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#MacroView: Rates, The Dollar & The 2021 Outlook

As we move into the second half of 2021, interest rates and the dollar continue to shape the outlook.
Of course, much of the debate focuses on whether rates and the dollar continue to miss the bigger picture. For example, just recently, Jim Bianco tweeted

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As we move into the second half of 2021, interest rates and the dollar continue to shape the outlook.

Of course, much of the debate focuses on whether rates and the dollar continue to miss the bigger picture. For example, just recently, Jim Bianco tweeted a critical point.

However, while I very much respect his opinion, I am not sure I entirely agree. Such is where the analysis of rates and the dollar suggests a different story.

The Inflation Premise

We previously discussed that inflation might indeed be more transitory given the drivers of increased prices were artificial. (i.e., stimulus, semi-conductor shortages, and pandemic-related shutdowns.) To wit:

“Inflation is and remains an always ‘transient’ factor in the economy. As shown, there is a high correlation between economic growth and inflation. As such, given the economy will quickly return to sub-2% growth over the next 24-months, inflation pressures will also subside.” 

China Yields Deflationary 05-28-21, China, Yields, And The Coming Deflationary Impulse 05-28-21

“Significantly, given the economy is roughly comprised of 70% consumption, sharp spikes in inflation slows consumption (higher prices lead to less quantity), thereby slowing economic growth. Such is particularly when inflation impacts things the bottom 80% of the population, which live paycheck-to-paycheck primarily, consume the most.”

However, another important factor behind inflationary pressures is an individual’s actions. As noted last week by Société Générale’s Albert Edwards:

“Surveys suggest that inflation fears have become investors’ number one concern. But why look at it that way? We could equally say it is investors’ own bullishness on the strength of this economic cycle that is driving prices sharply higher in the most cyclically exposed equity sectors and industrial commodities.”

Bloomberg’s John Authers discussed the same, noting a “reflexivity” to investors’ belief in rising inflation.

“In inflation, as in many other areas of economic life, perceptions can form reality, and that is certainly true of inflation. The University of Michigan monthly survey of consumers’ expectations perennially shows shoppers foreseeing more inflation than will in fact arrive. The important factor here is the direction of travel. If they are more worried about inflation, they will do more to guard against it, which will tend to push up prices.”

Psychological Inflation & China

Such is an important point, as Albert notes:

“When investors pile into commodities as an investment vehicle to benefit from rising inflation, they create substantial upstream cost pressures. Beyond the cascading effect of upstream commodity price pressures, headline CPIs are also quickly impacted as food and energy prices rip higher.”

In other words, investors cause inflation by their actions. However, this is where Albert keys in on another critical driver of inflation.

“In addition to this, the observation by investors that industrial commodity prices are rising only serves to reaffirm their belief about cyclical strength and rising inflation, most especially ‘Dr. Copper.” Many investors see copper as extremely sensitive to economic conditions.

The circular, or as George Soros terms it, ‘reflexive’ nature of financial markets makes them extremely vulnerable to being whipsawed. Yet because of the current extreme momentum, it would take a very heavy weight of evidence to convince this market to reverse direction.

We continue to highlight that commodity prices are at high risk of a major reversal because of the steep downturn in the Chinese Credit Impulse. We have highlighted this before and we are not alone. Julien Bittel of Pictet Asset Management posted the following chart.”

China Yields Deflationary 05-28-21, China, Yields, And The Coming Deflationary Impulse 05-28-21

“When commodity prices do start to fall, expect a major reversal in inflation sentiment. Furthermore, expect momentum to become as self-reinforcing and reflexive on the way down just as it was on the way up.”

As we discussed previously, this is something the bond market already expects.

What Rates Are Saying About Inflation

While investors expect surging inflation, the bond market continues to price in weaker future economic growth. As noted in “No, Bonds Aren’t Over-Valued.”

“The correlation between rates and the economic composite suggests that current expectations of sustained economic expansion and rising inflation are overly optimistic. At current rates, economic growth will likely very quickly return to sub-2% growth by 2022.”

Note: The “economic composite” is a compilation of inflation (CPI), economic growth (GDP), and wages.

