Heading into 2011 the overall consensus was to overweight the U.S. versus emerging markets as most emerging markets were undergoing monetary tightening while the U.S. had a second round of quantitative easing still to come. The Fed's often repeated line was interest rates would likely stay low “for an extended period of time.” The argument for overweighting U.S. equities makes sense, but that argument may soon be changing. Emerging market central banks are likely nearing an end to their tightening cycles and global growth appears to be heating up again at the same time rising inflationary pressures in the U.S. may begin to curb its growth.
The Doctors Weigh In—Global Growth is in Fine Shape
Economists are notoriously wrong as they nearly always fail to see a coming recession or a major economic turnaround. One of the chief reasons for this is their tendency to look backwards when projecting forwards. In other words, they look at recent data and project those trends forward and so they fail to see economic turning points. Rather than follow economists forecasts for future trends by looking backwards, investors would be better served at tracking the market by following copper and the S. Korean Kospi Index, two gauges that are said to posses a Ph.D. in economics as they show key reversals well in advance of a recession or ensuing expansion. Looking at these two doctors in gauging overall global health, we see a very positive prognosis.
As seen below, both copper and the Korean Kospi bottomed in 2009, well in advance of the U.S. stock market and signaled the end of the grueling recession that occurred in 2008. Since bottoming more than two years ago, both have remained in strong uptrends with copper prices surging above their 2006-2008 resistance levels near $4/lb. Copper late in 2010 broke out to new highs and has since retested the breakout point and held. Copper is advancing once again and looks set to test its former highs north of $4.50/lb.
Corroborating the message of copper is the Korean Kospi Index which just hit an all-time high this week as it broke above its 2007 highs and February 2011 highs. The breakout by the Kospi is quite significant in terms of gauging global growth given S. Korea is such a cyclical economy where more than 50% of their GDP comes from exports. Perhaps even more important, China, the juggernaut of global growth of the last decade, makes up more than 25% of S. Korean exports and so watching what the S. Korean Equity markets are doing is a good read on overall global health and Chinese growth. A breakout in the Kospi is sending a clear message that global growth is in fine shape and likely reaccelerating.
Source: StockCharts.com, Bloomberg
Confirming the improvement in global growth is my Global Leading Economic Indicator Diffusion Index. The diffusion index measures the percentage of countries whose leading economic indicators are accelerating, with an increase in the diffusion index suggesting global growth is set to accelerate. As seen below, when central banks all over the world began raising interest rates in 2010 to cool inflation and overheating economies, my diffusion index weakened from 100% to 0% by the summer of 2010 and signaled a growth scare well in advance of the U.S. and global markets. However, beginning in the fall of last year one by one leading economic indicators began to turnaround for various countries and my diffusion index has been steadily rising since, indicating we can expect a pickup in global economic growth over the next several months.
Source: Bloomberg
Confirming the improvement in global growth prospects are global equities. Looking at the charts below of foreign stock markets clearly shows global growth is not in any immediate danger of slowing.
Source: StockCharts.com
While Global Growth is Heating Up, U.S. Growth is Likely to Slow
Economic growth globally picked up steam in 2009 after collapsing in 2008, and along with the return of growth was a return of inflation. As mentioned above, to combat overheating economies and rising inflationary pressures, world central banks slowed their monetary growth rates and began raising interest rates which has helped to reign in inflation. The U.S., on the other hand, did not have the same runaway inflation and economic growth rates that foreign countries did and so our economy continued to improve with recent job gains being the most notable improvement. That said, it may now be the U.S.’s turn to combat rising inflationary pressures as the Consumer Price Index (CPI) is likely to jump in the coming months which will slow economic growth.
Inflationary trends lead economic growth trends as it takes time for consumers and businesses to respond to sticker shock. Thus, looking at current inflation levels sheds light on what the economy should look like in the months ahead, and present inflation levels are signaling an economic slowdown in the U.S.. Shown below is the US Headline’s CPI annual inflation rate (red line) shown advanced six months and inverted for directional similarity with the Institute for Supply Management (ISM) average for its manufacturing and non-manufacturing indexes (black line). As you can see below, the pickup in inflation (shown declining in chart) is forecasting lower ISM readings heading into summer, and given the ISM indexes are highly correlated with U.S. annual stock returns the S&P 500 may be stalling out here or at least have difficulty advancing strongly in the coming months.
