Ah, history! Those who forget its lessons are condemned to repeat it, and those who learn its lessons misapply their knowledge. The inflation experiences of the 1970s have induced us to go down both paths of error in the quarter-century since. Will we be dancing "The Time Warp" again this time?
One of the very many market reactions to
, discussed here last week in the context of petroleum prices, has been speculation that the Federal Reserve will back away from its near-stated path of an increase of 25 basis point in the federal funds rate at its Sept. 20 meeting. The market assumed, not without reason, that such an action would weaken the dollar and increase inflationary pressures by virtue of excess monetary creation.
Let's do some history, and place inflationary expectations in their broader context. The measure used for inflationary expectations (not reported inflation, as in the CPI) will be the difference between nominal yields and TIPS yields. The difference, ignoring the various
options embedded in TIPS
, is a break-even rate of inflation that should make an investor indifferent between holding the two securities.
The history of these break-evens for five-year and 10-year notes over the past six and a half years shows a marked downtrend between April 2000, near the stock market's peak, and November 2001, the aftermath of Sept. 11 -- and a steady uptrend from then until April 2005. The era of rate-cutting is marked for those who wish to make a causal connection between inflation and monetary policy.
If the chart below were a stock, would you buy it? We all are entitled to our opinions, but the picture looks bullish to me. If inflation is once again to be a scourge upon the land -- and those of us who lived through the 1970s cannot regard it otherwise -- what will the implications for the stock market be? The reaction to Katrina so far has been bullish on three counts:
- The notion, arguably misplaced, that rebuilding the Gulf Coast will be a massive stimulus to the economy.
- The notion, arguably inaccurate, that we have seen the highs for both petroleum and natural gas.
- The notion, arguably a triumph of hope over reality, that monetary policy will be relaxed.
Inflation and Stocks
If the last of the three reasons offered above is the most compelling, and the market associates lower interest rates with higher inflation, shouldn't we all be exiting stocks in droves? No: The history of inflation break-evens is that they lead the total return of the
by seven months. This phenomenon is known as monetary illusion for the way people feel better about excess liquidity before realizing its consequences.
If history is to repeat itself, the upturn in inflationary expectations this March in the aftermath of the
corporate bond selloff
, is still affecting the course of stocks today. The downturn in inflationary expectations between March and July would normally put downward pressure on stocks starting later this month -- recall the Sept. 20 FOMC date if you are into numerology -- but this course could be derailed easily given the extraordinary impact of Katrina.
And exceptions do occur: The Federal Reserve's post-9/11 influx of liquidity, marked with a green rectangle, succeeded in producing both an increase in inflationary expectations and a short-lived rally in stocks, but money illusion can take a dying market only so far. Seven months after inflationary expectations peaked, stocks were at or near the bear-market lows.
Inflation, Commodities and Bonds
Money illusion is somewhat understandable for stocks. Prior to the 1970s, common stocks were considered to be inflation hedges; the thinking went that corporate profits would rise along with the general price level. No such illusion ever applied to bonds, though, which makes the next bit of history even more mystifying. After the October 2002 bear-market low, inflation expectations started to rise steadily. Nominal 10-year note yields have remained in a low and tight trading range. Implicit in all this is a steady decline in the real interest rate during a time of strong economic growth. This would be true only if the supply of funds available to buy bonds was increasing faster than the demand for credit, certainly a possibility given the massive Asian central bank bond purchases seen since that time.
Equally interesting is another piece of history: the relationship between inflation expectations and commodity prices as measured by the Dow Jones-AIG index. Prior to October 2002, these two series were unrelated; after that date, inflation expectations tended to lead commodity prices higher in a closely correlated fashion until May of this year. Over the past four months, commodity prices rose much faster than inflation expectations, meaning higher commodity prices were not considered a harbinger of greater inflation.
Which stock groups benefit from rising inflationary expectations, and which are hurt? Let's return to the industry group analysis introduced here in
to answer this question. The table below depicts, by S&P market index, the winners (beta in black) and the losers (beta in red).
The groups hurt include home building, electric utilities, REITs, consumer- and real estate-oriented financials and housing-related consumer products groups such as housewares and specialty retailers, household products, home furnishings and home improvement retail. The theme here is obvious: Higher inflation will do the housing sector, the engine of growth for the past two years, no good. It must be emphasized that this is a
effect, one derived while holding all other factors constant. The massive post-Katrina rebuilding of the Gulf Coast could overwhelm the negative effects of higher inflation on these groups.
Winners are in the basic materials sector and include steel, aluminum, forest products, paper, chemicals, and metals and mining. The energy sector is represented, as are technology groups such as Internet retailers, Internet software and semiconductor equipment. Electrical manufacturing services, firms such as
, are represented in all market indices. Looking for winners, short-term or long-term, if inflation does emerge as a threat is to ignore another lesson of history: You can live with inflation for a while, but not forever. And the cure -- just ask Paul Volcker -- can be as rough as the disease.