Inflation Regime Change Is the Ugly Duckling of Financial Events

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The Fed is set on a rate-raising trajectory, largely because of burgeoning inflation. Jim Bianco with Bianco Research, who recently held a conference call titled Regime Shifts Are Not Pretty, takes a look at how the transition from a deflationary environment to an inflationary one is throwing a monkey wrench in expectations about the economy.

Perceptual Shift in Play

When it comes to the relationship that interest rates have to risk markets, the perception for a long time was that higher rates are bad for the stock market. This held from the mid-1960s to about 2000, Bianco noted, but since 2000, higher interest rates were generally perceived as good for the stock market.

The reason for this is, between the 1960s and the 1990s, the primary concern was inflation. Whenever interest rates went up, that was a signal that inflation was coming, Bianco stated, and when interest rates went down, there was relief that no inflationary pressure was imminent.

Since 2000, deflation took the lead as the largest concern. Interest rates went down because we were worried that we were in deflation, Bianco noted, hurting stocks. Thus, as interest rates went up, relief set in under the prevailing belief that we weren’t experiencing deflation.

“We're arguing that we're shifting,” Bianco said. “We're returning to an inflationary mindset, and the reason we're pushing 3 percent on the 10-year note and possibly higher is that we're worried that inflation is returning. The response has been that stocks are unchanged on the year despite booming growth and spectacular earnings.”

Two Narratives at War

The prevailing sentiment that we see in economic surveys is that everything is great, Bianco noted. Despite the strong environment, most aren’t making money in the stock market. This is in part due to the shift to an inflationary mindset, Bianco stated.

Higher rates are a net negative on the economy, he added. The larger negative issue to be concerned about is higher borrowing costs—higher costs of capital—and a general drag on the economy from the increase in interest rates, unless inflation kicks in and justifies the Fed’s stance. It is projecting six rate hikes between now and the end of 2019.

“They better get real inflation if they really want to raise rates that much,” Bianco said. “Because if they don't get inflation and they just erred, then we're going to wind up playing what I've called the oldest story in finance: we're going to invert the yield curve because we've pushed up short rates. Long rates won't rise because there wasn’t any inflation, and that will generally mark a slowdown in the economy.”

Though we’re still months away from an inversion of the yield curve, he added, and the negative effects could take around a year and a half after that point to come to fruition, there’s no sign the Fed is looking to back away from its rate-raising cycle.

Are Things as Good as They’re Going to Get?

Despite an excellent earnings season, the market hasn’t rewarded stocks much. Despite the high beats, the reason for lackluster performance is that investors already priced this in with the big move last year, Bianco stated.

“It’s asking a lot if you're unimpressed by a world record,” he said. “That seems to be what we've done with earnings. … I think it's going to be really hard for earnings to be a positive surprise for this market going forward.”

Other narratives used to play up markets now are similarly 2017 stories, such as relaxation of the regulatory environment, the tax cuts or concerted global growth expectations.

These stories just aren’t playing this year, and though growth in the US is still the strongest, Bianco said, Europe is in a world of hurt and is decelerating much more quickly than most realize.

It does no good to cite these old narratives, Bianco stated, especially if some are in the process of reverting. China is also decelerating, as is the whole emerging market sector. This will eventually impact S&P 500 revenues, Bianco stated, 40 percent of which come from overseas.

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