Source: Bloomberg
While government inflation rates are set to pick up, current rates are much higher and reflect more of what consumers are feeling at the stores and pump. U.S. inflation statistics are essentially bogus as they understate true inflation given all the tinkering government statisticians have done with how it is calculated, which is why following John Williams from ShadowStats who reconstructed the CPI back to its original method or MIT’s Billion Price Project (BBP) are show helpful. ShadowStats is showing U.S. Inflation closer to 10% and MIT’s BBP Index has been surging over the last few months and shows annual inflation accelerating north of 3%.
Source: ShadowStats.com
MIT Billion Price Project
Source: MIT
Not only is headline inflation which includes normal costs of living like food and energy accelerating, but even the Fed’s beloved “Core” CPI that excludes food and energy is set to increase rapidly well into 2012 as inflationary pressures built into the pipeline are finally becoming visible. Shown below is the National Bureau of Independent Business (NFIB) Small Business Pricing Plans Index along side U.S. Core CPI inflation. Trends in the small business community lead Core CPI levels by 15 months and are forecasting a sharp jump in the core inflation rate ahead, which will not give the Fed much cover for another round of quantitative easing (QE) as it had with the launch of QE 2 last November. As I said in a February article (“USD Hits an All-Time Low”), “what the Fed wants the Fed gets.” Back in December Bernanke said that inflation was too low...and now he's going to get his wish. Unfortunately, it is going to come with a price: economic growth.
Source: Bloomberg
Consumer spending plans show an inverse relationship to price which is intuitive. The higher prices are the less consumers can or will buy goods and services and vice versa. Monitoring the rate of change in retail spending can shed some light in terms of gauging when inflationary trends are begining to take their toll on the consumer. Looking at retail spending over the past year does show a decent rate of growth with nearly all categories showing single-digit to high double-digit growth rates (see far right column below). However, looking at shorter growth rates such as six month and three month rates of change (ROC) show a clear deceleration. The middle colored column below is red if the 6-month ROC is below the 12-month ROC, and the left colored column is red if the 3-month ROC is below the rate of the 6-month ROC, and green if higher. As shown below, growth rates in spending have visibly decelerated from the 12-month ROC and likely indicates that higher prices are beginning to hit consumer’s wallets.
Source: Bloomberg
Given consumption is more than 70% of U.S. GDP, tracking retail sales is vitally important. I’ve developed a retail sales diffusion index which measures the percentage of retail categories showing rising annual growth rates. Whenever the smoothed diffusion index dips below 80%, the economy, and thus the stock market, have fallen into trouble. The last two times the diffusion index dipped below 80% was late in 2000 before the 2001 recession, and early 2007, before the late 2007 to mid 2009 recession. While we are still above 80% currently, if inflation picks up as the NFIB Small Business Pricing Plans index suggest, retail sales may really take a hit and usher in a U.S. growth scare not unlike last summer’s, which led to a significant pullback in the markets.
Source: Bloomberg
Only adding insult to injury is the recent decline in the USD. I’ve written frequently on the USD and have made the case that a weak USD poses significant risk to the U.S. economy as highlighted in the articles below:
- Cash is Trash with Bernanke at the Helm (04/01/2011)
- Time for Gold to Shine? USD Breaks 3-Year Trend Line (03/19/2011)
- USD Hits an All-Time Low (02/09/2011)
Rather than rehash the same points made previously, I’ll summarize by saying that a weaker USD leads to rising import inflation which only adds fuel to the inflationary fire that is already heating up.
Investment Implications
With the inflationary pressures already built into the cake, we can expect to see higher inflation rates ahead that will begin to cool economic growth by directly affecting the spending habits of consumers and businesses. Lower economic growth means lower corporate profits which means weaker stock market returns in the U.S. As highlighted at this article’s open, with global growth reaccelerating and U.S. growth likely to slow, foreign equity markets are likely to outperform the U.S. and may provide superior returns. Additionally, with inflation set to heat up this summer we are likely to see rising bond yields and rising commodity prices. Thus, commodity-related exchange traded funds (ETFs) and commodity-producing companies will likely outperform the general stock market, while rising interest rates would mean declining bond prices and so U.S. bonds may be the worst performing asset over the next six months.