China Yields Deflationary 05-28-21, China, Yields, And The Coming Deflationary Impulse 05-28-21

There is a fundamental reason why the bond market is pricing in deflation currently.

“The correlation should be surprising given that lending rates get adjusted to future impacts on capital.

  • Equity investors expect that as economic growth and inflationary pressures increase, the value of their invested capital will increase to compensate for higher costs.
  • Bond investors have a fixed rate of return. Therefore, the fixed return rate is tied to forward expectations. Otherwise, capital is damaged due to inflation and lost opportunity costs. 

As shown, the correlation between rates and the economic composite suggests that current expectations of sustained economic expansion and rising inflation are overly optimistic. At current rates, economic growth will likely very quickly return to sub-2% growth by 2022.”

The Fed Will Push Deflation

The problem for the Federal Reserve is that the fiscal and monetary stimulus imputed into the economy is “dis-inflationary.” 

“Contrary to the conventional wisdom, disinflation is more likely than accelerating inflation. Since prices deflated in the second quarter of 2020, the annual inflation rate will move transitorily higher. Once these base effects are exhausted, cyclical, structural, and monetary considerations suggest that the inflation rate will moderate lower by year end and will undershoot the Fed Reserve’s target of 2%. The inflationary psychosis that has gripped the bond market will fade away in the face of such persistent disinflation.” – Dr. Lacy Hunt

The point here is that while economic growth may be booming momentarily, inflation, which is destructive when not paired with rising wages, will be transient. Given the massive surge in prices for homes, autos, and food, the reversal will cause a substantial disinflationary drag on economic growth.

The most considerable risk is a divergence among Fed policymakers which possibly leads to a policy mistake of tapering too quickly or even hiking rates. 

The majority of the inflation and economic growth pressures are artificial, stemming from the stimulus injections over the last year. However, with those inputs fading as year-over-year comparisons become more challenging, the “deflationary” impact could be more significant than expected.

There is also one other point about the Fed tapering the purchases. As shown in the chart below, rates rise during phases of QE as money rotates from bonds to stocks for the “risk-on” trade. The opposite occurs when they start to taper, suggesting a decline in rates if “taper talk” increases.

China Yields Deflationary 05-28-21, China, Yields, And The Coming Deflationary Impulse 05-28-21

The Story Of The Dollar

While many view the US Dollar as a proxy for economic strength, there is very little correlation between the currency on a short-term basis. However, as shown below, there is a long-term trend of the dollar’s value as compared to economic growth. In other words, the value of the dollar does reflect economic strength over the longer term.

Currently, the U.S. dollar is weakening as the Government is flooding the system with liquidity. Now, the money supply is spiking, but given the relative surge in debt, the injections fail to spur an increase in monetary velocity.

With the US dollar breaking down to the lowest level since 2014 and trading below its 2-year moving average, the risk of the dollar retrenching to “Financial Crisis” lows is not out of the question.

The massive increase in the US budget deficit as a percent of GDP also suggests that “deflationary” pressures weigh both on economic growth and the dollar. As Bryce Coward of Gavekal recently noted:

“The ballooning budget deficit suggests a level of 70 or 80 on the US dollar index over the coming years would not be out of the realm of possibilities. That would equate to a further decline of 11% to 22% from here. If the US dollar drops below $90 such would have fairly large ramifications for equities.”

The Fed May Be Right For The Wrong Reason

With double-digit rates of change in essential items like transportation (going back to work), food, goods and services, and energy, the impact on disposable incomes will come much quicker than expected. If we strip out “housing and healthcare,” which are fixed budget items (mortgage and insurance payments), we see that “household” inflation is pushing 5.86% annualized.

Such is particularly problematic when wages aren’t keeping up with inflation.

Inflation transitory 04-30-21, All Inflation Is Transitory. The Fed Will Be Late Again. 04-30-21

The Fed is probably right. Inflation will be transitory, but for all the wrong reasons.

Conclusion

There is a significant difference between a “recovery” and an “expansion.” One is durable and sustainable; the other is not.

Those expecting a significant surge in inflation will likely be disappointed for the one reason which seems to get mostly overlooked.

