In recent days/weeks we are getting the deflationary scare that I have been writing about for several months. As interest rates move higher and world GDP perceptions move lower, commodities and stocks have no where to go but down. From this scenario, two major questions arise?
1)Beyond valuations going down, will there be a financial shock-some financial institution or country gets into trouble-because of the speed and magnitude of interest rate increases?
2)After a few weeks/months of this "scare" what will the policy responses be from central banks and governments?
W/R to "1'" I say Yes-which will lead to another leg lower in commodities and stocks. W/R to 2, central banks will either drop tapering and/or increase QE programs with the ECB perhaps starting a QE program.
If I am correct on both, stocks will fall, at least 10% from recent highs and after a few months of pain, stocks and commodities will be great buys for the final leg of the bull market that won't end until inflation gets above 5% and is then choked off by much higher interest rates.
Indicators of the deflationary scare and how long it will last are several:
1)TIP hit a low on 6/24 of 108.81
5)10 yr bond minus 10 yr Tip-hit low of 1.91% on 6/24
What has yet to break down is oil-which I expect to get to the low $80s.
As long as "1-7" above continues to trend lower, then deflation is still the dominant econ force. As a consequence, "bad news" is good news visa vie stocks (bonds rallying) is a suckers game because bad news is going to be bad news-sales and earnings are going to still come under pressure. On the other hand, 1-7 have to turn up-sustained-before stocks can move higher based on sales and earnings growth.
One tidbit of "good" news today. A large Chineese steel company shut down today-taking some supply out of the market which has way too much capacity.
This gets to the "theme" that I think is the correct theme to be investing in. Buy into industries where supply will be constrained because of low industry investment in recent years. This insures that once demand improves, the remaining players will have pricing power. For example: MU in the case of D-Ram industry consolidation and minimal investment in new capacity. At some point, NG as industry investment has collapsed-with rig count at 18 year lows. Also, gold/silver now at 3 year lows have the industry slashing capX and new projects, which will limit supply starting in 2014. Some areas of tech, hardware, fiber optics have seen industry consolidation in recent years, should enjoy favorable pricing once demand strengthens.
Coal will be a sector to buy as well, as multi-year low prices and an active EPA close mines and slash industry investment.
Bottom line, buy into industries where investment has been slashed and/or there has been substancial consolidation because coming out the other end-pricing power and unit volume growth will drive those stocks much higher.
Some interesting revisions to GDP posted by the government on 6/26. Of course, the headline was the lower growth from 2.4% to 1.8%. However, to calculate that number a GDP deflator is used to account for increases in prices so the GDP number is a "real" number vs just recording higher prices.
The GDP deflator used by the government was 1.26% very low relative to the CPI's 1st Q annualized increase of 2.1%-also, extremely low vs an independent measure of inflation, the Billion Prices Project-BPP. Their measure of inflation, for the 1st Q was 5.35%. So if the BPP measure of prices increased was used, then GDP would have been negative 2.35%.
Bottom line, it is my view that numbers coming out of the Federal government are being politicized and/or incompetently under reporting inflation among other statistics. Specifically, I don't think the Feds are accounting for the fact that rather than increase prices for consumer goods, companies are just reducing packaging sizes or a defacto price increase.
Investment implications, the economy is much weaker than the official reports and inflation is much higher. Recently, we have seen a big spike in interest rates-that is the shot across the bow. When the economy gets stronger, and that may take awhile, interest rates will jump even more to catch up to the under reported inflation. In the interim, the weak economy will be a poor back drop for sales and earnings growth. Stocks still way over valued.