Inflation

The current environment will likely persist longer than most expect which will put further downward pressure on profit margins. As margins come under pressure, companies increase leverage to prop up ROE. However, the market wants higher duration, not higher leverage.

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Inflation met or modestly exceeded expectations. The three key drivers for inflation (oil, the Dollar and the Chinese yuan) continued to improve. But we are not rushing to declare victory on disinflation. “Organic” inflation, such as sustained wage inflation, has been very elusive so far.

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Both CPI and PPI surprised to the upside.The three key drivers for inflation (oil, the Dollar and the Chinese yuan) all saw some improvements.  Despite the recent improvements, we are still in no hurry to call the bottom in inflation.  The downturn in the energy and manufacturing industries has wide-reaching effects. Patience and caution are still warranted.

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The U.S. 10-year yield was quite volatile, fluctuating in a 100 bps range between 160 and 260, and ending up a mere 10 bps higher for the year. But it was still better than most other major asset classes which saw all risk and no reward.

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With the recent weakness in oil prices and the renewed strength of the U.S. dollar, we would not be surprised to see weaker headline numbers in the next few months. The expectations of a rate hike might actually end up pushing the rate hike further out. We are now less sanguine about a pick-up in PPI in the rest of the year.

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The smoothed, 26-week rate-of-change in the DJ Corporate Bond Index, a reliable indicator of monetary conditions over many different market and economic cycles, turned negative in mid-June.

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Our current view is the lift-off will be December or later. Assuming inflation will pick up and the Fed hikes the rate by the end of 2015, stocks will perform relatively well, with international stocks a better bet than U.S. stocks.

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The common driver behind the sharp reversal of many recent asset class trends is the unwinding of the ECB QE trade.

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While there’s understandable obsession over the likely level of inflation (especially with the year-over-year CPI dipping below zero in the past two months), equity managers with no interest or skill in inflation forecasting might be better served by monitoring the character of inflation—i.e., whether it was led by changes in consumer or producer prices.

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Inflation and inflation expectations are key inputs to central banks’ policy decision process. Divergent policies have very different impacts on inflation.

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Are U.S. markets for labor and capital actually getting tight?

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The short end of the yield curve sold-off to price in an earlier-than-expected rate hike, while the long end rallied as the prospect of tightening reduced longer-term inflation expectations.

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While our tongue-in-cheek “Correlation Of Everything” measure has retreated from record levels, it remains far above anything seen prior to 2010.

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We expect the 245-250 area, the upper bound of the previous lower range, to be a strong barrier.

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Inflation measures are broadly in line with expectations, and overall inflation pressure is anemic.  We maintain our view that inflation will be a non-factor in the first half of 2014, and it might increase moderately in the second half.  Inflation on the producers’ level is weak, too and the PPI inflation pipeline doesn’t seem to pose any immediate inflationary threat either.

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The “dual mandate,” which means the Fed is paying close attention to both inflation and employment, presents a clear dilemma for the Fed when it comes time to decide on a taper.

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We maintain our view that inflation will be a non-factor for the next six months but will increase moderately in the following six months.

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Overall demand slack, stubbornly low velocity of money, an overall stronger dollar, painfully low labor cost inflation and weakness in commodity prices are strong disinflationary forces.

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Inflation at both consumers’ and producers’ level is still modest. A drawn out government shutdown and debt ceiling debate will hurt the economy, which could further push out the taper timeline.

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