“If the economy was growing organically, which would create stronger rates of wage growth and inflation, then there would be no need for zero interest rates, continued monetary interventions by the Federal Reserve, or deficit spending from the Government.”

The obvious problem is that not all “spending” is equal. Pulling forward consumption through stimulus is indeed short-term inflationary but long-term deflationary. Since 1980, there has been a shift in the economy’s fiscal makeup from productive to non-productive investment. 

As we have pointed out previously, you can not overstate the impact of psychology on an economy’s shift to “deflation.” When the prevailing economic mood in a nation changes from optimism to pessimism, participants change. Creditors, debtors, investors, producers, and consumers change their primary orientation from expansion to conservation.

  • Creditors become more conservative and slow their lending.
  • Potential debtors become more conservative and borrow less or not at all.
  • Investors become more conservative, and they commit less money to debt investments.
  • Producers become more conservative and reduce expansion plans.
  • Consumers become more conservative, and save more, and spend less.

As we have been witnessing since the turn of the century, these behaviors reduce the velocity of money. Consequently, the decline in velocity puts downward pressure on prices. Given the massive increases in debt and deficits, the deflationary drag continues to increase as stimulus fades from the system.

Likely, the dollar and rates already figured this out.

The post #MacroView: Rates, The Dollar & The 2021 Outlook appeared first on RIA.

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Baltimore City Responds After Dozens Of Businesses Threaten Not To Pay Taxes

Baltimore City Responds After Dozens Of Businesses Threaten Not To Pay Taxes

This weekend, the Baltimore Police Department (BPD) closed down multiple city streets around the Inner Harbor, in a stretch called "Fells Point," after dozens…

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Baltimore City Responds After Dozens Of Businesses Threaten Not To Pay Taxes

This weekend, the Baltimore Police Department (BPD) closed down multiple city streets around the Inner Harbor, in a stretch called "Fells Point," after dozens of local businesses threatened the new city government, run by Mayor Brandon Scott, to not pay taxes because they're "fed up and frustrated" with the outburst of violence. 

Last week, 37 restaurants and small businesses sent a letter to the mayor's office titled "Letter to City Leaders From Fells Point Business Leaders." They threatened to stop paying city taxes and other fees until "basic and essential municipal services are restored." This comes as Madam State's Attorney Marilyn Mosby halted petty crimes during the pandemic and made such a measure permanent - the idea was to decrease violent crime, but that seems to have severely backfired.

What's happened in the historic bar strict is absolute mayhem at night, transformed into a dangerous area where violent and rowdy crowds have ruined the once pleasant atmosphere along with multiple shootings. 

So this weekend, BPD closed down streets around Fells Point, which includes parts of Aliceanna, Thames, and Bond streets.

In addition, Maryland State Police will conduct sobriety checkpoints in Fells Point. 

Local news WJZ13's Mike Hellgren tweets a couple of images of the increased police presence across Fells Point.

One of the 37 concerned business owners on the list is Bill Packo, who owns Barley's Backyard and has been operating in Fells Point for three decades. He spoke with WJZ13 about the out of control violence and public drunkenness:

"It's a shame. What they're letting happen to Fells Point is what they let happen in the Inner Harbor, and now it has made its way here," Packo said. "There's alcohol being sold by individuals out there, drugs, and clearly we all know about the shootings that took place last weekend. But there needs to be some control out there. There is none whatsoever."

BPD's mobile police command was spotted outside another shop in the bar district. It looks very dystopic. 

Meanwhile, Scott, who was newly elected, skipped out on the virtual community town hall meeting on Thursday at 7 p.m that was to address the issues in Fells Point. 

Packo called out Scott for not attending the meeting: 

"It's an embarrassment to the city. It's an embarrassment to the mayor no matter what the schedule was," he said.

Again, as we've said before, the chaos in Fells Point comes as the city descends into what could be the most violent period ever. Mosby has halted police officers going after petty crimes that have inadvertently backfired. Another liberal-run town with good intentions in policies not exactly panning out as they thought. 

