Food and energy are the offending variables, this morning’s inflation report for April informed. And what does Mr. Market do with offensive data? Dismiss it, of course.
The top-line consumer price index advanced 0.5% last month, but extracting food and energy from the mix shows consumer prices as unchanged in April, the Labor Department reported. Whether or not such an extraction is enlightened is a topic for another day on Wall Street. In the here and now, there are far more potent issues at hand to celebrate, such as the fact that oil prices remain in retreat again today, a trend that adds weight to the inflation-is-a-tootheless-beast implication suggested by this morning’s core-CPI number.
The bond market was quick to draw that inference. Traders bid up the price of the 10-year Treasury Note due in May 2015, which in turn reduced the yield considerably to is closing of around 4.09% today, the lowest since the middle of February.
Adding to the bullish aura on bonds today was a prediction by fixed-income guru Bill Gross, chief investment officer of Pimco, that the 10-year Treasury yield could fall to as low as 3% over the next three to five years. The reason: scant evidence of mounting inflation pressures.
“If 3% inflation is all we can get from the past 5-years’ asset inflation, it’s hard to believe that we get more from what’s left,” Gross wrote in his latest monthly investment outlook. “The potential to reflate via interest rates is nearly over.” He explains that the combination of globalized free trade and a surplus of cheap labor in Asian markets means that “it will be difficult to generate U.S. inflation higher than our current 3% even if interest rates fall further.”
It’s hard to argue otherwise in light of this morning’s CPI report. “This is telling us that much feared inflationary pressures are moderating,” Anthony Chan, senior economist at JP Morgan Asset Management, tells AP via The Washington Post. “This is very, very encouraging.”
The view that inflation’s threat is receding harks back to the state of mind that prevailed at the Federal Reserve in 2002 and 2003, when deflation was Public Enemy Number One and injecting liquidity into the monetary system was the first, last, and best vaccine against a downward spiral in prices. The strategy of juicing up pricing pressure worked, or at least it seemed to work. Inflation, measured by CPI, moved up convincingly in 2004 and as of last month was advancing at a 3.5% year-over-year rate, which is tied with November’s pace as the fastest since 2001.
Now we’re told that, a la Bill Gross and others, that the engineered inflation of the recent past has run its course. The Fed, in its infinite wisdom, will simply turn a few switches back at the shop and inflation’s moment in the last few years will evaporate on command. What’s more, this great monetary feat may be unfolding as we write. Indeed, the 3.5% advance in the CPI falls to 2.2% after subtracting food and energy from the calculation. What’s more, even that 2.2% is middling based on the last several years.
But before we retire inflation from our list of fears it’s instructive to take a deeper look at April’s CPI report. Note, for example, that while core CPI (ex food and energy) was nonexistent last month, a number of component groups showed lesser signs of repairing just yet to the sleepy world of absolute price stability.
Consider, for example, that food and beverages advanced 0.6% in April, housing was up 0.3%, and medical care rose by 0.2%. Apparel was the sole victim of deflation, falling by 0.6% last month, a trend that’s prevailed often in recent months. But there’s no question that prices generally are rising, or so the details of the CPI report counsel. Whether they’re rising enough to warrant inflation anxiety is open to debate, but prices are rising nonetheless. In fact, Bill Gross himself, along with others, have warned that the government may be underestimating the reported inflation figures.
Meanwhile, Peter Schiff of Euro Pacific Capital, an inflation hawk’s inflation hawk, wasted no time in challenging the veracity’ of today’s unchanged core CPI rate. In a commentary posted on his company’s web site, he argued in his usual stinging tones that inflation is something more than indicated by the core CPI rate lets on, which Schiff labels “pro-forma CPI,” a reference to the discredited methodology for calculating corporate earnings translated into a pricing-metric equivalent. He goes on to throw down the rhetorical gauntlet, predicting that “bond investors foolish enough to believe the ‘core CPI’ propaganda will likely be just as disappointed as stock investors who fell victim to the same scam with pro-forma earnings.”
Nonetheless, the preference for seeing as inflation as yesterday’s worry suddenly finds new popularity. It must be stated too that this optimism is built in no small degree on the house of energy and the expectation that the price rally in oil is now behind us.
But just how wise is it to ignore energy when considering current and future inflation? Indeed, investors have been burned more than a few times in history in expecting oil prices to remain cheap and/or drop sharply. Has something changed to make such optimism any more appetizing for the thinking investor?
In any case, one school of thought advises that we’ve seen oil prices throw their worst at the economy and the damage has been limited. As Ed Yardeni, chief investment strategist of Oak Associates, wrote in a note to clients today, first-quarter S&P 500 earnings rose by 13.1%–the 12th consecutive quarter of double-digit earnings increases for the venerable benchmark.
Still, declaring the energy threat as dead and buried may be premature. As Yardeni acknowledges, oil demand continues to “soar” among emerging economies, including China and India. Five years from now, it’s a safe bet that global demand will be materially higher than it is today. From that assumption follows the perennial, though currently marginalized question, Will supply be able to keep pace?
The answer may not have much to do with identifying the path of least resistance for bonds and stocks in the coming days and weeks, but it has everything to do with devising an informed investment strategy for the years ahead.