as-bad-as-we-feared. Which pretty much sums up ex-UK Europe.


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--Christian Thwaites, Brouwer & Janachowski, LLC

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