Local news WMAR2's Eddie Kadhim interviewed a man who summed up the city's response in Fells Point: 

Another man said the violent crime in low-income neighborhoods is just spilling over into the downtown area. 

Tyler Durden Sat, 06/12/2021 - 15:00

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Visualizing The History Of US Inflation Over 100 Years

Visualizing The History Of US Inflation Over 100 Years

Is inflation rising?

The consumer price index (CPI), an index used as a proxy for inflation in consumer prices, offers some answers. In 2020, inflation dropped to 1.4%, the lowest rate..

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Visualizing The History Of US Inflation Over 100 Years

Is inflation rising?

The consumer price index (CPI), an index used as a proxy for inflation in consumer prices, offers some answers. In 2020, inflation dropped to 1.4%, the lowest rate since 2015. By comparison, inflation sits around 5.0% as of June 2021.

Given how the economic shock of COVID-19 depressed prices, rising price levels make sense. However, as Visual Capitalist's Dorothy Neufeld notes, other variables, such as a growing money supply and rising raw materials costs, could factor into rising inflation.

To show current price levels in context, this Markets in a Minute chart from New York Life Investments shows the history of inflation over 100 years.

U.S. Inflation: Early History

Between the founding of the U.S. in 1776 to the year 1914, one thing was for sure - wartime periods were met with high inflation.

At the time, the U.S. operated under a classical Gold Standard regime, with the dollar’s value tied to gold. During the Civil War and World War I, the U.S. went off the Gold Standard in order to print money and finance the war. When this occurred, it triggered inflationary episodes, with prices rising upwards of 20% in 1918.

However, when the government returned to a modified Gold Standard, deflationary periods followed, leading prices to effectively stabilize, on average, leading up to World War II.

The Move to Bretton Woods

Like post-World War I, the Great Depression of the 1930s coincided with deflationary pressures on prices. Due to the rigidity of the monetary system at the time, countries had difficulty increasing money supply to help boost their economy. Many countries exited the Gold Standard during this time, and by 1933 the U.S. abandoned it completely.

A decade later, with the Bretton Woods Agreement in 1944, global currency exchange values pegged to the dollar, while the dollar was pegged to gold. The U.S. held the majority of gold reserves, and the global reserve currency transitioned from the sterling pound to the dollar.

1970’s Regime Change

By 1971, the ability for gold to cover the supply of U.S. dollars in circulation became an increasing concern.

Leading up to this point, a surplus of money supply was created due to military expenses, foreign aid, and others. In response, President Richard Nixon abandoned the Bretton Woods Agreement in 1971 for a floating exchange, known as the “Nixon shock”. Under a floating exchange regime, rates fluctuate based on supply and demand relative to other currencies.

A few years later, oil shocks of 1973 and 1974 led inflation to soar past 12%. By 1979, inflation surged in excess of 13%.

The Volcker Era

In 1979, Federal Reserve Chair Paul Volcker was sworn in, and he introduced stark changes to combat inflation that differed from previous regimes.

Instead of managing inflation through interest rates, which the Federal Reserve had done previously, inflation would be managed through controlling the money supply. If the money supply was limited, this would cause interest rates to increase.

While interest rates jumped to 20% in 1980, by 1983 inflation dropped below 4% as the economy recovered from the recession of 1982, and oil prices rose more moderately. Over the last four decades, inflation levels have remained relatively stable since the measures of the Volcker era were put in place.

Fluctuating Prices Over History

Throughout U.S. history. there have been periods of high inflation.

As the chart below illustrates, at least four distinct periods of high inflation have emerged between 1800 and 2010. The GDP deflator measurement shown accounts for the price change of all of an economy’s goods and services, as opposed to the CPI index which is a fixed basket of goods.

It is measured as GDP Price Deflator = (Nominal GDP ÷ Real GDP) × 100.

According to this measure, inflation hit its highest levels in the 1910s, averaging nearly 8% annually over the decade. Between 1914 and 1918 money supply doubled to finance war efforts, compared to a 25% increase in GDP during this period.

U.S. Inflation: Present Day

As the U.S. economy reopens, consumer demand has strengthened.

Meanwhile, supply bottlenecks, from semiconductor chips to lumber, are causing strains on automotive and tech industries. While this points towards increasing inflation, some suggest that it may be temporary, as prices were depressed in 2020.

At the same time, the Federal Reserve is following an “average inflation targeting” regime, which means that if a previous inflation shortfall occurred in the previous year, it would allow for higher inflationary periods to make up for them. As the last decade has been characterized by low inflation and low interest rates, any prolonged period of inflation will likely have pronounced effects on investors and financial markets.

Tyler Durden Sat, 06/12/2021 - 19:00

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Visualizing The Biggest Companies In The World In 2021

Visualizing The Biggest Companies In The World In 2021

Since the COVID-19 crash, global equity markets have seen a strong recovery. The 100 biggest companies in the world were worth a record-breaking $31.7 trillion as of March 31 2021,…

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Visualizing The Biggest Companies In The World In 2021

Since the COVID-19 crash, global equity markets have seen a strong recovery. The 100 biggest companies in the world were worth a record-breaking $31.7 trillion as of March 31 2021, up 48% year-over-year. As a point of comparison, the combined GDP of the U.S. and China was $35.7 trillion in 2020.

In today’s graphic, Visual Capitalist's Jenna Ross uses PwC data to show the world’s biggest businesses by market capitalization, as well as the countries and sectors they are from.

The Top 100, Ranked

PwC ranked the largest publicly-traded companies by their market capitalization in U.S. dollars. It’s also worth noting that sector classification is based on the FTSE Russell Industry Classification Benchmark, and a company’s location is based on where its headquarters are located.

Within the ranking, there was a wide disparity in value. Apple was worth over $2 trillion, more than 16 times that of Anheuser-Busch (AB InBev), which took the 100th spot at $128 billion.

In total, 59 companies were headquartered in the United States, making up 65% of the top 100’s total market capitalization. China and its regions was the second most common location for company headquarters, with 14 companies on the list.

Risers and Fallers

What are some of the notable changes to the biggest companies in the world compared to last year’s ranking?

Tesla’s market capitalization surged by an eye-watering 565%, temporarily making Elon Musk the richest person in the world. Food delivery platform Meituan and PayPal benefited from growing e-commerce popularity with their market capitalizations growing by 221% and 151% respectively.

Tech companies TSMC and ASML Holdings were also among the top 10 risers, thanks to a shortage of semiconductor chips and growing demand.

On the other end of the scale, Swiss companies Nestlé, Novartis, and Roche Holding were all among the bottom 10 companies by market capitalization growth. China Mobile was the only company to decline with a -12% change. The company was delisted from the New York Stock Exchange as a result of an executive order issued by former president Donald Trump, and recently announced its intention to list on the Shanghai Stock Exchange.

A Sector View

Across the 100 biggest companies in the world, some sectors had higher weightings.

Technology had the highest market capitalization and was also the most common sector, with Big Tech dominating the top 10. Companies in the consumer discretionary, financials, and health care sectors also had a strong representation in the ranking.

Despite having only five companies on the list, the energy sector amounted to almost 10% of the top 100’s market capitalization, mostly due to Saudi Aramco’s whopping valuation.

An Uncertain Recovery

From near market lows on March 31, 2020, all sectors saw increases in their market capitalization. However, top 100 companies in some sectors outperformed their respective industry index, while others did not.

Basic materials and industrials, both cyclical sectors, were high performers in the top 100 and outperformed their respective industry indexes. Technology companies also outperformed, and accounted for $255 billion or 31% of all shareholder distributions by the top 100, far more than any other sector. Apple alone spent $73 billion on share buybacks and $14 billion in dividends in the 2020 calendar year.

On the other hand, the worst-performing sectors in the top 100 were health care, utilities, and energy. While the index performance for health care and utilities was also relatively poor, the wider energy sector performed fairly well.

It’s perhaps not surprising that all sectors saw positive returns since their low levels in March 2020, buoyed by fiscal stimulus and central bank policies. As countries begin to reopen, will the value of the biggest companies in the world continue to climb?

Tyler Durden Sat, 06/12/2021 - 23:00

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